Wednesday, 14 July 2010

Understanding the Numbers

Revenue down - bad. PEP up - good! That seems to be the message from the industry as published by The Lawyer (see here). The top 30 firms (as always, measured by revenue) have shown a drop in revenues of nearly £0.5 billion. "Don't worry", would appear to be the message, "PEP has risen".

I know that this has been a theme of mine recently, but let's just see what this means.

Revenues down
This means that clients are spending less. There is a smaller amount of money in the industry. It's not a small sum of money, either. The industry has contracted significantly and so almost the same number of firms (sorry Halliwells) will be chasing a smaller pool of work.

In any other industry this would see prices fall as market power moves to the client and would see businesses doing everything that was required to get their organisation through the difficult times - cost control, improvements in efficiency, increasing or using reserves as required (this is the rainy day that every firm should have been saving for).

Firms have been talking about cost controls - but for most law firms this means firing people. Care needs to be taken, however, since there are significant costs associated with both firing and with hiring staff - redundancy payments, legal fees, lost work time for meetings, poor use of executive time, recruitment charges, "ramp up" costs (as new staff find their feet in a new environment) etc etc. The last time I did a calculation for a law firm, it was cheaper to retain an associate if they were likely to be fired and then someone hired 17 months later. Let me repeat that - it was cheaper for the firm to pay an associate to sit at their desk doing nothing than for the firm to fire them and buy someone else in 17 months later. Never mind the fact that there would be some useful work for them to do - or the PR/HR benefits in being seen to retain staff wherever possible.

I'm not seeing many efficiency improvements. Many firms seem unaware that they have processes never mind looking to see how these could be made more efficient. As for reserves - most law firms seem to think that these are not necessary. I'm am amazed that there is no appetite to smooth out the highs and lows in PEP. Reducing pay outs in the good years would enable a smaller reduction in the bad. May daughter understood this piggy-back mentality when she was ten...

At first glance this seems to be good news - Profit per Equity Partner has gone up. Surely if profit has improved that is a good thing? Yes - except that PEP does not simply measure net profit. PEP is a measure of the net profit that has left the firm. This is the amount of money that the Equity Partners removed from the firm to their own accounts.

Why would firms boast about this? I will never understand why the most favoured measurement of a firm says "look how much we've stripped from the firm!". I don't know of any other industry that makes such a noise about partner or executive payments.

What would be more impressive for the good of the firm would be a measurement of retained profit or a statement of reserves. Why have law firms not been building up reserves to see them through this sort of market? Yes, there are tax advantages in the way things are done now - but this is a very short term view of business.

What is unfortunate is that PEP makes lawyers as a whole and partners in particular look greedy.

Neither revenue nor PEP should be the numbers the industry discusses. Let's look at simple net profit or retained profits or profit per fee earner over five years - or the trend in profit per fee earner or partner over five and ten years. These are useful measurements which focus on the firm rather than on the industry or the personal interests of the partners.


  1. Interesting post Peter.

    But this 'stripping' concept is just as relevant across all industries and government.

    Basically we all got greedy for the simple reason that we could. There is a fundamental society/cultural problem around our obsession with short termism. And now the 'pot of gold' has been emptied we are running around saying"it's not my fault the pot of gold is empty, it's there fault." It is all of our faults.

    I always find it odd when sme's and business say "oh we want more borrowing from banks." Isn't that how we got into this mess? we need to be less lazy and more smart.

    Ultimately though the situation provides an opportunity for the strategic, the innovative, the valley gazers. Those who take a reactive short term view will only put off the pain for now and then wake up too late, unprepared when recovery happens.

    Don't under estimate the chaos of bad (also read no) internal decision making over the coming months and years.

  2. Thanks Jon - interesting thoughts. I agree that most industries and, yes, governments, had the same short-term "spend it now" mentality.

    I was particularly horrified to hear a local MP trying to saving his school building programme by saying "we could just extend the PPP payment terms by 20 years or so and then we can afford it". As you say - exactly the thinking that got us into a mess.

    What is odd about the law is that firms using PEP to essentially boast about how much they are taking from the business. Most other firms and industries at least try to keep it quiet!