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.

2 thoughts on “PEP talk: beyond the low-hanging fruit

  1. Pingback: The Hitch-Hiker's Guide to the Legal Services Act

  2. Pingback: UK Blawg Roundup #6: The Time Travel Edition – The past, present and future practice of law

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