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CASH DASH The Magic Circle has never felt such pressure to manage revenues more efficiently. What’s happened to the invincibility of the UK’s largest law firms? The bottom line is cashflow JAMES BAXTER
THE WORLD’S LARGEST LAW FIRM IS feeling pressure like never before. Its feted collection of London partners is testing the resolve of a management that must improve global revenue generation on a daily basis. You can see the strain on managing partner Peter Cornell’s face. Elected on a ticket of bringing a voice to the partnership, and seen as one of the more consensual leaders, he’s now one of the toughest nuts in the firm. With Clifford Chance posting, by its own high standards, some of the worst financial figures in memory, nothing is sacred any more. ‘The Clifford Chance lockstep could not sustain any further drop in profitability,’ admits Cornell. His brutal honesty is hard to avoid for a firm that has posted such poor 2004 figures. But Cornell, who some would say is in a corner, is also in fighting mode. Battered by peers and press over the string of top-level partner departures, Cornell’s choice is stark – preside over a firm where costs keep rising, profits slipping and partners leaving, or take drastic action, now. Unsurprisingly, he’s chosen the latter route. Strong words are just the start of it. Here, Legal Business examines the nitty-gritty cash problems he and his peer-group UK law firms have to master, from tax hits to debtor days and a simple inability to bill as much on a deal as US rivals manage to achieve.
Talking heads Up against a resurgent domestic mid-tier and the increasing profitability of its Wall Street rivals, the UK’s global elite is facing its toughest test yet. With profits stagnant or slipping within the UK’s global elite firms, and no clear sign of the big-ticket transactional work picking up to 2000 levels, the
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> UK’s top firms are running out of ways to justify some cost bases that spiralled during the boom years. When the going got tough, the quality of financial management, for some, left a lot to be desired. A refusal to effectively tackle staff levels and salary costs earlier in the downturn was the elite UK firms’ biggest mistake. Linklaters is the most prominent exception. The firm, which uniquely saw its turnover hold firm at £720m this year, was one of few to admit to taking action to manage staffing levels, when it engineered a 21% attrition rate for partners, lawyers and support staff from 2002.
shifts in levels of business in one office or country, but within that constraint we do need to manage staffing levels very carefully.’ The firm said it has no single attrition target, other than to end duplication of roles across its global network and substantially increase the individual profitability of those who remain. Cornell hopes this will combine with expected annual efficiency savings of around £3m. The new global practice management
‘US firms are about being a business, UK firms are about being a partnership. The profit differential is inevitable.’ Charles Fuller, Latham & Watkins
Linklaters managing partner Tony Angel notes: ‘At the beginning of the downturn we had just done our first merger, and we have invested tens of millions into European expansion and integration in the three years since. With transactional levels falling, you simply cannot do this unless your attrition, duplication and headcount are firmly under control.’ The firm’s stance puts its projected attrition rate on a par with its more aggressive Wall Street rivals such as Skadden, Arps, Slate Meagher & Flom, and a world apart from the 10%-15% turnover rate common among its UK peers such as CC. It’s not popular, it causes a stir, but it works. Clifford Chance’s lawyers should be on high alert.
Cornell’s profit pledge Clifford Chance’s average equity partner profits fell to £558,000 this year. It is no coincidence that the firm’s management has now finally resolved to make staff utilisation a central plank of its three-year profit recovery strategy. ‘When you’re part of a global firm like CC you are obviously more vulnerable to market fluctuations,’ Cornell says. ‘The partnership culture will not allow us to hire and fire according to short-term
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system and integrated business development structure will help. Complete intolerance of non-star performers will do so even more. Cornell’s in a fearsome mood – his highly aggressive cost reduction plan is aimed at heaving profits to a staggering £1.2m at plateau level by 2007. If all goes to his optimistic plan, profits will increase to £8,000 per unit next year, £10,000 in 2006 and £12,000 the following year. This equates to PEP doubling from £562,000 to £1.07m in less than three years. Currently, the figure per unit is £6,300. A firstyear equity partner at CC is given 40 units, rising to 100 at plateau level nine years later. ‘We achieved a major increase in profitability over just two years in the late 1990s,’ Cornell says. ‘Our feeling is that we can do this again.’ That Clifford Chance should have made its move going into the downturn and not coming
out is an obvious criticism. As Giles Pugh, director of Hildebrandt International, notes: ‘The Magic Circle has become a lot more rigorous in the way they manage staffing costs, yet many were slower to react going into the downturn than the mid-tier firms. They were chasing a focus on leverage for too long. Essentially, they went long on talent when they should have gone short.’
Continental divides
J)NMagic Circle finance director explains the G F ]5 R Y [H 3 0 I:2 A & vT C j.M E w -kb d m K cgyU u ,p re’sfin alS W oth B issue that so frustrates London management partners embarking on efficiency drives: ‘Our lock-up [work-in progress plus debtor days] in London is around 110 days, which is good. In some European jurisdictions we are getting close to 180.’ The UK’s global elite law firms, meanwhile, were too expensive to compete with the UK mid-tier on the relatively lively flow of domestic corporate consolidation and property development work. At the same time, the recent surge in headline US takeovers highlights the disproportionate cost/benefit endgame of having cracked Europe, but not the States. In the first quarter of 2004, the US had reached its highest three-month deals total – $535.6bn (£288.63bn) – since the heady days of 2000. European M&A, meanwhile, floundered, reaching a combined value of just €136.6bn (£90.1bn). The Royal Bank of Scotland’s CEO Sir Fred Goodwin, whose bank has made a number of major acquisitions in the US, recently said that his acquisition strategy would remain focused upon the US market because it was easier to do deals there than in Europe. From this perspective, it is hard to dispute that the higher profitability of the US leaders is as much about their superior home market as a more ruthless attitude to staff utilisation.
Agreeable disagreement The US model also has high-value litigation as a primary revenue driver – particularly in the securities field. The last place major US corporates want to be is in trouble with either the SEC or state regulators, and they pay to be kept out of trouble. One whiteshoe firm told LB that it makes a net premium of over 40% on this work. From this position, it is hard to see how the top
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English firms will narrow the profit differential that will allow them to make serious inroads into the US market, unless systematic changes are made to the current business models.
Cornell, whose investment in Rogers & Wells brought with it exposure to the securities litigation market, believes that the litigation factor will set his firm
apart. What’s more, combining that with rigorous cost control, hard-line individual partner profitability targets and a better managed focus upon its most lucrative clients, CC hopes to compete with the
FACTS OF LIFE: CASHFLOW However the money is managed, it must first come through the door. As our Global 50 demonstrated last month, and the Legal Business 100 confirms in these pages, the proportionate costs of being a UK and a US law firm have some curious imbalances. For instance, the cost per lawyer (CPL) posted by the Wall Street leaders is surprisingly higher than their Magic Circle counterparts. This is mainly because of the higher salary costs in the competitive New York market, whereas overheads play a greater role in determining UK firm costs. Nonetheless, the figures suggest that arguably the key critical variable influencing PEP is in fact revenue per lawyer (RPL). It is no coincidence that the three US firms in Legal Business’s Global Elite with the lowest RPL – Shearman & Sterling (£426,000), Cleary Gottlieb Steen & Hamilton (£449,000) and Skadden, Arps, Slate, Meagher & Flom (£491,000) – are those with a greater proportion of lawyers outside the US. Remember, though, that these figures are still far higher than the UK firms. Linklaters, for example, has an RPL of £300,000, with Allen & Overy weighing in at just £266,000. Wachtell, Lipton, Rosen & Katz and Cravath, Swaine & Moore, meanwhile, have the highest RPL (and virtually no presence outside the US market). While US hourly rates are lower than the UK on a straight conversion, the much higher RPL indicates that profitability differences are as much about contrasts between the US market structure and attitude to pricing as those of costs management. According to top US securities partners, Wall Street investment banks will bill US corporates around 7% of a transaction’s value to run the deal, compared with around 2.5% in Europe. Spot the margin for difference. US lawyers are clearly in for a far higher share of the spoils, and from a far larger market. Combine this with the greater billable hours targets met by US lawyers and their propensity to join a transaction at its planning stage – and not just in execution – and the profit differential becomes inevitable. Management consultant Alan Hodgart notes: ‘US firms will bill more hours against a job and recover a much higher percentage of cost. I know of two top Wall Street firms that have a net premium most years whereas most UK firms struggle to recover 90%-95%. Hence the US firms get better pricing – that is total cost to client – than can be achieved in Europe.’ Slaughter and May has few lawyers outside the UK and – in support of it – the highest RPL (at £339,000) of the major UK firms. The firm has the best premium pricing practice in the UK, the best corporate client base and is not weighed down by the greater resistance to pricing that occurs in mainland Europe.
Firm
Revenue generation Cost + Profit per lawyer £0
per lawyer
= REVENUE per lawyer
£100k £200k £300k £400k £500k £600k
TOP CITY FIRMS Clifford Chance
£246k
Freshfields Bruckhaus Deringer
£185k
£145k
= £330,000
Linklaters
£205k
£95k
= £300,000
Allen & Overy
£199k
£85k
= £284,000
Lovells
£182k
£104k
= £286,000
Slaughter and May
£190k
Herbert Smith
£158k
Norton Rose
£119k
£77k
= £323,000
= £339,000
£149k
= £233,000
£75k
= £189,000
£70k
VIBRANT UK FIRMS Eversheds
£124k £29k
= £153,000
DLA
£174k
= £218,000
Berwin Leighton Paisner
£198k
Bird & Bird
£157k
£39k
= £196,000
Osborne Clarke
£132k
£55k
= £187,000
Nabarro Nathanson
£132k
£70k
= £202,000
Olswang
£177k
SJ Berwin
£217k
£44k £61k
= £259,000
= £232,000
£55k £104k
= £321,000
US GIANTS Skadden, Arps, Slate, Meagher & Flom
£282k
Latham & Watkins
£200k
Weil, Gotshal & Manges
£223k
Shearman & Sterling
£269k
Davis Polk & Wardwell
£324k
Sullivan & Cromwell
£277k
£297k
= £574,000
Cleary Gottlieb Steen & Hamilton
£264k
£185k
= £449,000
Simpson Thacher & Bartlett
£287k
£209k
= £491,000 = £409,000
£209k £245k £157k £257k
£274k
= £468,000 = £426,000 = £581,000
= £561,000
September 2004 Legal Business 93
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REAPING THE SAVINGS Some of this year’s success stories have been from that oftmaligned sector of the market, the ‘mid-sized’ firms. The more successful firms in this category got their salary cost base under control far earlier in the downturn. It is no coincidence that Osborne Clarke and Berwin Leighton Paisner – which posted profit hikes of 40% and 30% respectively this year – got to grips with assistant attrition and under-performing partners back in 2002. Addleshaw Goddard, meanwhile, has cleared £11.2m of debt since its merger two years ago, and saved £2m by running the entire back office system for the merged firm at the same staffing levels used by Addleshaw Booth & Co prior to the deal. Addleshaws managing partner Mark Jones says: ‘Our support staff measures alone should save us around £4m by next year. We have been systematic about salary costs and overheads, with the result that we are now budgeting for up to 15% profits growth for 2004/05.’ Simon Beswick, managing partner of Osborne Clarke, adds: ‘We had geared up our internal structures for an everexpanding market position. When the market fell we needed to cut our cost base to reflect the reality of life. We are in good shape now, almost directly as a result of getting our cost base right at the beginning of the downturn.’
> white-shoe firms without the need to offer a raft of above-lockstep deals to attract laterals. ‘To take on the top local firms in any jurisdiction you need to be a “go-to” firm,’ Cornell explains. ‘We are already that in New York with our securities litigation practice and we intend to put corporate and finance on a similar level.’ He adds: ‘It’s all about client focus. The US operation is already advising 44 of our top 50 global clients and this will form the platform for significant profit growth.’ Clifford Chance, by rights, should be on the back foot – it lost more than 20 partners from its New York operation alone in the past two years. Middlemen aren’t helping – a partner at one of the New York giants tells Legal Business: ‘The recruiters have pretty much all got a policy of not pushing CC to potential candidates. The fall-out from the past year has not helped it, or any of the other UK firms for that matter.’ This may be unfair: Clifford Chance is a £220m US business; Jones: budgeting for growth
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the other English firms have some way to go. Allen & Overy and Linklaters, the two other most developed Magic Circle firms in New York, have also struggled to attract corporate rainmakers. Linklaters’ Angel notes: ‘We took a top-tier team of litigation partners [from Shearman & Sterling] last year, yet we would concede that the corporate side is a totally different ball game. We have made the decision that it is not worth doing anything in New York unless it is at the very top end of the market. To do this you must have the patience to play the long game.’
Accounting for tax hits Back home, and for UK firms large and small, profitability is further threatened by a oneoff tax hit that may come next year. There remains considerable market confusion over the introduction of the long-trailed rule, enigmatically known as ‘Application note G to FRS5’. But the upshot is that firms must now account for work in progress (WIP) at its billable value – rather than cost. The change could lead to up-front tax bills soaring by tens of millions of pounds at the top end, and even higher proportionate sums for smaller, less well-structured firms. Many leading law firm bankers, however, believe that a tax shake-up could be a blessing in disguise. The common view is that UK accounting methods have restricted the top firms, compared with their US rivals. UK firms account on an accruals basis, whereas the majority of US firms account on a cash basis. With cash accounting, revenues are recognised only when cash is collected and costs are recognised only when they are paid. Accruals accounting recognises revenue when earned, which is often before the cash is collected. Colin Ives, chartered accountant at Smith & Williamson, says: ‘A cash-managed firm is undeniably more responsive. The bestrun UK firms manage their accounts on a cash basis even if they are forced to reckon upon an accruals system.’ While the majority of top firms have introduced tougher cash collection targets regardless of their accounting system, a firm adopting accruals-based accounting will have a billing drive towards the end of the year
Angel: controlling attrition
and therefore end it with maximum debtors and minimum WIP. US firms, meanwhile, will have a monthly billing and year-end cash collection drive, finishing the year with higher WIP and minimum debtors. The US predilection for merit-based remuneration also injects more rigour into the billing process, compared with the UK preference for lockstep pay systems. Skadden’s managing director Earle Yaffa notes: ‘We make cash collection integral to individual partner evaluation and our billing is managed rigorously on a monthly basis.’ One New York-based law firm banker adds: ‘UK firms assume an income that they can’t always get in. With unpaid bills and client pressure on bill reductions more prevalent during the downturn, this has become a serious concern. A cash business is much more responsive to the vagaries of the market and allows the Wall Street firms to spot trouble early on. It also means they can pay out profit directly after closing the books, and not have to borrow or withhold partner draws.’
Bulge bracket billing This view is given weight by PricewaterhouseCoopers’ Financial Management in UK
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Law Firms survey, which found that ‘the impact of quarter-end and year-end billing bulges should not be underestimated’. The survey states that the trend is ‘indicative of a lack of focus on billing during the year (with a consequent impact on investment in clients). The Giles Pugh, Hildebrandt International pressure placed on finance departments by these billing drives can be considerable and proclamations come not a exacerbate the risk of billing errors and minute too soon. The increasing potential disputes’. profit differentials, though, The poll of the UK’s leading firms found suggest that the gap that that nearly one in five of the top 20 had an separates the Magic Circle firms average of more than 90 debtor days. For a from effectively competing with firm with 100 equity partners and billings of their white-shoe rivals in the £100m per annum, carrying debtor days of holy grail of New York, is not – 90 rather than 60 results in an annual despite the best efforts of the funding cost of £4,000 per equity partner. English firms – narrowing. There, in a nutshell, is an achievable manageClifford Chance’s achievement ment target. will be towering should Cornell With bad debt and belated client make his partners deliver on his discounts dragging profits down, many UK promise. Many, however, remain managing partners have been tempted to rehugely sceptical. state last year’s results – if only to make this One London-based US year’s look less depressing. The move towards partner at a UK firm says: ‘The limited liability partnerships will introduce a UK firms need to bin this dream much-needed requirement of transparency to they have of competing with end-of-year accounts – that it’s taking so long the US on profitability. It is is in part due to the unwillingness of some never going to happen. The firms to reveal the efficiency (or otherwise) of their financial infrastructure. But with A&O the first global UK firm to convert to a UK LIFESTYLE CHANGES: LLP (in May this year), the signs are that the BRITS TO YANKS… majority of the UK’s top 50 firms will seek similar status within the next two years. Kathy Greaves, group financial officer at We asked two lawyers who moved from British to A&O, says: ‘Accounting was not an issue in American law firms just how their professional the partners’ decision to convert to an LLP as lives changed as a result. Nick Holt, now a we already used the required accounting principal at consulting firm Global Legal Search, policies under UK GAAP. Other firms using is a former Clifford Chance partner who joined different accounting treatments will have to Weil, Gotshal & Manges in 1996. ‘What US firms swallow a major re-statement of their figures are good at is making you realise that every time when they do eventually convert.’ you spend something that cannot be billed back The transactional slowdown has exposed to the client, then it is your own money you are some sloppy financial management on the parting company with,’ he says. ‘When I was at part of the top firms. Lax attitudes to billing Weil Gotshal there were no corporate credit and debtor days have combined with a cards, no company cars – there was no need.’ hesitant approach to engineering staff Charles Fuller, a Simmons & Simmons partner attrition levels: both damage the Magic who left to join Latham & Watkins in 2003, says: Circle’s standing in the global legal order. ‘US firms are about being a business – every All the evidence now suggests that cost has to be accounted for somewhere along aggressive cost control and more rigorous the line. UK firms, meanwhile, are about being a financial management must now be at the partnership – the profit differential is inevitable.’ top of the agenda. Peter Cornell’s forceful
‘The Magic Circle firms were chasing a focus on leverage for too long. Essentially, they went long on talent when they should have gone short.’
investment banking relationships are too entrenched and there is an absolutely ruthless obsession with the bottom line which the lockstep culture can’t handle.’
Home threat For the first time in recent memory, the UK’s global elite firms are feeling threatened in their home market. While no one is suggesting that the likes of Berwin Leighton Paisner or DLA are going to usurp the elite firms on headline UK transactional work, the closing profits gap suggests that rated Magic Circle partners could be tempted to earn similar amounts at less pressured firms lower down the pecking order or – conversely – substantially more money at one of the newly invigorated US leaders in London. The squeeze, most definitely, is on. Cornell concedes this, yet states: ‘If I am a leading general counsel then I want to know that I am instructing a firm that has the best legal brains and can deliver a quality international service. If a firm can genuinely offer those things, then it will get the business.’ Maybe so – this theory has kept a lot of top partners in very comfortable existences for decades. But in the absence of any transactional boom on the horizon, the Magic Circle doesn’t have much left to play with. The long-overdue bottom line obsession might have come too late to radically alter the figures for 2004/05, but it’s the next generation of clients and partners who will raise most question marks over the coming years. Times are changing. This new financial world order is more brutal, less fun and – as some Magic Circle veterans will shortly find out – doesn’t have space for as many expensive equity partners. Many large UK firms, which for a decade or more have believed themselves to be at the vanguard of global legal growth, are starting to appear somewhat quaint. LB james.baxter@legalease.co.uk
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