Law firms and lenders - who calls the tune now?

Many of the conversations that I have had over the past few months indicate that the relationship between banks and firms has fundamentally changed since the beginning of 2008 – particularly in the past eight months. This is not so much because firms have changed; rather, the whole world is a very different place. There are approximately 10,000 law businesses in England and Wales, and my perception is that this change is being experienced by firms at all levels.

As little as 18 months ago, there were many banks active in the law-firm sector, as well as a number of secondary and specialist funders, and the well-established asset finance companies. Funders were crawling all over each other to lend money to firms and every bank seemed to be claiming that it had a ‘specialist’ firms or professional practices unit. The supply of funding was seemingly inexhaustible.

The attractions were understandable. This, after all, is a sector with a track record of very high profitability and negligible losses; so, even with wafer-thin lending margins, this still represented profitable business. What is more, this business was characterised by incredible longevity, due to the inherent conservatism of professional firms. During my time as director of professional practices at Barclays, there were a number of relationships that could be traced back to the 18th century.

The message was clear – if you looked after the customer well, you could count on having the business for a long time. Some individual facilities were akin to long-term annuities: a partner’s capital loan would be provided when a partner entered the equity and was not subject to repayments, being ‘interest-only’ until the partner died, went bankrupt or left the equity. If he/she joined at 30, the loan may be outstanding for 30 or 35 years at a margin (for the biggest firms) of one per cent over base rate. A very thin rate for such long-term lending, but the bank may have to do precisely nothing to look after that facility, just sit and watch the interest come in.

This was all very well, but perhaps a bit dull, being based on simple debt and money transmission operations. Firms have never been great buyers of the sexier swaps, options and other capital-markets derivative products. However, you must add to this the prospect of getting a slice of the firm’s clients’ funds on deposit, which the banks found positively mouth-watering. Not only were these funds available in huge quantities (it was not uncommon for a mid-sized firm to have more than £50m available to deposit), but the income being earned was risk-free and so did not use up valuable balance-sheet capacity. Being a lender to the firm or its partners has often been a pre-requisite for the bank to get at least some of the deposits.

This was a classic buyer’s market. The banking business of firms was in great demand and they knew it. Not only were margins driven down to unheard of levels (some banks were even funding partner capital at 0.7 per cent per annum), security was very rarely sought, and the terms and conditions of lending were very loose indeed.

But then the world changed. In particular, balance sheets, perceptions of risk and a mix of things on which banks could safely make money changed. Essentially, balance sheets were wiped out overnight by the sudden realisation that the sub-prime fiasco (which itself had been burning on a long fuse) had cross-infected the whole international banking system, and no bank could accurately assess the extent of their exposure. Those balance sheets, for those banks that have survived in one form or another, have been expensively rebuilt, and it seems certain that many will need continual rebuilding for some time to come.

Balance sheet capacity, the raw material for lenders which was, until recently, in such abundant supply, has now been severely curtailed. Not only have some lenders simply withdrawn from the market (namely, many foreign banks, making up 25 per cent of the UK capacity in 2007, have retired to lick their domestic wounds), but those that remain active have a more conservative view on the extent to which they will gear-up their balance sheets. If the banks don’t feel that way, they have newly-aggressive regulators sitting on their shoulders, and you can bet the regime is going to get tougher. If balance sheets have become much more precious, then simple economics dictates that they are sold much more dearly.

On a micro level, the individual risks in the legal sector are now being viewed in a less sanguine manner. The banks’ attitude to the lending part of the relationship has shifted, even if they all proclaim that they are still open for business. Firms, especially larger ones, are still viewed positively by comparison to other sectors (property, retail and so on). Unfortunately, that sense of invincibility has gone. I’ve always had a feeling that UK firms don’t go spectacularly bust, they just fade away or get merged out of existence – now I am not so sure. There are some fairly heavily indebted firms out there, and for some their new business is falling away rapidly. Many firms have now converted to LLP, so in those cases the partners do not stand to lose everything, which means there is less to stop them walking away. Banks, on the other hand, have more to lose with LLPs (and there is an old banker’s adage that your earliest loss is your lowest loss), so they may be tempted to take pre-emptive action where previously they would have relied on the partners to dig the firm out of its hole.

With the recession starting to really bite, on top of the forced retrenchment of the financial services industry (which has been the principal driver of the huge growth in fees and profits in the legal market), there have been some dire predictions about the likely consequences for firms. Six months ago, one senior banker said to me that of the 10,000 or so law businesses in England and Wales, fewer than 8,000 are expected to survive. I saw him recently and the prediction remains. Whether this turns out to be fantasy or fact, it does demonstrate the nervousness that lenders feel, and this is something that will be felt keenly by firms. Older bankers may have been around the block a few times, but there is a feeling that they haven’t seen anything quite like this. Inevitably, they are now on the defensive.

Whatever the number of firms that come through the recession, there will certainly be many fewer practising lawyers, given the continuing attrition we are witnessing in firms of all sizes and at all levels from trainee to partner. This affects the banking relationship, because up to now bankers have always been happy to lend to the partners on very easy terms in order for them to put capital into the firm. This gave the bank two levels of comfort: first, the firm – but if that goes down taking its capital with it, then second, the partner’s personal covenant was likely to be good because he/she could always get another job elsewhere. This view is looking increasingly shaky and is reflected in the very different terms on which partners can now borrow to subscribe capital.

However, banks are still just as eager (more so, perhaps) to foster relationships with firms that hold substantial clients funds on deposit: not surprising, bearing in mind the strains on the banks’ own funding positions. This is one of the few bargaining chips that firms possess in a market that has changed 180 degrees, from buyer’s market to supplier’s market. Although banks are still open for business, the deal has changed. Even the largest and strongest firms can expect a level of due diligence and ongoing scrutiny that would have been seen as intrusive and unacceptable previously. This may not be a bad thing, and can perhaps be seen as equally good discipline for both banks and firms – but don’t expect to feel comfortable.

Regulatory capital (lending capacity) is a scare resource and a whole lot more valuable than it was. It is now being sold for a much higher price, sometimes up to four times the previous margin, and it is being protected much more diligently than before. Overdrafts have always been ‘on demand’ facilities, and many firms are nervous about the fact that they are essentially uncommitted, so they are seeking to place a greater proportion of their debt on a committed basis. However, medium-term loans and other committed facilities are being documented much more strongly in the banks’ favour – the days of ‘covenant-lite’ are a thing of the past. Undrawn commitments (which, nevertheless, tie up capital) are becoming much more expensive. Security, by way of debentures or partner guarantees, is being routinely sought, whereas not so long ago such things were almost unheard of. The banks will also prefer to lend to partners for subscription of capital, especially if capitalisation is regarded as thin; but, bearing in mind the perceived weakening of the partner’s covenant, he/she may be asked to provide tangible security to back it up.

Chart one, which applies to mid-sized firms in the top 100, shows some examples of how things have changed. First, medium-term funding is only available up to five years, and the reality is that many firms have difficulty in agreeing facilities beyond three years. In 2007, it was not uncommon for firms to gain access to funds for seven or even ten years. Also, for any given term, the interest margin today is up to four times what it was before the credit crunch.

The restrictions on term are even more dramatic in respect of partners’ capital loans: if, previously, a partner could borrow for an indefinite period but, potentially, thirty years or more at a margin of one per cent (or less), that same partner can now probably only borrow over two or three years, annually renewable, at a margin of three to four per cent.

As chart two shows, fees have also shot up. Not long ago, a managing partner would have laughed if the bank had asked for a front-end fee (aka facility fee, negotiation fee or renewal fee) and would have threatened to take his/her business elsewhere. It may stick in the throat somewhat, but this is just the reality of the changed relationship and the banks need to make profits in a different (traditional?) way.

Many firms are now rather less trusting of the banks, and would dearly like to reduce their reliance on them. This can be rather problematic for several reasons.

First, after 13 years of fairly uninterrupted growth, most firms are actually undercapitalised. As fees have risen, profits have gone up and been paid out, and the risks of doing business have seemed minimal: fixed capital has not kept pace with the increasing size of the firms. Now, at a time of heightened risk, there needs to be a re-balancing, which means that many firms actually need the bank more (or the partners do).

Second, with the pressures of the recession, lock-up for most firms is increasing because clients are taking longer to pay and bad debts are also going up. Overdrafts are now being pushed much closer to their limits.

Third, declining fee income coincides with paying tax from the previous, more profitable year, and these funds have not always been put aside.

Firms must accept, I believe, that the relationship has changed, and do what they can to make it as workable and cordial as possible. If a firm feels over reliant, then it must do what it can to lessen that reliance, which in most cases will have an overall benefit in that this is likely to stem from good management.

Generally, I would expect the banks that know and understand firms to remain supportive and constructive. I won’t give you chapter and verse on how to get the best out of your bank these days, but here are a few suggestions:

Have a convincing strategy for the short/medium/longer term – in a riskier world a bank takes comfort if its customer shows it knows where it is going and how to get there. Banks like to feel that the leadership is in control of the business and is backed by an equity group that is committed, united and disciplined. It is not unreasonable, perhaps, to expect banks to understand that professional partnerships are very different from most corporate commercial structures: but you should not rely on it. Nowadays, every lending decision probably goes through several committees and the danger is that some key individual may feel uneasy if important decisions are blocked or delayed because a 75 per cent majority cannot be achieved.
Demonstrating strong financial management is critical: control of costs, better than average (or, at least, visibly improving) lock-up, financial information produced on time and accuracy of cash/profit projections all score points with nervous bankers.
Invest in the relationship: allow the bank to feel it is a trusted insider, not just any supplier. Be up-front and honest, especially with unwelcome news: communicate early, regularly and often, and ensure there are no unpleasant surprises. Do what you can to understand the hierarchy within which your relationship manager is working – he/she is probably working under extreme pressure. Develop relationships where possible above and beyond your relationship manager (for example, credit manager and senior executives).

In my view, it is worth making the effort: being in conflict with the bank is incredibly wearing and distracting, and in most cases it is perfectly avoidable. Ensuring the relationship is healthy is entirely in your firm’s own interest.

William Arthur is a senior adviser at KermaPartners. He can be contacted at william.arthur@kermapartners.com