Insights

"Leverage matters.  But which levers to pull?"

by Simon Slater, Managing Director, Intelligent Office Consulting Services

My piece in the last edition of Intelligent Times ended on a cautionary note: smaller law firms would need either to keep equity very tight or be highly geared (preferably both) in order to compete with larger more efficient firms and make a profit margin sustainable and generous enough to allow for investment.

This time, I want to focus on the importance of gearing or "leverage" as it is more commonly known. Leverage is not the answer to improving productivity and profitability per se; no, it has to be the right kind of leverage in the right part of the business. And this varies from practice to practice.

Getting the mix right can have a dramatic impact on profitability. Looking at three headline statistics demonstrates this clearly. PwC's Law Firm Survey 2010 contrasts the fortunes of Top 10 firms with those in the Top 51-100 bracket:

Average profit margin: 37%

Average staff costs: 37%

Other overheads (average): 26%

Average profit margin: 23%

Average staff costs: 43%

Other overheads (average): 34%

Very quickly it becomes apparent that in the Top 51-100 firms, total costs outweigh profits by 3.3 - 1, whereas in the Top 10 firms the ratio is just 1.7 - 1.

The reasons for this are numerous. Scale is one obvious advantage. The higher value work that is available to Top 10 firms is another. But other reasons relate to leverage.

Among the Top 25 law firms fee earner to equity partner ratios currently average 5 -1. This has, quite rightly, been an obsession for many law firms over the last fifteen years. What is more interesting now, though, is the fact that among these leading firms the average fee earner to secretary ratio has reached 3.5 -1. Even more dramatic is the fact that this fee earner/secretary ratio has improved by 50% in a single year.

Firms are clearly keen to realise the benefits of better gearing - and of the better working practices and better efficiency - with which it goes hand-in-glove.

Secretarial staff costs are the second highest support service cost (after IT), and so the impact of such an improvement is bound to be marked.

Back on the front line, there is another interesting trend relating to leverage: PwC report that - again among the Top 25 firms - chargeable hours have fallen in all categories of fee earner except for paralegals and legal executives (of which they employ more than ever before), for whom they have increased by 5% during the last year.

This is a break-through. Firms are actively seeking to reduce the "cost of production" of their legal services. The usual response of partners and senior solicitors to recessionary pressures in the past was to protect their own personal billings (sometimes described as "work hogging"). Not now.

Practices are looking long and hard at exactly what resources - "lawyers", secretaries, support staff - are really necessary to the delivery of good quality, good value legal services.

However, such change requires real skill to ensure successful, sustainable implementation.

A great deal of consultation and planning is required to transform working practices and produce the return on investment desired.

If you needed more evidence of the fact that leverage plays a pivotal role in practice economics, then look no further than these statistics:

Average fees per fee earner for a Top 10 firm in 2010 were £345k

Average fees per fee earner for Top 51-100 firms were less than half that figure, at £167k

Average profits per equity partner for a Top 10 firm in 2010 were £917k

Average profits per equity partner for Top 51-100 firms were less than a third of that, at £278k

Put it another way, the Top 10 firm's profits per equity partner are 2.65 times greater than its fees per fee earner, whilst the Top 51-100 firm's profits per equity partner are just 1.65 times greater.

Whichever way the data is cut, the message is unambiguous: leverage matters.

One way in which law firms will seek to achieve better gearing is through merger. According to Winmark, the professional services research consultancy, 81% of UK law firm managing partners and chief operating officers (sample size: 95) believe that mergers are fairly or very likely in 2011.

But some tough commercial decisions lie ahead if such combinations are to be consummated successfully.

Whatever a firm's strategy for growth (or survival), the role of leverage in helping cope with the twin challenges of downward pressure on fees and upward pressure on value is incontrovertible. And the skill required to pull the right levers in the right part of the business should not be underestimated.

It's not all doom and gloom, though. To end on a brighter note, the PwC survey reports that 83% of Top 100 firms are somewhat or very confident about growth in 2011. And the financial press is predicting a 5%-10% rise in the FTSE.

It should be an interesting year. Again!

simon.slater@intelligentofficeuk.com
t: +44 (0) 845 658 9443
f: +44 (0) 845 658 9445
m: +44 (0) 7786 903 530

Download a PDF version of this article

Share this article