Growth, Lockup and Funding

The recent PWC Law Firms’ Survey 2014 headlines highlight a set of trends that herald a return to the ‘good times’ in the legal market. However, it is worth digging a little deeper and asking to what extent these trends signal good news across the board and, importantly, what those firms outside of the top 100 surveyed by PWC can take from all this.

The survey identifies a number of positive signs for firms in the top brackets – namely that over 70% of firms have reported growth in turnover above inflation; that profit margins have increased for many; and that staff utilisation has increased (essentially driven by fewer people working longer hours – a trend to which there must be an upper bound).

However, below the headlines pricing is a concern, with average rates down, some by 10%. As George Beaton writes, ‘price-down pressure continues – no doubt driven by clients and hyper-competition’. Cyber security is an increasing threat and the war for talent is again hotting up. Mergers do not seem to be producing the expected efficiency gains, although the appetite for mergers remains strong. Could it be that the efficiency gains are not going to the firms, but to the clients in the form of price reductions? This could be the start of “the Race to the Bottom”.

But most concerning of all is that lockup is deteriorating, with firms of all sizes making capital calls and the size of the capital calls increasing. This issue ought to be of particular interest to mid-tier firms because of the extra funding burden it places on the partnership. The assumption is often that growth in turnover will lead to higher profits, and thus to increased drawings.

Minimising the Lockup Cycle

However, this can only happen if the lockup cycle is kept to a minimum. If lockup days get above a certain point (which varies with margins), the growth in turnover leads to such a growth in funding requirements (to fund the increase in WIP) that the increased turnover, even if it creates increased profits, also leads to increased tax bills – which will ultimately impact negatively upon partners’ capacity to draw money out of the business. Indeed, this is driving the increasing trend towards capital calls on partners – the opposite of the expected (and desired) outcome.

Even in the top 100 firms, lockup can vary between 120 and 150 days. We have seen cases where effectively half of the firm’s turnover is ‘locked up’ in WIP and debtors. In this context, it is no wonder that partners are being called upon to inject cash into the business. But by getting a strong handle on the lockup situation, firms can greatly reduce their requirement for funding, whether that be from partners or lenders. This frees up capital for investment and ultimately means that firms can grow without increasing their requirement for additional funds.

The Overtrading Trap

A recent briefing by the SRA added their perspective to that of the accountancy firms. They highlighted that the risk of overtrading  - running a business on insufficient capital, leading to a cash crisis - has now become one of their primary concerns. They are seeing firms of all sizes that have weathered the recession hitting cash flow issues as they struggle to rebuild on their existing capital base.

So, the top firms are growing again, and this is no doubt a reflection of the generally positive news in the economy at large, as well as the booming property market, especially in the South-East. This trend is also likely to be filtering down to many smaller firms, and we are seeing at least anecdotal evidence of this. However, growth in revenue is not without its perils, the most immediate of which is the (failure of) management of lockup and the consequent need for funding.  Surely it is better to tackle the management issues which extend the lockup period unnecessarily, rather than risk the future of the firm.

For firms that succeed in dealing with these issues, the trend towards growth in fee income need not be a false dawn. Indeed, another of the SRA briefing points is that the gap between the successful firms and the rest is steadily widening.

The message is clear – the improving economy can be a boon to well–managed firms. For others it could be a curse.