Law firms seldom pay much attention to their capital structures. This has certainly been the case traditionally. Management of this important area was and still is often delegated to ‘the partner who seems to have the best handle on the financial stuff‘, sometimes the banking partner as he or she works with financial institutions! Given recent experiences via Dewey & le Boeuf and Goldman Sachs this seems like a risky option. Instead, very careful strategic financial advice and planning is required. Far more attention should be given to the strength of firm balance sheets than they received in the past. I asked Cameron Taylor to join Legal Leaders Blog as a guest on this important subject.
Cameron has for the past decade annually analysed, reported on and presented the financial and performance results from Australia’s leading Legal Benchmarking Survey, FMRC, at their large firm meeting. He has 15 years experience in law firm management at a senior level and as a consultant working with international and domestic law firms in Australia on financial strategic issues.
His first comment to me on this was: ‘predicting rain doesn’t count – building a financial ark does!’ He continued:
A 2007 study described Goldman Sachs as one of the truly great professional partnerships, “a global juggernaut with such strengths that it operates with almost no external constraints in virtually any financial market it chooses, on the terms it chooses, on the scale it chooses, when it chooses, and with the partners it chooses”.1
A year later its financial position was so dire its CEO speaking to the U.S. Treasury Secretary said “I’ve never rooted so hard for a competitor (Morgan Stanley), if they go, we’re next!” 2
Two decades of rising profits and few disasters have resulted in law firm balance sheets being a dull subject which is given limited attention by management and boards. This benign neglect of fundamental financial structures, when they are capable of generating infrequent but severe adverse consequences, is dangerous.
CAPITAL STRUCTURE MATTERS FOR LAW FIRMS
It doesn’t matter whether your firm is big or small, your capital structure matters. Undoubtedly, it is a subject of strategic import and it deserves serious attention on a regular and technically thorough basis. Make sure you get good advice and understand it.
Capital structure significantly affects risk and its management is an essential task for firm leaders. The optimal capital structure constantly evolves and law firm leaders must constantly be briefed on, consider and report on at least these five factors:
- the firm’s profitability;
- legal industry dynamics;
- the economy;
- financial market conditions; and
- Government regulation.
When these factors indicate rising business risk, even a previously conservative debt level may be too much for some firms.
Firms should determine if their business is more fragile or precarious than in the past and if the change is cyclical or structural. For instance, if a deterioration is structural, should firms continue using a capital structure which was adopted when they were smaller and less complex operations?
The following factors suggest that there has generally been an erosion of the underlying strength and stability of many professional practice businesses:
- challenging economic conditions;
- rising competitive intensity;
- revenue growth dependent on a war for market share;
- reduced pricing power;
- increasing lateral movements of partners and teams;
- declining financial flexibility formerly provided by partners preparedness/ability to endure periods of diminished or no drawings; and
- long run legal salary cost pressures.
THE EASIEST PERSON TO FOOL IS YOURSELF
Partners may take comfort from the substantial equity capital disclosed on their firm balance sheet. However, looking beyond the raw numbers and the accounting treatment to the economic substance, equity subscribed by a partner financed by a 100% loan to the partner is clearly a highly leveraged proposition.
Searching analysis should recast the financial statement figures to reflect this leveraged position, as well as the reality of possible unrecorded future liabilities, such as retired partner payments and partner income guarantees. Operating profit to interest ratios as well as debt ratios should be calculated, deducting realistic minimum partner salaries.
The time to take action is long before vulnerability rears its head. Steps such as building real equity on balance sheets via profit retention when incomes are rising and the pain is not as noticeable, make a lot of sense. For instance, Australian firm data shows few firms elected during the long period of economic sunshine, to build equity originated liquidity to strengthen their defences for potential future contraction. It seems that most never thought it would happen.
MARGIN OF SAFETY
In July 2011 there was a high speed rail crash in Wenzhou China. In April, 2010, the Chairman of the Japan Central Railway pointed out that China was operating these trains at speeds twenty-five per cent faster than those permitted in Japan. “Pushing it that close to the limit is something we would absolutely never do, he said.” 3 The wisdom of building a culture whereby the firm operates well inside, rather than on the border of safe limits, is surely prudent in a business with high operating leverage.
Real equity capital and a strong balance sheet gives firms staying power in difficult conditions. What worked well in the past does not always work for changed conditions in the future. Management and boards should review how large a margin of safety their capital structure provides based around extreme rather than familiar, comfortable conditions.
If firms build a financial ark they need not be troubled about future conditions. If they do not, they should expect no kindness from financiers if forced to restructure their debt in unfavourable conditions. The folly lies in a firm allowing itself to get into such a position.
- Charles D. Ellis, The Partnership – The Making of Goldman Sachs, (New York: The Penguin Press 2008), p xv
- Henry M. Paulsen, Jr. , On the Brink (New York : Hachette Book Group 2010), p 264
- Japan Rail Chief Hits at Beijing, Financial Times, April 10 2010
Sean Larkan, Partner, Edge International