Why you should avoid the distractions of the annual financial reporting round

Followers of law firm financial news will have seen the first sets of annual results coming out from the UK’s leading law firms over recent weeks. As ever, those early results include a good number of success stories, with instances of strong growth in both revenues and profits. It won’t be for some weeks yet that we’ll see the broader picture across the UK profession when the full league tables are published, but it’s not too early to start asking some questions about what might end up being reported, or indeed about the whole nature of the annual results round-up.

The early triumphs that we’ve seen sit rather at odds with other, wider developments being reported. We recently learned of the Solicitors Regulation Authority’s conclusion that up to 160 firms in the UK are in financial difficulty, including, it seems, a number of the top-200 firms. We have also seen substantial rounds of further redundancies being announced by large firms as they look to maintain competitiveness and match staffing levels to workloads.

There may be further bearish signals about the industry around the end of July when substantial tax payments fall due, which could end up being a factor in tipping one or more firms into the hands of insolvency professionals. Such outcomes would not be happy ones to see as a profession, but they seem more likely to occur in six-month cycles as competitive pressures tighten, specialist funders reassess the risks of lending and the exit routes from insolvency events become more well established.

Our industry is going through a major transition and one that may take years to work through. From a distant vantage point now, or with the benefit of hindsight in future, many will see this as a positive phase, perhaps labelling it as one of “creative destruction”, to borrow a phrase from the economics lexicon.

The phrase does at least make clear that such a transition may not feel all that positive to industry insiders as we travel through it, even if the ultimate outcome is economically superior in the sense of a more competitive and efficient offering to the market (which of course, we all want in the end).

Overreliance on PEP

The macro reasons for this painful period of economic transition have been widely discussed within our industry and more broadly, but I sometimes wonder how far the financial reporting traditions we have established (or allowed others to establish for us) have added to the pressures that law firms are now experiencing, some to such acute levels that business failure seems imminent.

I don’t of course suggest that the fascination with profit per equity partner (PEP) as a measure in our industry had much to do with the collapse of Lehman Brothers (although financial engineering of another kind did, of course, lead to its downfall). But, we have given a lot of prominence to a measure that can be managed quite significantly in the short term by firms themselves and which has a limited relationship with cash generation (not to mention solvency) and long-term enterprise value. Its lure as a measure has probably had something to do with its rather deceptive simplicity, coupled with a hint towards the perceived lifestyles of the highest earners in our industry.

The result of the prominence given to that single measure has been to create at least some incentives for firms to act in ways that are probably not in their long-term interests. For example, some firms are cutting or restricting investment, keeping the equity as tightly held as possible for as long as possible and managing year-end accounting exercises (within the rules of course), with that single number as the main driver.

This has created several ways in which instability can arise and then grow within firms as short-term investment decisions are made, too much focus is placed on single-year performance and heads are turned to the greener grass of somewhat higher PEP up the road.

Those are risky games in the good times and dangerous ones in the less good times.

As a personal view on this, for mid-size firms at least, it’s rarely helpful to stand out at either end of the PEP ladder and better to value stability than record attainment in any given year.

But, more important still may be to turn the focus away from the annual financial reporting round and focus more on building a long-term position in the industry where you stand out as a go-to firm in the areas that you have chosen to give your attention. You will then be able to generate consistent cashflows to fund the investment needed to keep your firm at the top of its field (and of course pay out those retained profits on time!).

That will still be no mean feat in these challenging times, but avoiding some of the distractions of the annual reporting round may just help a little.