Why the irregularities in calculating PEP make it an inadequate indicator of success
When times are good, most partners are content with their lot. However, over the last three years, legal practices have been hit with an onslaught of lower demand for services, increased competition, higher tax rates, regulatory change and the disappearance of traditional funding. Partner expectations should therefore have also changed. However, a managing partner at a significant-sized law firm was recently heard to say: "We know that our performance has suffered in the recession and we can live with that as a partner group, as long as we are not suffering more than the competition." You can understand his concern. When partners feel squeezed, they tend to be more likely to look at opportunities elsewhere.
October 19, 2011 at 07:03 PM
5 minute read
Smith & Williamson's head of professional practices, Giles Murphy, argues PEP should be replaced with profit per member
When times are good, most partners are content with their lot. However, over the last three years, legal practices have been hit with an onslaught of lower demand for services, increased competition, higher tax rates, regulatory change and the disappearance of traditional funding. Partner expectations should therefore have also changed.
However, a managing partner at a significant-sized law firm was recently heard to say: "We know that our performance has suffered in the recession and we can live with that as a partner group, as long as we are not suffering more than the competition." You can understand his concern. When partners feel squeezed, they tend to be more likely to look at opportunities elsewhere.
If the partner looking elsewhere is a strong performer, they may get a better financial offer from a competitor and the reality is that many firms that lose a key individual often find that the performance of that partner was effectively subsidising the profit shares of others.
So how can you tell whether your firm is performing above or below your peer group? Historically, when firms traded as partnerships, their financial performances were kept private. There is no requirement for any LLP to make a public announcement on their financial performance but, on the basis they file accounts by – at the latest, nine months after the year end – many now issue a press release explaining how well they have performed – often caveated by phrases such as 'in the circumstances'.
But do these press releases really tell us anything? Most firms release information on their total turnover or income. This is a relatively objective figure to measure and is therefore a good starting point, but it is often stated simply as a percentage movement compared to the prior year (as opposed to a trend over several years). Moreover, such figures rarely note the proportion of organic growth (the equivalent of 'like-for-like' sales) or how much of the fee income was 'acquired' through lateral hires or mergers.
Firms often disclose a profit per equity partner (PEP) figure, and this is where objective comparison becomes particularly difficult.
First, there is no definition in accounting standards as to how PEP should be calculated. As a result, 'profit' may or may not include exceptional one-off costs and/or the costs of salaried or quasi equity members. Similarly, the number of 'equity partners' used could be the number of individuals at the beginning or the end of the year or, alternatively, the average over the whole year. Besides, how do you define 'equity partner'? Is this term used just for full equity partners or for any level of partner at the firm? Put simply, PEP can be manipulated far too easily and this means it is not an effective measure of success.
Take the announcement from Olswang in September that it was creating a single partnership structure. The revamped system has five levels. For the purposes of reporting average PEP numbers, Olswang will not include all partners, as it only treats the top three partner bands as full equity partners. So at least the firm is being completely open about its calculation.
But if PEP is such an unreliable indicator of underlying performance, what alternative should we be using?
A more objective measure is profit per member (PPM). PPM is a simple number that can be calculated from every set of LLP accounts filed at Companies House and therefore provides a means to compare competing firms.
Professional practices are increasingly adopting limited liability status, a trend which is likely to gather pace if external capital takes hold. As a result, we are likely to see more and more reporting along corporate lines. Any partner's profit share is essentially made up of a payment for work done in the business and a reward for being an owner in the business – essentially, a salary and a dividend.
In a company, the 'partner salaries' (which may also include some form of bonus) become a cost to the business – therefore the accounts reveal a net profit after these costs have been taken into account. The net amount is then available for payment to shareholders as a dividend or to be retained within the business.
Using this basis, a partnership could take its profit, deduct all of its costs – including a 'notional salary' for all partners – to arrive at a net profit which is more comparable to a limited company. If all professional practices were to adopt such an arrangement, results would be more readily comparable with competitors.
This approach requires the subjective decision as to what the 'notional salary' should be. It may, of course, vary from partner to partner depending on, for example, the location at which the individual works and their particular focus. In my experience many firms are already setting notional salaries for internal purposes, whether it be for profit sharing arrangements, performance comparison between departments or to calculate the true cost of an hour of chargeable time.
When firms adopt this approach they tend to use figures ranging between £150,000 and £250,000 for equity partners. If figures of this level begin to be quoted and used more publicly, then we may find discussion moving away from talk of PEP to talk of profit after notional salaries – from PEP to PANS.
Giles Murphy is director and head of professional practices at Smith & Williamson.
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