PEP talk: beyond the low-hanging fruit

Most of us realise that profit per equity partner (PEP) is a distorted and distorting measure of law firm success. But its use persists.

It is distorted because its underlying metric (net profit) is perversely stated relative to any ‘normal’ business. The accounting treatment of professional partnerships, combined with the taxation of them, encourages a full income extraction approach – that is, all profits are usually taken out as income within as short a period as possible after the financial year to which they relate.   There is usually no allocation of any element of ‘wage’ or employment cost to an equity partner, and no recognition that some element of the distribution of net profit is a return to invested capital and to entrepreneurial risk.  To some extent, therefore, allocations of net profit represent a short-term income distribution of what in other businesses would be longer-term capital growth.  The ‘net profit’ of a professional partnership is accordingly not comparable to that of most other businesses – and so is relatively (and significantly) over-stated.

PEP is distorting because it drives behaviour that seeks to maximise the numerator (net profit) and minimise the denominator (equity partners).  For example, in many firms, the ‘strategy’ recently has been to appoint new partners not as equity partners but as salaried or fixed share partners (or similar variations on that theme).  In the six years to 2010, figures from the annual Legal Business surveys of the top 100 firms show virtually no net growth (just 2%) in the number of equity partners in those firms.  Over the same period, the number of non-equity partners increased by 40%.

As the financial crisis took hold, and law firm revenues began to fall, managing profit by increasing human leverage and fee income was no longer the name of the game.   Attention turned to cost-cutting programmes to reduce expenses in the (often vain) hope of maintaining profit levels.  Unfortunately, law firm profitability is much more sensitive to fluctuations in revenues than it is to variation in expenses.

With costs reduced (usually by trimming back-office and related overheads, and squeezing suppliers), the profit management project turned from maintaining PEP through cost-cutting to PEP engineering through denominator-cutting.  Having stemmed the influx of new equity partners (as described above), attention turned to removing underperforming equity partners.

All well and good, and often long overdue.  But if a firm chooses the wrong partners to cull – that is, those who have a client following (or book of business) – reducing denominators will also result in a loss of revenues, and the net effect might be neutral (or worse) for PEP.  On the other hand, if the removal of partners does not significantly affect fee income, that rather suggests that net profit has been shared with people who were being allowed to take more than their fair share of this mixed return to productivity, investment, entrepreneurialism and capital.  To put it another way, the PEP was distorted by being available to those who were not worth it.  Removing them is not achieving any true saving to the business but is simply restating the firm’s profitability on a fair and proper basis.

So, by this stage in the economic playing out of the financial crisis, the low-hanging fruit has been taken.  Removing surplus costs from the business, along with equity partners who were not making a net contribution to it, simply puts the firm on to its true footing.  These have been tactics that perhaps bought some time – probably in the hope that by now ‘normal’ practice and PEP would have been restored.  To some extent, it might even have worked: the American Lawyer figures for US law firms’ profitability for the calendar year 2010 show some restoration of PEP.  It will be very interesting to see if English law firms’ results for 2010-11 mirror this.

Unfortunately, it’s not looking as though this creates a sound platform for future profitability in the face of continuing flat revenues for law firms, and a cost base that many think has been pared back as far as it can be.  The old ‘normal’ is still not expected to make an appearance any time soon.  If the right costs have been cut, and the right partners removed (or retained), there is no further scope for maintaining or improving PEP by using the same tactics.  Indeed, to do so would run the risk of jeopardising the business since such an approach would imply removing valuable partners and reducing the firm’s resources and support to (or below) a critical level.

So, where next?  Although the tactics have so far addressed both the numerator and denominator of PEP, arguably, they have not really addressed the fundamentals.  The next temptation is usually to redesign the profit-sharing arrangements, normally with some performance-related or bonus element.  In English law firms, the tendency is to pull up short of ‘eat-what-you-kill’ systems.  What is too often missed, however, is that once the firm’s and partners’ performance is properly managed and underperformers removed, the firm’s problem is not its profit-sharing structure but not enough profit to share.  Changing the way in which profits are shared at a time when there is not enough money to go round is inherently dangerous; a lot of babies are thrown out with the bath water.

My conclusion, therefore, is that with no scope for more of the same, and little point in moving the profit-sharing deckchairs, now has to be the time to look at the fundamentals – and that means returning to the numerator.

Future approaches to PEP management must, in my view, be the result of reinventing the firm’s business model.  The elements of that model are: creating meaningful value for clients in the performance of the firm’s services; resourcing the firm to create that value; financing the firm to secure those resources; and generating sufficient returns to the firm’s stakeholders (and I’m assuming here that the ‘right’ equity partners are now in place).  The first two of these are the fundamental issues that need immediate attention, and both are elements that crucially drive net profit.  It is true that these two elements also contribute significantly to the fourth – returns. By challenging management’s thinking about having the ‘right’ resources (including how many equity partners the business really needs), they will have some effect on the denominator, too.  But value creation and resourcing fundamentally drive the generation of net profit rather than the sharing of it.

First, then, the firm’s revenue needs to be grown by concentrating on creating value for clients.  This requires the firm to be close to its clients, to understand what value looks like to them, what represents success in the transaction or resolution, and to demonstrate how the firm can deliver real benefit.  It isnot the same as ‘value added’, which is usually found in the periphery of the relationship rather than at the heart of the professional service itself.  This exploration is also a necessary part of achieving competitive advantage.

Second, the cost base needs to be revisited – or, rather, redesigned.  This is more far-ranging that stripping out surplus overhead, squeezing suppliers and looking at outsourcing.  What’s required is not so much outsourcing as alternative resourcing.  Thinking about the entire configuration and use of the firm’s resources is necessary, including: lawyers and non-lawyers, professionals and support staff, human beings and technology, craft and process, physical and virtual, internal and external.  Using new approaches to case and project management, and integrating the firm’s business process and support functions into a seamless and more cost-efficient infrastructure, are an inevitable part of the redesign.  This might result in legal or business process outsourcing (LPO or BPO); it might mean using cloud technology, paralegals or professional project managers; it might mean off-shoring; it might mean collaboration with suppliers or even competitors to secure otherwise elusive economies of scale.  In short, the result will be a new way of structuring the delivery of legal services which does not merely adjust the firm’s cost base but designs a very different approach to making profit.

Understanding and delivering value creation and new resourcing approaches are still in their infancy in law firms.  But these must be core to the next wave of managing the PEP numerator.  At the same time, the denominator must not be allowed to drift out of kilter again.  Profit is the outcome of the firm’s business activities, but it is an outcome that needs to be managed actively.  If it is, perhaps then PEP can begin to move beyond distortion and then approach some semblance of a meaningful measure of return – at least in a professional partnership.

Of legal aid and lemonade

Legal aid and hard facts

As we wait for the Government’s response to the consultation on its proposals for legal aid, it might be worth reminding ourselves of some salient facts:

(1)  This country cannot afford publicly funded legal advice and representation for all citizens on all legal issues that will face them in their lifetimes: difficult choices therefore have to be made about what falls within the scope of legal aid and what does not.

(2)  The ‘right’ choices about scope need to be made, otherwise there will be vulnerable people without legal advice and representation in circumstances where the common consensus in any decent society would be that it should be available.  The wrong choices could also result in the total bill to society increasing, if the absence of legal advice and representation leads to greater costs to healthcare, housing, unemployment, family breakdown or welfare benefits.  These are policy decisions.

(3)  The Government and other public authorities could bring down the demand for legal aid (even in circumstances where everyone thinks it should be available) by taking steps to ensure that front-line staff perform their duties competently and make the right decisions first time so that claims and appeals against actions and decisions by public servants are reduced.  The public purse might still end up paying, but it’s important that the costs of quality, incentives for good performance, and ‘polluter payment’ for poor performance, are allocated to the proper budgets.

(4)  The legal aid bill will be reduced by around £350 million: except to the extent that any of this reduction is achieved by the reduction of the Legal Services Commission’s administrative costs, of course the turnover of legal aid providers in the aggregate will go down.  It is not the job of the Government, the LSC, regulators or taxpayers to keep law firms in business (or profitable).

The market for lemons

If consumers find it difficult to assess the quality of the service being provided to them, they will only be prepared to pay an average price for the uncertain (and therefore presumed average) service.  Over time, this will cause providers of a high-quality service to leave the market because they will be unable to achieve a fair price for what they offer.  This will, in turn, lead to a further reduction in the average quality of service available.  A 2001 report for the OFT noted that, in this situation, if a firm providing a high-quality service cuts its prices to compete with cheaper rivals, and consumers interpret this as evidence that the firm is now providing lower quality, the firm may even hasten its own demise.

Consumers might, therefore, consciously choose not to instruct high-quality providers because they find it difficult to assess the true quality of what they are being asked to pay for.  Rather than risk being ‘ripped off’, they decide not to pay a higher price (for what might well be better quality) and instead opt for cheaper providers.  This creates a downward spiral of consumers paying cheaper prices to lower-price competitors who stay in the market as higher-quality and higher-priced businesses leave it.  The result of this ‘adverse selection’ leads to a market that has generally reducing quality and price – Akerlof’s (1970) so-called ‘market for lemons’.

A number of reasons have been put forward to support the argument that adverse selection would have little effect in the market for legal services.  Most obviously, all lawyers must meet minimum educational standards, which automatically deselect those without that education from the consumer’s range of choices.  The availability of a forum for complaints from consumers (the Legal Ombudsman) should also have a disciplinary effect on the profession and encourage non-hazardous behaviour, as will the possible use of conditional and damages-based fee arrangements – particularly where the risk is not all borne by the opposing party.

The high level of importance placed on a good reputation for lawyers is also thought to act as a strong tool in reducing adverse selection problems.  In addition, the nature of the legal services market itself solves some of its information asymmetry, in that at least in contentious matters quality issues do not solely concern the practitioner representing a given client, but are comparative to those representing the opposing party and are potentially subject to judicial comment.

However, all of these reasons can be said to apply already within the legal aid market, and therefore can no longer act to curtail the development of the market for lemons.  Indeed, in the context of legal aid, the ‘lemons’ issue could be compounded.  It is not so much that the client might engage in adverse selection, but that a monopsony buyer (the LSC) chooses not to pay for high-quality providers.  It does this not because it finds quality difficult to assess, but because it can – and, by some views, must – drive down the cost of legal aid.  There is a public interest tension at the heart of this choice.  If we accept (as I believe we must) that the total legal aid bill must be reduced, there will be an inevitable trade-off between the scope of legal aid and the risk to quality.

Even if scope is cut back, the broader the scope of advice and representation remaining available, the higher the demand will be (relative to even narrower scope).  To the extent that any removal from scope or of eligibility does not achieve the desired reduction in the aggregate cost of legal aid, cuts in the cost of provision within scope will have to be imposed.  It would be idle to pretend that this would not reduce providers’ income.  (Whether it also reduces providers’ profit will depend on the responses of providers to consolidation, restructuring. and the use of technology and processes to deliver economies of scale that could maintain prior levels of profit.  For the LSC to use fee levels to drive such changes in behaviour is not unreasonable, and I remain to be convinced that quality and access to justice would inevitably be compromised by such changes – though there is clearly a risk that they might.)

So, the risk for Government is that scope and fee reductions will drive high-quality providers away from the provision of legally aided advice and representation.  This creates a serious possibility that legal aid will become a market for lemons with generally reducing price and quality, and fewer high-quality providers choosing to remain in it.

If life hands you lemons …

Some years ago, a friend of my wife gave her a kitchen plaque which said: ‘If life hands you lemons … make lemonade’.  I take this to be an exhortation to seek something palatable out of inherently bitter or unwelcome ingredients.

If legal aid is (or becomes even more of) a market for lemons, the challenge is to find the equivalent of lemonade.  It might not be your preferred drink; there might even be different varieties (traditional, cloudy, and so on); and there will also be different perceptions of the quality of various brands.  There is not necessarily a single, homogenous result; but there is the prospect of something passable.

What might the legal aid equivalent of lemonade be?  At the heart of the dilemma, it seems to me, is a questionable assumption that quality and cost are inseparably linked – or, to put it another way, that any reduction in price must lead to a reduction in quality.  Other industries have had to grapple with this apparent conundrum.  Quality is not a singular concept but a variable one (see my views on this in Quality, values and standards: the future legal landscape).  So the inevitability of the link is not apparent to me.

The solutions must suggest gaining scale that can produce economies of scale through consolidation and acquisition (or possibly cooperation through joint ventures and the like), and to innovate delivery through new processes and technologies.  The restructuring of firms to reinvent the delivery and staffing of legal aid provision must follow, as night follows day.

What is absolutely clear is that simply expecting to carry out legal aid work in the same way as before – with the same people, structures, and costs – cannot survive a new approach in which the aggregate income available to legal aid providers is less than before.  Something has to give.  Income will reduce in the aggregate: but any given firm’s income will not go down if it can increase market share (hence the need for scale and consolidation).  If the income for each unit of provision (act of advice or assistance) goes down, profit does not inevitably reduce if the firm’s cost base is restructured (hence the need for innovation in delivery, process and staffing).

The flavour of this legal aid lemonade is not difficult to guess.  It’s not really a question of whether one likes it; it’s also no longer a question about whether or not it’s ‘right’.  It is going to happen.  (I have written above and elsewhere about the Government’s obligation to address the systemic issues of matching rights and funding, and the need to remove hurdles from the courts and from public authorities’ decision-making processes: see Civil legal aid: squaring the (vicious) circle.)

I sympathise with legal aid providers.  Life is tough, and it’s about to become even tougher.  I regret that my sympathy will do nothing to generate income or profits for legal aid lawyers.  But against this backdrop, it would be better to start making lemonade than staring at a pile of lemons wondering what to do with them.

Reserved legal activities – where next?

The current reserved activities are rights of audience, the conduct of litigation, reserved instrument activities (sometimes inaccurately referred to as the conveyancing reservation), probate activities, notarial activities, and the administration of oaths.  The Legal Services Act 2007 gives the Legal Services Board the power to recommend changes to this list.  The Legal Services Institute (LSI) expressed the view in early 2010 that, before the Board considers exercising its powers, it should establish criteria for reservation that it could apply to both current and prospective activities.  Our first paper therefore investigated the origins of the reserved activities to see if, from their history, any criteria could be suggested.  Unfortunately, we found no coherent policy or rationale underpinning them.  We therefore went on to consider in our second paper (available here) what might provide a contemporary rationale for reservation.


The case for reservation

For the future, we consider reservation to be appropriate where:

(1) regulation, and reservation in particular, is in the public interest; and

(2) either other regulatory responses are less effective;

(3) or reservation affords a degree of additional protection to clients.

We suggest that reservation can be justified in principle on the basis of the public interest if it either secures a public good or offers consumer protection.  We therefore suggest that
reservation is justified in the public and consumer interest where, as a result of legal advice or representation, detriment to the consumer’s (a) liberty, (b) physical, mental, emotional or social well-being, or (c) property, could arise, and for which compensation after the event would not represent an adequate or reasonable remedy.  However, we do not think that this supports the reservation of all ‘solicitor services’.


Public good reservations

The LSI considers that the requirements of the rule of law, the administration of justice and access to justice, as well as the benefits to England and Wales of having a well functioning legal system, justify the continuing reservation of rights of audience, the conduct of litigation, and court-related reserved instrument activities.  Equally important
are the proper execution of the administration of oaths and notarial activities, for the effective administration of justice, and to support reliable social and trading relationships both domestically and internationally.

There is also a public good in having an effective and reliable property market.  In part, this arises from the support of conveyancing chains and simultaneous completions, which in turn are based on the credibility and enforceability of undertakings given by the authorised persons involved.  Rather than the current narrow reservation of preparing the contract and the instruments of transfer or charge (which does not address the public benefit that needs securing), we believe that there is a strong case for the extension of reserved instrument activities to include all conveyancing services.

We would also consider that immigration advice and services might now be added to the public good group of reservations – moving them into the mainstream of reserved legal activities from being regulated (but not reserved) under a parallel but largely identical regulatory framework.  This was in fact suggested in the White Paper that preceded the Legal Services Act, but was not followed through at the time.


Consumer protection reservations

Problems with a will are only likely to come to light after the death of the testator, and after-the-event remedies are not sufficient.  The LSI therefore believes that there is a strong consumer protection case to be made for the reservation of will writing.

The probate reservation is in our view the most contentious of the Act’s current list, and its narrow scope difficult to justify on public good or consumer protection grounds.   We therefore advocate its removal from the list of reserved legal activities, with a strong case then for a broader reservation of the administration of an estate following a grant of probate or letters of administration to protect against misappropriation or misadministration.

Finally, although insolvency practice and claims management services are both currently regulated, we could not see a sufficient justification for bringing them within the framework of reserved legal activities.