Profit and Loss

June 23, 2014

Avid readers of the English legal press may recently have seen a lot of agitation about an international law firm, Dentons, and one of the commonly seen measures of law firm financial performance, PEP (profit per equity partner – in the USA, PPP).

The agitation concerned Dentons’ refusal to provide an American legal magazine, American Lawyer, with their PPP figures for all jurisdictions where they operate (this information is public only in some jurisdictions,).  American Lawyer (Am Law) drew some adverse inferences about this refusal, Dentons responded to the effect that Am Law’s articles suggested they could not be trusted with a calculator, and there followed another round of back and forth.  More Am Dram than Am Law, some might say.

PEP is very interesting and relevant if you are, for the year in question, the statistically average partner, because it represents what you earn that year – even in the same firm, however, other partners’ returns may be greater or lower.  It’s also very interesting for the managing partners in the firms concerned because it gives something with which to compare themselves against their rivals, and it provides prurient sources for copy for the legal press.

What PEP doesn’t reveal, in any meaningful way, is how the law firm has really performed in that year, or what its financial health is really like.

It doesn’t give a really accurate index of performance for the year because it is so easily distorted by the number of equity partners in the firm – the same overall profit figure produces a much bigger PEP for a firm with tighter equity than one with more equity partners, even if other figures more indicative of the firm’s performance as a unit – such as expressing profit as a percentage of its overall revenue – favour the second firm.  In the wider business world, there may be many more lines on the financial position of a company than its profit to revenue ratio, but a company with a higher percentage of profit to revenue, all else being equal, is regarded as healthier.

The wider business world – there’s a thought.   Acres of space is devoted to the analysis of the financial performance of companies, some of it on this year’s profit for sure, but also to their balance sheet.  This leads to my second point about PEP’s limitations as a measure of financial performance – it gives no insight into the firm’s long term financial stability, only how it performed in the given year (and with the weaknesses noted above).

In that wider business world, balance sheets speak loudly.  Providers of long term contracts find their potential clients checking their balance sheets, to satisfy themselves that they will be around long enough to perform.  The law firm world has operated in a different medium for decades.  Historically law firms have not had many long term commitments – few long-term contracts and other than property rental, most other commitments were of the sort that turn up on a Monday and can be fired if the work dries up.  There have been exceptions of course – Dewey Leboeuf being the most startling by stacking up long-term commitments to laterally hired partners.  It’s worth noting that in March 2012, they reported their PEP figure for 2011 in excess of £1 million.  By May 2012 they had filed for bankruptcy.  So much for PEP as a measure of their financial health – with the vast majority of each year’s profits paid out to the equity partners, past profit has a limited impact on current financial resilience.

But as the practice of law evolves, the investment needs of law firms are evolving too, and as law firm margins are subjected to pressure from new entrants, different retainer structures, harder-nosed GCs and other factors, firms may find that, like other service providers in other businesses, they have to flex their business models and retain more profit to support their investment and other financial needs for future years.

There’s a role for in-house lawyers in this.  As technology drives increasing intimacy between law firms and key clients, the consequences of law firm failure become more acute.  It will become less simple than paying the work in progress on a file to get it released to a new firm.  So when striking relationships with firms which they see as long term advisers to their employers (as opposed to one-off instructions for short-term deals), they should think about the desired longevity of the relationship and the ability of the law firm to fulfil it. They should look at (or ask for) the law firm’s accounts and scrutinise the balance sheet just as much as this year’s profit.

I started by referring to the UK legal press, and I am going to end by quoting from Legal Week (20 June 2014 – “Dentons vs the legal press: partners react to PEP row”).  The article quotes various leading partners in leading law firms on the use and abuse of PEP.  I was impressed by the reaction of K&L Gates’ Peter Kalis – “… We’ll know that our industry has matured when the leading industry publications begin asking for balance sheet information and other financial indicia…  Such information gets to the heart of a law firm’s financial health, and its public scrutiny can prevent law firm failures.”

Hurrah.  That’s a forward thinking statement.  I think the market will also have matured when the provision of financial information by law firms to prospective clients is seen as a normal process of winning work.  That maturity lies in our hands as clients – we should look at our advisers’ financial statements – if we don’t like what you see or, worse still, don’t see anything, then it may be time to change advisers.  Reading about a law firm’s failure is bad enough, without being involved as a client.

Jonathan Smith, Director LBC Wise Counsel

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