Caroline Thorpe pores over the top 30 UK firms' LLP accounts covering the past two financial years and assesses their performance during the ongoing financial storms

Just as the icy blast of winter has so far refused to give way to spring, so too UK business continues to feel the chill of years of turbulence in the global markets.

As we teeter on the edge of a triple dip recession, tales of sluggish growth, static pay and austerity blues can seem hard to escape. Yet a first glance at accounts from the UK's leading law firms tells a different tale. 

Legal Week's analysis of the most recent limited liability partnership (LLP) accounts filed with Companies House by the UK's 30 largest law firms – click here for tables – reveals tighter financial management and steady performances despite the downturn, resulting in rising average revenues and profits, stronger balance sheets and increased headcounts between 2010-11 and 2011-12. 

But while the group as a whole has fared better than many other industries, closer inspection of individual firms' numbers unearths a more mixed picture. 

While revenue and average profits per equity partner (PEP) have historically been the figures used to benchmark law firm performance, focus on these numbers alone can hide a multitude of disparities in key financial indicators such as operating profits, staff costs and debts – not to mention how firms choose to fund their investments and pay their partners.

Here then, Legal Week for the first time draws together and compares all the core financial indicators buried in hundreds of pages of LLP accounts covering the past two financial years. 

In poring over the numbers, we reveal everything, from the firms with the tightest grip on staff costs and the best rate of partner capitalisation at one end of the scale, to those with the largest debts and highest staff costs as a percentage of revenue at the other. 

Three top 30 firms are not included as they have either not converted to an LLP (Slaughter and May) or had not yet filed their accounts at the time of going to press (Stephenson Harwood and Withers). 

The accounts we look at are the consolidated group filings for the LLP containing each firm's UK partnership. As such, the figures for firms operating under verein structures such as DLA Piper, Hogan Lovells, SNR Denton and Norton Rose do not represent total performance and costs globally. 

As the accounts cover the 2011-12 period, they do not include some consolidation that took place after this last financial year. So while Clyde & Co and DAC Beachcroft feature in their post-merger forms, Pinsent Masons' combination with McGrigors and Herbert Smith's full financial union with Australia's Freehills do not appear.

The profit conundrum

PEP may be the comparator many firms like to benchmark themselves on given the need to ensure partner pay remains broadly in line with key rivals, but it is notoriously easy to manipulate.

Differences in regional weighting, multiple tiers of partners and how costs are accounted for can all make the average PEP figure announced by law firms distinctly blurry around the edges. 

Smith & Williamson head of professional practices Giles Murphy comments: "The most important indicator of sound finances is most definitely not PEP – even though the entire market is obsessed with that number."

In contrast, operating profit – which looks at what is left after overheads such as staff costs and salaried partners have been taken into account – is far more straightforward. 

Of the firms analysed, 16 posted operating profit margins (operating profit as a percentage of revenue) of at least 30% for 2011-12. Total operating profit across the firms surveyed rose by 6.9% and average operating profit margin stood at just below 30%. 

But this positive indicator masks significant differences across the group. The best performer overall by operating profit margin is Allen & Overy (A&O) at 41.1%, followed by Olswang on 36.3%, DLA Piper (35.8%), Holman Fenwick Willan (34.9%) and Addleshaw Goddard (34.5%).

By contrast, DAC Beachcroft saw its operating profit fall to 13.9% of revenue as a result of the merger of Davies Arnold Cooper and Beachcroft, which took place midway through the last financial year. Other firms with operating profit margins of less than 25% include Norton Rose, Clyde & Co, Simmons & Simmons, CMS Cameron McKenna, Irwin Mitchell and SNR Denton.

Partner remuneration

All firms use different criteria to determine who qualifies as a member of the LLP (meaning not all members are necessarily partners and vice versa); however, members and partners are broadly aligned. 

Overall, the number of members at the 27 law firms increased by 5.1% between 2010-11 and 2011-12 to an average of 223, with total member numbers climbing from 5,736 to 6,030 – equating to around 10% of total staff numbers. 

Sixteen firms saw member numbers increase against 10 firms seeing a decline. At one firm – Herbert Smith – the number of members stayed the same.

Profits available for distribution to members, meanwhile, increased by 5.1% across the group analysed. This compares with an increase in average PEP across the top 50 as a whole of 4.2% based on financial results from firms announced last summer.

Bucking the trend, seven firms saw the sum available to distribute to members fall, ranging from a 40% drop at Irwin Mitchell to a dip of 4.8% at Berwin Leighton Paisner.

Extrapolating profit per member from profits available for distribution in the accounts means this figure ranges from £8,070 at SNR Denton, £98,800 at Hill Dickinson and £119,060 at Kennedys through to £1.1m at Linklaters.

However, some firms, including SNR Denton, classify a large part of their profit available for distribution as 'members' remuneration charged as an expense', skewing their numbers. 

While six top 30 firms announced PEP of more than £1m at the year-end, Linklaters is the only firm with accounts showing a profit per member figure of more than £1m. Average profit per member for the group analysed stands at £397,000, compared with average PEP across the top 50 of £587,000 for the same financial year. 

Some of the firms' accounts include details about the highest paid partner. Excluding Irwin Mitchell and Holman Fenwick Willan, where the highest paid members are corporate vehicles, the trio of firms making the highest payouts to individuals are Freshfields Bruckhaus Deringer, Linklaters and DLA Piper. 

Meanwhile, Kennedys, Nabarro and Hill Dickinson bring up the rear of the firms disclosing their largest partner payouts. 

Capitalisation

In an uncertain economic climate, the amount of capital firms hold in the business becomes increasingly important, with Cobbetts and Scotland's Semple Fraser the most recent examples of what can happen when firms do not have the capital and cashflow required to meet payment obligations. 

In total, capital held across the group reached £2.8bn by 30 April 2012 – 2% up on the previous year-end and representing 27% of the firms' combined revenues. 

"Most firms have done something proactive since the 2008 collapse, building capital to have a more resilient balance sheet," says James Tsolakis, head of legal services at Royal Bank of Scotland. "But it's all relative as to whether they've done enough and having regard to where they are in their business cycle. Firms intent on growth will need more capital, for example."

Despite this degree of recapitalisation, there is variation across the sector, prompting fears that some firms have not done enough to bolster their balance sheets – particularly when cashflow is taken into account.

The staff equation

Unsurprisingly for a service industry, staff costs are the legal market's largest expense. Taking into account the mergers of legacy Davies Arnold Cooper and Beachcroft, and Clyde & Co and Barlow Lyde & Gilbert, total staff numbers (including fee earners but excluding LLP members) rose by 6% from 54,506 to 57,758. The average number of employees per top 30 firm was 2,139.  

Correspondingly, the top 30 firms' combined employee wage bill totalled £4.5bn in 2011-12 – a 7.3% rise on the previous year – and a figure which equates to 42% of the group's combined annual revenues. 

According to David Harris, co-chief executive of Hogan Lovells, tough market conditions often lead to rising headcounts for reasons beyond consolidation – not least the fall in attrition due to fewer recruitment opportunities. 

"[The number of employees] will tend to increase in this environment as you get people staying in positions longer and new people joining as trainees," he says.

DLA Piper's international LLP, which includes all of the firm's operations outside the US, saw the largest percentage increase in staff costs, with the firm spending £273.8m on employees in 2011-12, compared with £208.3m the previous year – a 31% rise against a group average of 7.3%.

Driven in large part by its merger with Australian partner DLA Phillips Fox in May 2011, total employee numbers at the firm, which recently confirmed 45 job losses with a possible 116 to follow as a result of a review of its UK business, increased by 22.1% to 5,056 over the period.

Mergers also drove Clyde & Co and DAC Beachcroft to the largest and second largest increases in total staff numbers. Clydes' salaried workforce, for example, swelled from 1,243 to 2,089 in the wake of the firm's merger with legacy Barlows in November 2011, resulting in a 30.3% rise in costs. 

At the other end of the scale, employee numbers fell at eight firms: Addleshaw Goddard, Irwin Mitchell, CMS Cameron McKenna, SJ Berwin, Eversheds, Nabarro, Simmons & Simmons and SNR Denton, which saw the largest decline at 9.1%. Six of these firms shaved a combined £17.1m from their staff costs. However, Irwin Mitchell and Eversheds' salary bills rose, despite headcount reductions.

Of course, staff numbers and costs cannot be looked at in isolation. Comparing them with revenue gives an indication of the true cost to each firm. Here, average staff costs equating to 41.4% of revenue belie significant disparity between individual performance. 

Those with the highest percentage staff costs are DAC Beachcroft (52.5%, but skewed by the addition of a full year's costs from legacy DAC against only six months of revenue); SNR Denton (52.3%) and Linklaters (48.1%).

This compares at the opposite end of the scale with Olswang (31%), CMS Cameron McKenna (32%) and Addleshaw Goddard (32.7%).

Notably, Camerons has outsourced virtually its entire back office to Integreon, while Addleshaw Goddard has a transaction services team in Manchester making heavy use of paralegals rather than qualified lawyers for some work – an increasingly common trend.

The average cost of an employee (including both fee earners and support staff) during the past financial year ranged from £34,210 at Hill Dickinson through to more than £130,000 at Linklaters, against an average of £70,000 across the group as a whole. 

Further adoption of cost-saving measures such as A&O's decision to shift back office functions to Belfast, Herbert Smith's use of Belfast for legal support work and increased use of paralegals for higher volume less complex work generally is likely to drive down costs in future. 

Making clients pay

But while some firms have been taking action to cut their own costs, the LLP accounts show they have been less effective at controlling clients, some of which have been delaying payments as they also feel the effects of market conditions. 

The amount owed to the top 30 by clients, known as trade debtors, totalled £2.93bn at the end of 2011-12 – equating to an average of £108.4m per firm. Significantly, this is more than 4% higher than at the end of the previous financial year. 

"At the beginning of the recession, that [rise] wouldn't have been a surprise because everyone is a bit cautious with cash and avoids paying until they have to. The fact that it's happening now is a bit more concerning," argues Murphy. 

"The fact that it has gone up either suggests that law firms have lost their focus on this area or the marketplace is just getting more brutal. Law firms are very thinly capitalised and the moment they have any cash, the partners want to have their drawings and distributions. So if outstanding bills increase by a relatively small amount, some firms can suddenly find they are short of cash."

DAC Beachcroft senior partner Simon Hodson concedes: "We were not as prompt as we could have been in collecting clients' money owed to us. 

"It got worse, in part because we had two systems to look at [consolidating following the merger in October 2011]. The number of days outstanding increased. Part of [the solution] is management, and part of it in due course will be systems driven. In the coming 12 months, we'll be putting in a new system, which will be paid for out of cash flow."

Murphy advises: "Good practice with all clients would be to have an agreed fee in advance, regular invoicing and making sure the client terms are clear. If payment is due within 10 days, on the 11th day you ring them and ask them where your money is."

Law firm borrowings

On top of the growth in monies owing from clients, the analysis reveals that net debt across the top 30 increased, with 15 firms carrying debt, worth an average of £24.2m more than the value of their assets. 

Technically Simmons & Simmons was the most burdened firm, with net debts rising 1.7% to £51.9m in 2011-12. However, the bulk of this takes the form of revolving capital loans used instead of asking members to borrow themselves.

Reclassifying these facilities would reduce borrowings to around £4m – less than 1% of operating profit. Other firms with high levels of net debt as a percentage of operating profit include Kennedys (61%) and DAC Beachcroft (150%).

Tsolakis (pictured) advises that debt should be read in context: "[It] should be qualified by looking at where a firm is in its business cycle. Some firms have no debt and have credit facilities, but don't use them.

"Other firms, relatively speaking, are heavily borrowed and it's a really interesting contrast, more in terms of financial philosophy than risk, appetite and position for the future."

"Everybody has to do what is best for their business," says Wim Dejonghe, managing partner at debt-free A&O (see case study, above). "My take is that other firms have done pretty well [at managing their finances] and it's been a tough market out there for the past five years."

Hogan Lovells' Harris also prefers not to borrow: "We obviously have bank facilities but don't generally draw down on them. We've always adopted a prudent approach and have no debt." 

Tightening the purse strings

What, then, should the UK's largest firms be doing to ensure that next year's filings make for more reassuring reading? Accountants and bankers focused on the law firm market enthusiastically support holding back partner distributions, a move already becoming more evident in the market.

Tsolakis says: "It's a prudent way to manage the business. It's an easy way to recapitalise the firm and it's an important part of the process by which partners can reinvest in the business." 

Murphy goes further still, arguing that "the full profit distribution model is dead" for larger firms, which should instead consider overhauling arrangements so that a portion of profits are routinely kept from partners and reinvested back into the business. 

He adds: "The problem is that management might want to do that, but then there are 100-odd partners saying 'We want our cash'."

And attention needs to focus more on low hanging fruit such as fee structures and legal process or back office outsourcing, with other options including increasing the use of cheaper regional offices or link-ups with regional firms. Pricing also needs to be reviewed to ensure the most cost-effective options for both clients and firms. 

As Murphy concludes: "It's hard. It will require a totally different working practice."

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Case study: DAC Beachcroft

"Odd" is how Simon Hodson (pictured) describes his firm's 2011-12 accounts – and DAC Beachcroft's senior partner is right. 

The firm certainly stands apart from most of its top 30 counterparts: operating profit down 12.6% against an average 6.9% increase; staff cost inflation more than double the top 30 average and net debt up 237.6% to £34.1m between 2010-11 and 2011-12.

Then there's the more than 1,000% year-on-year hike in capital introduced by members to £7.1m, and the £2.6m pension liability that has appeared on the balance sheet where none sat before. 

The oddities follow Beachcroft's merger with regional firm Davies Arnold Cooper in October 2011. Rather than a cash call, the increase in members' capital "is additional capital, but it comes about because of the influx of new members," explains Hodson.

"Essentially, it is new working capital."

Similarly, the pension liability is inherited from the legacy firm DAC and closed to new members. Hodson says the sum will be paid off over time, but does not consider it a real liability since it is subject to triennial revaluation.

The merger also incurred an £8m associated cost, while net debt climbed to 150% of the international firm's operating profit. 

DAC Beachcroft will continue to grow – "We expect the headcount to be greater than 2,300 by the year end" – with investment funded by a variety of means.

According to Hodson: "There are some investments which are day-to-day costs to the business, so we pay them as we go. Sometimes we borrow money; sometimes it's a capital call. We use a mix and like to have a balance between capital and borrowings.

"Some firms have no borrowings, but members' appetites could change. You're looking at quite a variety of different approaches which is interesting because in the wider business world, there isn't such variety. 

"There's a lot of tradition [in the legal sector] and sometimes that excuse gets in the way of change. What it is that results in change taking place will vary from firm to firm."

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Case study: Allen & Overy

The UK's third-largest firm by revenue fares well in comparison with its top 30 peers. A&O's £486.1m operating profit tops the table for 2011-12 and represents a 12.6% increase on the previous year's figure.

Meanwhile, the £369.2m of members' capital on the books at the 2011-12 year end is greater than any of its rivals, despite falling 2.9% year-on-year.

"I honestly don't think we focus on one indicator [of financial health]," says A&O managing partner Wim Dejonghe (pictured).

"You need to find the right balance between your revenues on the one hand, short-term profitability and long-term prospects. Getting that balance right is our main focus.

"You need to focus on growing your revenues, keeping costs in line and making the right level of investment. I'm afraid it's not a simple mathematical exercise."

The magic circle firm has no debt, preferring to use working capital to fund investment rather than asking its members for funding. 

It is seven years since A&O approached partners for a working loan, though it did retain an average £30,000 per partner in earnings in the wake of its 2009 partner restructuring. 

"The last time we increased capital contributions from the partners was when we moved into our new building [in London] in 2006," explains Dejonghe. "We haven't called for partners to increase their contributions since."

He adds: "You could conclude that this is a pretty conservative approach to take, but that's what keeps our feet to the fire in terms of managing our working capital. Because we manage our cash quite tightly, that gives us a lot of predictability."

It is a course he is sticking to: "We don't have a Plan B and we don't plan to have a Plan B."

To view the LLP accounts of the UK's top 30 firms, click here

Company reports on DLA Piper, Herbert Smith Freehills and Norton Rose Group are available for purchase at legalweekreports.com