Feature

posted 23 Apr 2009 in Volume 3 Issue 4

Recession: An opportunity for law firm FDs?

Recessions provide opportunities in unexpected ways. Experienced FDs know that businesses need a balance of entrepreneurial flair and financial discipline to succeed throughout the business cycle. When times are good, and opportunities plentiful, self-discipline can be considered an irritant, not least in law firms where access to funds has been largely unfettered and bloated balance sheets tolerated or even encouraged. But times have changed. The boot is on the banker’s foot, and firms have to respond.

The banks say they are still keen to lend to the legal sector; however, probe a little and a more complex picture emerges. They will lend more to existing well-run customers, effectively at the expense of the rest; and to a banker, ‘well-run’ includes strong financial management.

Once partners begin to understand the new rules, if they want to continue drawings at the current rate, they will have to embrace stronger financial management. It is then up to the FD to take the opportunities, both for themselves and their firms, by managing the recession to advantage in three main stages:

Setup for success (or even survival);
Securing the defence – cash flow, capacity and costs; and,
Seizing the opportunities that emerge.

Law firms are different

There has been a 20‑year bull market in the City and a strong, largely buoyant property market throughout that period. Many firms have done extremely well, as one banker said to me, “despite their management”.

The downside is that many firms are ill-prepared to deal with more difficult times. Whole generations of partners have never had to manage in hard times, and financial management, which is a core skill in almost every other area of commercial life, has been undervalued by firms. Managing Partner Forum’s 2008 Survey indicated that, even in larger firms, 50 per cent of FDs are not on the firm’s board and 70 per cent of partners do not consider the FD to be an equal. Hardly a recipe for motivating the FD – whose job is difficult enough as it is!

Firms have been insulated from the need for stronger financial discipline by a combination of their inherent profitability, the complexities of the partnership/LLP structure and relatively easy access to cash and borrowings. As a consequence, firms have generally got the quality of financial management that they deserve. Those that have accorded the subject and person due respect are far better positioned to emerge successfully through the recession.

A change is coming?

This recession has removed the insulation. Cash is no longer easy to access, bloated balance sheets are now a ‘bad thing’, volumes have reduced and excess capacity removed, but fixed costs built up in the good times mean that profitability is still down. In short, the traditional answers that have worked for years (drum up more work and/or put up prices) won’t work in the current environment.

Politics versus economics

These new circumstances create the ideal opportunity for top calibre finance managers to demonstrate their value to the firms. In many partnerships, politics outweighs economics. Resources are allocated based on the strength and position of the partners involved, rather than on economic performance and financial justification. Departments may become overstaffed, support ratios vary erratically and opportunities for process improvement neglected – particularly when in competition with opportunities for business growth that abounded in the good times.

The by-product of this is that many FDs have seen opportunities for improved efficiency, but been unable to implement them. These may have been politically unpalatable, but are now an economic necessity. Many partners subscribe to financial discipline in theory, but find there are specific reasons why the disciplines should not apply to them, their staff or clients – particularly where payment is concerned. This will not wash with the banker, the FD may have to be the messenger. In a recession, when the consequences of slackness can be severe, economics must take precedence.

Setup for success

Change the way they think, not just what they do

FDs need to take advantage of this situation. Professionalism in the techniques of financial management is a given, but handling partner communication is the differentiator. Many lawyers do not understand the subtleties of accountancy and financial management, but they are intelligent people. They may need to be educated (again) and regularly briefed. They need, now more than ever, to understand the consequences of non-compliance. Once they understand why certain actions are required, they are much more likely to deliver.

This will be time consuming for an already hard-pressed FD, since the communication will not only need to be written, both words and numbers, but time will need to be spent with each of the partners addressing their issues and concerns, of which there will be plenty at the moment.

Change what they do anyway

Structure, systems, people is the old consultant’s mantra. Decision-making needs to be streamlined, and maybe less democratic, and a tight management board needs to be in place – with the FD included!

Establish financial planning/control processes that would be taken as the norm in the corporate sector and ensure that there is accountability in departments and a balanced financial result. Financial management is not solely about the past; it implies far more emphasis on the future, with regularly updated forecasts, and on the commitment to deliver across a range of metrics with a regime of sanctions and rewards.

Measure what matters

Look at the whole of the practice profit pipeline, not just chargeable hours and bills delivered:

Clients ? Instructions ? Legal work ? Billing ? Collection

Much more emphasis needs to be put on new clients and matters, and also on cash generation. Evaluated matter intake gives early warning of future difficulties – a strong ‘no surprises’ rule is useful.

Process changes are needed to ensure that all opportunities to minimise cash exposure and risk are taken throughout the working capital cycle. Attention to the cyclical patterns is important (monthly/quarterly/annually). Billing 25 per cent of turnover in month 12 and then putting them in the top drawer so that they can’t be collected is a real problem, especially if the VAT bill falls in the following month. It is far better to have interim billing and even interim year-ends.

Clearly the first priority is to ensure survival; and in this recession, even established firms cannot take that for granted. Visibility and early warnings are vital, as partners need to understand that the consequences of lax behaviour now are potentially far more severe than ever before.

Cash flow, cash flow, cash flow

The immediate priority in almost every firm is to focus on cash flow and systematically reduce lock-up. Strong systems and processes are needed and responsibility must be clearly allocated with relentless follow up. The appropriate level of lock-up over the firm as a whole is a question of portfolio management and capital structure, but at the departmental/work-type level, ratios do not work as well as standards. For example, the standard lock-up period for a clinical negligence case may be four years. For residential conveyancing (even if measured), it should be less than four months. If improvements are going to be achieved at a departmental level, any lock-up that is over standard should be eliminated. Departmentally the process is:

Set (or agree) standards;
Identify exceptions; and,
Eliminate them.

This will produce results that astonish the uninitiated. Processes will not deliver results, however, if the partners do not buy-in and the partnership culture tolerates maverick behaviour – hence the regime of sanctions/rewards for cash generation as well as other performance.

Capacity and costs

Take action on costs. There are two aspects to cost reduction, particularly in a recession – capacity and efficiency. Few lawyers seem to have grasped the distinction. Most understand that if, for example, volume is down 20 per cent, then resources have to be reduced by 20 per cent in the affected areas; this reduction will be primarily made up of fee-earners and support staff, since staff costs can represent 70 per cent of total expenditure. Many firms seem to believe that this will produce satisfactory results on its own – it won’t.

Capacity reduction is essential and can be achieved very quickly. It will cost money for severance payments, therefore the focus on cash flow needs to be in place to ensure that these payments can be met. In most firms, however, long-term profitability has blunted the focus on efficiency.

Cost management for efficiency

Even simplified activity-based cost management initiatives can identify major savings opportunities in support activities and this will find favour with many partners. Far too many tasks/activities are undertaken that simply do not add value.

The same techniques will also produce results in areas of law that are becoming more commoditised/subject to fixed fees. Politically, this may be harder to achieve, but in the long run, the payoff is probably greater.

Turning fixed costs into variable

One reason why capacity reduction is not in itself sufficient is the existence of substantial fixed costs – not only external payments such as property, IT and professional indemnity insurance, but also the staff costs of small departments – it is hard to reduce costs by 20 per cent in a department of one.

One way of turning fixed costs into variable, which will be demonstrated by activity analysis, is that of outsourcing and of capacity management in respect of support services (and this will also probably improve efficiency). Most firms will want to retain a core support-staff that meets 60-80 per cent of their support requirement. Many, however, may choose to find variable cost top-up opportunities, buying in the resource as and when required. This can apply to most areas of support activity, but particularly transcription. Strategic outsourcing, whereby the whole of a function is outsourced, is also gaining ground, but it is still well behind the commercial sector – although the recession may change that.

Taking advantage of opportunities

Having secured the base, there are likely to be opportunities – not least relative to those firms that do not have the requisite financial management in place.

More work, rather than more clients

In a recession, firms fight especially hard to hold on to their existing client base. Getting new clients will be particularly hard unless competitors mess up, and so focus attention on increasing work from your existing clients by database marketing and cross-selling, assuming the culture change extends to this.

Spend time, not money

The basic principle of selling in a recession is to spend time, of which you have plenty, rather than money, of which you have little. Selling, not marketing, is the name of the game.

Watch weaker competitors

There is bound to be consolidation in the profession and, consequently, merger opportunities – although due diligence takes on an even greater focus because mistakes may be irreversible. Less risky are opportunities to recruit disaffected partners or teams, particularly those in successful areas of law who see their remuneration and prospects held back by their partners in more damaged areas – especially if their firm mistakenly takes the view that pain should be shared around equally. This is sometimes described as ‘fairly’, however, a fair distribution of pain should not affect those who are still highly productive and profitable; otherwise, they may walk.

Not just recruits

There will be opportunities to attract disaffected clients, where the competitors have lost a key fee-earner or reduced their service levels.

Counter-cyclical work types?

Some areas of work are counter-cyclical; in particular, areas such as employment, debt collection and insolvency and, since the UK government seems determined to maintain levels of public expenditure, maybe those clients that deal with the public sector (for example, in construction).

Taking advantage

These opportunities will appear. They will often need a rapid response and they will need funding. To take advantage of them, firms first need to ensure that they have secured their own cash flow and profitability and, if they do not have current facilities, they must be on good terms with their banks – defence before offence.

The financial management disciplines outlined above are not just desirable for their own sake. Strong discipline, commitment, adherence to projections and good financial communication are absolutely necessary to gain the support of the ever more selective bankers.

In summary

The recession will produce major dislocation in the legal market, but it will also produce opportunities both for well-managed firms and their FDs.

Such firms need to show sound financial results and a quality of financial management that will reassure both existing partners and funding providers. This is unlikely to include many of those firms who treat the FD as an inferior, and exclude them from the key decision-making processes.

On the other hand, for those FDs whose technical, managerial and (above all) communication skills are appreciated, the future looks bright, even in a recession, as they cement their position at the heart of firms that are likely to outperform the market.

And by the time this recession is over, the Legal Services Act 2007 may have changed the role of the legal FD still further – but that is another story...

Barry Wilkinson is a partner at Wilkinson Read & Partners. He can be contacted at barry.wilkinson@wilkinsonread.co.uk