Feature

posted 9 Feb 2009 in Volume 3 Issue 3

Opportunities from financial turmoil

As an accountant specialising in advising law firms across the country, readers will not be shocked if I say that the last quarter of 2008 was a depressing time to work in, or to advise, law firms.

In my market sector, I advise firms with 50 partners or less. Looking at the sector as a whole, this size covers around 75 per cent of firms; therefore my client experience is a good straw pole of the issues that exist within the legal market.

I want this article to be positive and point out the opportunities that currently exist for firms – however, as opportunities arise from the challenges, we first need to consider the problems that exist for many firms as we move into 2009.

Severe decline in the property sector

For many firms undertaking both residential and commercial work, this can typically amount to between 35 per cent and 60 per cent of their fee income. It is difficult to know how long the decline in this sector will last, and with the advent of the Legal Services Act (LSA), it is debateable whether this line of work will ever return to high-street firms in the same way.

The decline in this area of work after such a prolonged buoyant market means that for many firms there is a need for restructuring, prompt management decisions and, of course, accurate financial information to make those decisions.

General economic decline

This factor is of great relevance to firms; however, it is not as significant as the property downturn. Balancing declines in commercial work, firms are experiencing increased demand for litigation, employment-related matters and, indeed, matrimonial work particularly in lower asset/income relationships.

Those firms adept at making changes in their business and ensuring a balanced portfolio of income will be well positioned to weather these fluctuations.

Impact of bank base-rates and declined liquidity

The majority of firms significantly subsidise their fee income through interest receipts on client funds.

This income has enabled firms to semi-commoditise domestic conveyance work over the past 20 years. However, there is little costing undertaken to assess the real cost of undertaking conveyance matters when pricing the service to take into account the income from interest receipts as well as any synergy purchases of other legal services across different sectors of the property market.

For many firms, the effects of the swift decline in base rates in late 2008 have not yet been felt, however, they will certainly start to bite in the first quarter of 2009. In addition, the level of client funds held for many firms will be dramatically reduced: the combined effect will materially reduce firms’ interest income and cash flow.

The costing point made above will become more important to firms needing to make financial decisions on whether to compete in the future for business in certain markets.

This type of decision requires much stronger financial knowledge of the business than generally exists in firms: just as a business manufacturing ‘widgets’ needs to know the true cost of production, so will firms need to understand the total cost of delivering services.

Cash flow

Firms exposed to property work in particular are facing the most significant cash flow problems. For many firms, these problems arise from a combination of a slow response to a declining market, poor lock up control and a lack of understanding of how their firms are funded and their funding needs.

Firms are not just exposed to the economic and property downturn, however, and there are further cash flow problems that will cause pressures.

In particular, the income tax payments in January 2009 (and potentially as far ahead as January 2010, depending on accounting year-ends) will be major cash draws for firms. For many, these will be payments on profits from buoyant trading periods. Depending on what tax reserve planning has been made, there will be varying degrees of panic at the level of these payments.

Market liquidity

A further problem for firms will be their sources of finance to weather these conditions. For most, this effectively means the partners themselves and banks. Banks continue to retrench from lending – they are all ‘open for business’, but not necessarily as willing to do business as they once were.

Historically, for most firms, obtaining external finance for working capital has been relatively straightforward. Banks have generally been happy to lend on a proportion of lockup and in a lot of cases have artificially inflated the extent to which this funding is given, relying upon commercial property in the balance sheet or the existence of personal guarantees from partners or members.

There are now significant repercussions for firms from this lending approach:

Liquidity and the economic climate is restricting the extent of funding being provided;
Declining commercial property values further restrict bank finance availability; and, most importantly,
Since credit had been easy to obtain, firms do not have the same degree of control over cash levels that now need to be applied and, just as essentially, they do not know what drives the need for cash in their business.

LSA

All the above issues are economically linked and predominately developed over the past year – these are the relatively ‘easy’ issues that the legal sector faces!

Fundamentally, the LSA still represents the most significant issue that law firms need to address in the medium term – it should not be ignored.

Despite these gloomy comments, there are real opportunities arising from current conditions that well-managed firms should embrace. Some of these opportunities are briefly explored below.

Control of lock up

For the past five to ten years, a significant issue that has developed in firm financial management has been the cash tied up in debtors and unbilled time. The move from a cash to accruals basis for the taxation of unbilled time has accelerated the tax point of this asset, accentuating these problems. The expansion of conditional fee arrangements and the litigation sector as a whole has also highlighted the issues of funding working capital.

Firms’ current need for cash makes it a necessity, rather than an aim, to reduce lock up. Partners and fee-earners are dependent on cash for their monthly drawings and jobs will be better disposed than previously to help to improve cash control procedures.

Using this as an opportunity to put in place good working practices, if continually implemented, should mean the longer term financial control of the business is established.

Key controls in firms that are successful will include:
Debtor and unbilled time targets set by individual fee-earner based on their work type – monitored on at least a monthly basis;
Credit limits for existing and new clients that are notified at the outset and enforced;
Close control by department heads over payment terms;
Partner drawings linked to monthly cash collection within their teams; and,
Weekly cash flow projections and circulation of position to partners and key staff.

Management of capital funding

For many firms, a lack of understanding of how cash is generated and used in their business is a core reason why cash is badly controlled. This means many firms have little appreciation of what external funding they need or indeed what level of capital funding is required from their own partners.

This is the most significant factor that holds firms back in terms of financial development. While firms can implement policies to reduce lock up, if they do not actually understand why they need to reduce lock up and what effect this has on funding then there is an underlying lack of financial control of the business.

I work closely with many firms to help them understand how their business is funded, i.e. what funding they need and how the funding mix will be provided between third parties (for example, bank, HP providers and general creditors) and how the residual funding will be provided by partners. Firms need to have processes like this in place to understand the effect on their business of changes in both the economy and their business model. To react in the modern legal sector, it is essential firms know who finances their business and why.

Management structure – speed of response

Professional firms sell time rather than manufacturing ‘widgets’ and in general are slower to react to changing markets than their ‘company’ counterparts. A significant reason for this is that professional firms deal with people assets that cannot be purchased from Europe in one week and Asia the week after. As a result, rapidly changing their core costs is not something that can, or arguably should, be considered.

What is clear is that there is a marked difference in the management ethos between law firms and ‘widget’ producers in making wider commercial decisions and implementing change. This is the area where opportunity exists.

To compete in the modern legal services market, firms need to consider their management structure, how they make decisions and how this can be achieved while controlling the ‘need’ for partners to be involved in running their business.

Many firms already have management boards providing more effective control – whether these structures are still too cumbersome or expensive to maintain will be seen over the next few years.

The slow proliferation of LLP structures in the market may also provide impetus for a more corporate approach to management of firms which may be driven further by the availability of external investment following the LSA.

There is no single answer to this issue; however, firms that can manage themselves more effectively and react more quickly to markets and consumers are will be more sustainable in the modern legal market.

Partner performance

In many firms, a core issue of financial control is managing profits per partner. If profits are not high enough, firms are in danger of not attracting or retaining key people: if profits are too high, there is the risk of restricting partnership entry to such an extent that the long term succession of the firm is being jeopardised.

In times of economic prosperity, firms tend to carry partners that are not necessarily performing at the required level. Many partnerships would rather avoid the personal difficulties and tensions that addressing these issues can present – a factor that can be seen in partnerships of all sizes no matter how they are controlled.

In a downturn, partners’ patience with underperformance in their peers will diminish. Early action to take out under-performing partners or renegotiate their terms will not only provide greater overall partnership harmony but also improve the financial structure of the firm in the medium term.

Tax planning

By occupational requirement, I give some brief mention to this issue, but I only do so in the context of currently topical issues!

Accounting year-end

Many firms will be experiencing fluctuations in their profitability. Assuming a partnership or LLP structure, this immediately gives rise to swings in partner income-tax liabilities due to the payment on account regime.

Firms should give early consideration to their accounting year-end date to assess whether advance planning could defer income tax payments or accelerate reductions to payments on account. Careful consideration also needs to be given to personal overlap profit positions of partners here as a whole – the full impact of such changes are not always obvious at the outset.

Trading structures

The Pre-Budget Report 2008 has potentially set significant increases in the marginal rates of income tax for higher-earning individuals rising to up to a marginal rate of 61.5 per cent on certain elements of income.

While it is likely that firms will still include a controlling partnership or LLP, it will become increasingly common for there to be subsidiary companies or structures designed to withhold profits to fund capital accounts, repay historic debt or provide future investment capital accounts.

We are currently working with clients to look at such structures for the future as a means of controlling exposure to income tax and see this as a likely natural development moving forward.

Key staff retention

Many firms have faced demoralising rounds of redundancies. Whether these have been swift and abrupt or over a more drawn out period, the key remaining employees will be worried about their positions.

It is important for firms to show that they are being fair in their treatment of staff. When the market improves, it will be essential to retain the skills of key fee-earners. If these fee-earners have seen a firm that is fair to their employees they are more likely to remain loyal than take the opportunity to jump ship at the most inconvenient time for the firm – this should be kept in mind during redundancy negotiations.

It is also important that firms openly acknowledge they will potentially have periods when there is little work for fee-earners to undertake – being open with employees on this issue is important. From a financial control perspective, it does not help a firm if an employee simply time records to look busy, only to find three months later that unbilled time is significantly over-valued and irrecoverable.

Staff development

With surplus fee-earner time available, now is a great opportunity to give projects to fee-earners to help them develop and to illustrate to key people that they are important to your business moving forward.

Projects to consider here may include:

Developing marketing initiatives;
Pitches to potential clients;
Incorporation as an LLP;
Developing a new service offering;
Reviewing cross selling of services to clients within the firm; and,
Undertaking ‘free’ legal reviews to keep in touch with clients.

It is important, however, for time spent on such projects to be monitored and controlled so that the fee-earner does become divorced from the need to time record and monitor personal productivity. It is also essential that the firm has an understanding of the individual’s productivity and performance on a particular task – setting time budgets for such projects at the outset and monitoring results in arrears is essential.

External investment

It is expected that 2009 will see the potential for non-lawyer owners in firms, potentially marking the start of a major change in the way firms are managed and funded.

Not only will this offer a capital raising opportunity for firms to help them plan for the future, but it will also mark the ability for firms to tie in external expertise and commitment in a way that has not previously been possible.

Although this is only the start of the route to potential full third-party ownership of firms, it marks a significant potential change in the culture of law firm management. It will be interesting to see the extent of appetite from both firms themselves and potential investors over the coming year.

In summary

For most firms, weathering the economic downturn will provide great challenges, in particular as result of the reliance of firms on the property sector. While these issues are essential short-term matters that need to be addressed, firms would be advised to not take their eyes off the biggest factor – the changes being presented by the LSA.

In the meantime, there are many opportunities available to help firms face the current problems and build more financially robust firms to address the future.

Andrew Allen is a legal sector partner with Winter Rule Chartered Accountants. He can be contacted at aallen@winterrule.co.uk