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Barry Wilkinson analyses the forces tranforming the legal market and assesses the prospects for independent law firms to maintain their independence.

We have written extensively in recent years about the changes in the market and the impact these have had, and will continue to have, on the business operations of UK law firms. A shifting regulatory environment (and changes to legal aid), ever increasing competition and advances in technology are forcing firms to consider their business model – and we have long argued that the implications of these changes will include consolidation via M&A (and failures), and the further growth of niche or boutique areas.

However, these effects are felt at a more granular level within the firm, and one of the key issues that has been highlighted in a recent article in The Lawyer is the challenging nature of the role of the managing partner.

Lone Working

Being the managing partner of a law firm has never been an easy job, and one of the key areas highlighted by those managing partners interviewed in the article is the solitary nature of the role. Andrew Lilley, of Travers Smith, suggests that ‘for that reason I found it helpful to work with an external coach’. We would of course advocate this, but irrespective of whether external help is sought, it is vital for the managing partner to have trusted advisors he or she can call on for advice and to provide a sounding board.

Moreover, the pressures on the managing (or senior) partner – which certainly have not diminished in recent years and almost certainly include the challenge of maintaining and enhancing profitability in the face of increasing competition and growing pressures on costs – mean that an effective management team is crucial. Firms may, understandably, not move in the direction of an entirely professional management team, but the top job must be supported by a skilled FD or CFO and, depending on the size of the firm, a COO or director of operations, an experienced marketing and business development director, and CIO or equivalent. In smaller firms some of these roles may be combined, but the functions themselves are vital to a successful business.

First Among Equals?

One of the key challenges for the managing partner is how to engage all the partners, who are after all owners of the business, while still being able to take (often unpopular) decisions and steer a course for the firm. Lawyers are by their nature intelligent people who are well capable of arguing their corner, and so gaining constructive input and taking the firm and its people in a certain direction – with or in spite of certain sections of the partnership – are important attributes of a successful managing partner.

Commercial Imperative

Admittedly, certain aspects of the current environment can help in this regard. The financial pressures all firms face mean that managing partners can legitimately feel they have a strong mandate to insist on unpopular, but necessary, disciplines. As Mark Dembovsky, former CEO of Howard Kennedy, argues in the Lawyer article, ‘your partners need to understand the old practices and behaviours, such as waiting a year to be paid or taking on a job without due diligence, are no longer acceptable.’ This is a mantra we have always maintained with our clients and, with the good old days of stable and seemingly ever-increasing profits behind us, it is more relevant than ever.

Nevertheless, some more intransigent partners will continue to behave as they always have, and so the characteristics of a good managing partner – the ability to listen and take decisions, coupled with a thick skin, in many ways remain a similarly constant theme.

A Mixed Blessing

The role of the managing partner is not, and never has been, for the faint-hearted. However, those people with the skills and the support structures described above, as well as the vision and dedication required to articulate and follow a clear strategy, will continue to find it a rewarding position.

And at Wilkinson Read we would of course be delighted to assist in any way we can.

We were first introduced to the ‘client journey’ over 10 years ago by John Niland, of Success 121, and it was a concept that helped us to re-evaluate the performance of our business in a relatively objective way and – importantly – from the perspective of the client. Through a series of questions, each of which relate to a specific stage in the ‘journey’ a client takes from first hearing of the firm, through project sign-off to payment of the final bill, a fairly comprehensive self-assessment is possible.

The three questions that for us highlighted the most burning issues to address, and which resonate most strongly today as we work with law firms on maximising returns on their business development activities, are as follows:

• “We have an effective mechanism for following up people that we meet”
• “When somebody refers another, we undertake to call the prospective client as soon as our mutual contact has obtained permission for that call.”
• “We have a prepared process for producing proposals that includes active participation with the customer.”

The Cost of Missed Opportunities

Our own experience at the time was not dissimilar to the answers we get from law firms when we pose these questions today. Snowed under by the work at hand and unwilling to impose ourselves on prospects who may not want to hear from us, it is all too easy to create opportunities but never follow up. This is, of course, doubly costly because – added to the business we are missing out on – there is the wasted resource and opportunity cost involved in generating those initial conversations.

At a recent conference, a firm of business analysts presented on a client research project in which they had interviewed and surveyed a large number of actual and prospective clients about their experience as they followed the “client journey” from first enquiry through to completed transaction – and probed the reasons for not proceeding if that had been their decision.

The firms in question generally scored highly for general levels of satisfaction and relationships with fee earners, especially compared with benchmark data for a far larger sample of law firms.

However, when it came to follow-up processes, the firms’ scores can only be described as appalling. A significant number of unconverted enquiries resulted.

Following Up on the Follow Up

As a consequence, a number of the departments concerned instigated formal processes for ensuring that every single enquiry and quotation was followed up and tracked – to the point of having a conversation with the prospective client to find out why they had gone elsewhere if they had done so. The result of this systematic attention to follow-up was an increase of up to 30% in the number of instructions taken on, as compared with the period prior to the implementation of this approach.

These lessons may not, of course, apply to every department in every firm. However, research in the US has shown that buyers expect to be involved in a dialogue with suppliers of professional services and not be given a “take it or leave it” option.

The clear conclusion is that, however they choose to go about it, firms must take the issue of follow-up seriously – otherwise opportunities will continue to be missed, and resources will continue to be wasted.

One of the problems we regularly come across working with law firms is the lack of headroom, or buffer, the partners have when it comes to the firm’s cost structure. In balance sheet terms, the late Professor Larry Ribstein summed it up best – law firms behave as ‘thinly capitalised workers’ cooperatives’ – they have very little in retained earnings, which puts huge pressure on partners’ profits when times are difficult.

In terms of the Profit and Loss Account, conventional analysis is misleading. Law firm profit margins are usually quoted before allowing for partner drawings, or allocating a notional salary for the partners. If this taken into account, the Law Management Section (LMS) Survey carried out by the Law Society shows that the profit margin is typically only in the region of 5%.

The LMS survey has highlighted that, in the median firm, fixed costs (most of which can be allocated to people and premises) represent over 90% of the firm’s cost structure. Very few costs in the typical law firm vary in line with activity – which is a good thing when volumes are rising. Simply put, higher income with fixed costs means disproportionate levels of profit. In stable, growing markets, firms can get away with having high fixed costs. In uncertain or contracting markets, being able to respond is essential.

If volume falls, either in the short or the long term, the only areas that can be cut quickly are ‘decision costs’ such as marketing and training. This in itself is likely to produce a vicious cycle of decline, as lack of investment in areas that deliver longer term return leads to falling revenues, which further eats into profit margins.

Turning Fixed Costs into Variable

So the question is, how can fixed costs be turned into variable costs? A limited amount can be done with IT, by using cloud storage and replacing hardware, and procuring software as a service. Similarly, break points can be negotiated and property contracts can be renegotiated as they expire.

However, people costs represent the majority of the fixed costs in a law firm – and so people costs must be made variable, and ideally not be cutting the partners’ drawings. In other industries this would be called sub-contracting, but in the legal world we like to say outsourcing.

Business processes can be outsourced, including secretarial and transcription services, IT, finance, HR, and most non-fee earning functions. This has so far been popular among very small firms who cannot afford the overheads of employing in-house staff, and also with very large firms, where the efficiency savings and the redirection of management time have justified the approach.

Outsourcing the Middle Market

However, many more firms in the middle market can also benefit from business process outsourcing as a way of procuring the requisite expertise without the fixed overhead of in-house staff.

Legal process outsourcing is an exploding market, which has already reached a market size of $1bn and is growing at a compound rate of 85% per year. To date it has largely been exploited by larger firms, but is increasingly becoming available to consortia of smaller firms, and there could be great benefits to be had by exploring this avenue.

In the short term firms can maintain their cash flow through better lock-up management, and this is an approach we would wholeheartedly endorse as a short-term solution to a short-term problem. However, the bottom line is that in the medium term the break-even point simply has to be lowered in order to preserve margins and mitigate the effects of fluctuating volumes of sales.

This means that fixed costs must be reduced, and in many case replaced by variable cost structures. This may be unpopular with many people in the firm, but it is better than the alternative when firms start to struggle to break even.
 

Perhaps the timing was coincidental but the January seminar of APP, the Association of partnership practitioners, was particularly interesting.

The seminar was entitled “managing a professional services firm in distress” and the main speaker was Dermot Power – best-known as the administrator of Halliwells, the Manchester firm which went under not long after declaring a turnover of £80 million and a profit per equity partner of over £500,000.

Falling Demand

Dermot started by saying that the recently published official data suggesting we are in recession only serve to confirm the anecdotal evidence many of us have seen – but then made the key point that in a recession demand for most legal services will fall. Not a good start to the year.
He also indicated that (prior to the new recession) his firm had recently conducted independent business reviews for law firms turning over £30 million, £60 million, and £90 million. So not all of the problems are at the smaller firm end of the market!

One of his key insights was that over the last 20 years Work in Progress has played a major role in changing the funding structure of law firms. Until the 1990s, WIP was not formally recognised in the accounts, and nor was it taken into consideration in lending formulas. Up to 2008 WIP was identified by accountants as a tangible asset, recognised by HMRC and is taxed accordingly and used in lending formulas (by both firms and bankers) to justify increased borrowings.

One of the consequences of the banking crisis and recession that resulted was that it exposed the questionable quality and recoverability of much WIP. It also exposed how little the lenders truly understood the asset against which they were lending. Naturally, this means that lenders are far less keen to lend against WIP.

The conventional view is that firms need to do two things – firstly, to be far more circumspect in their accounting for and valuation of WIP internally; and secondly, if they want the banks to lend, they have to be far more clear in their communication with the bank of how and why the WIP justifies its valuation.

Regular readers will know that we very strongly believe in a third imperative, which is to pay far less attention to the accountancy and far more to the cash flow and the realisation of the WIP. Put simply – turn it into cash as quickly as possible.

A Cultural Shift

As the research for our 2010 report Cash Management for Law Firms identified, to do this successfully requires not just a big stick approach, nor even just systems – but a cultural shift. Fee earners need to be educated in the cash flow imperative and have appropriate cash flow standards (rather than targets), not only established for each work type but rigorously adhered to.

But if we are heading into a recession then firms need to be extra vigilant in adhering to standards. If work is scarce there is a temptation to take on work on unclear or less stringent terms – which will only lead to increases in WIP and worsen cash flow just at the time you need positive cash flow. Fee earners need to appreciate that WIP is essentially a wasting asset and performance measures need to be far more clearly focused on bills collected, rather than bills raised or even worse chargeable hours created.

It 2012 is going to be a difficult year, financial disciplines will be crucial not only in work in progress management, but also in cost management as we see in our blog on Cost Reduction in the New Legal Market.