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Continental European law firms are taking on the Anglo-Saxons at their own game: our annual benchmarking survey tracks a sharp increase in use of the highly-leveraged business model as independent legal practices, particularly in Italy and Spain, are seeking to maximise profits by pushing the ratio of equity partner to fee-earners as high as 1:10.
Combined with strong M&A big-ticket earnings this has – across the board – fed into another bumper year for the bottom line. But, given the fiercely competitive commercial market, significantly ramped-up leveraging and its resulting pressures on salaries and recruitment, this good news must be tempered with a note of caution: the steeply-geared prototype remains untested by tougher times and, furthermore, could permanently alter traditional independent firm culture and structure.
Our latest survey report analyses these issues and many more, including changing professional regulations and marketing and training, in eight key jurisdictions. JEREMY FLEMING outlines the results and identifies country-by-country trends of law firm performance across the continent.
European independent firms are chasing their Anglo-Saxon rivals down the path to a highly leveraged business model – employing almost ten fee-earners per equity partner in some countries – a trend which could pose them significant challenges in the event of a market downturn. Our annual survey of the European legal market, conducted in association with legal information providers LexisNexis Martindale-Hubbell and accounting advisers BDO Stoy Hayward, reveals a distinct increase in leverage across all sectors, indicating that even smaller practices have driven up leverage to increase profits. The results of such a strategy are also clearly seen in the financial results – firms have had yet another bumper year for profits.
James Harley, international marketing director at LexisNexis Martindale Hubbell, comments: “Over the last three years there has been an incredible drive by legal practices, especially in the UK, to ramp up their leverage to increase partner equity.” The figures of fee-earners per equity partner (Table 1) bear out the trend for higher leverage elsewhere, with Italy and Spain taking the lead, where leverage is now creeping up to 10:1 in the upper quartile. Last year, already ahead of other countries, Italy’s upper quartile figure was a ratio of 1:7.6; now it has increased to 1:9.5.
There has been a marked reluctance among the larger practices in Italy to make associates and assistants up to partners, according to Stefano Sutti, managing partner of Studio Legale Sutti in Milan. He says that the pressure to increase leverage results from a more competitive market for commercial instructions – with a larger number of firms chasing a finite amount of work there is a desire to keep profit within the equity partnership. He admits that although he subscribes to a Japanese model practice – in which there are few fee-earners to partners – his outfit has also experienced the pressure on leverage as a result of recent growth. Tony Williams, a partner with London-based consultancy Jomati, observes that in the City too, the trend is for more substantial corporate work to go to fewer players, increasing the competition and creating the incentive to leverage firms up.
The benefits of this continuing leveraging trend are clear. Combined with the M&A sector resurge it has delivered another boom year in profits, according to our survey. Firms from 15 European countries contribute data towards the poll – with eight key jurisdictions providing the most data – and a healthy performance is clear from the profit-per-partner figures (Table 2). 2005 was a good year, and the 2006 figures remain stable in the median band, but have shot up across the upper and lower of the three bands: Germany’s results in the upper quartile have leapt from €506,900 last year to €1,052,900 now, while the average – notwithstanding the inclusion of Polish data in the survey for the first time – increased by more than 10 per cent in the upper quartile.
Consequently, the amount of profit available to distribute remains high, as fees per fee-earner reap the benefits of big-ticket transactions across the continent. Although this has declined on average from last year, that figure is depressed by the relatively poor showing of Poland in the upper quartile (€135,000), and the individual figures show some remarkable leaps. Germany for example increased its fees earned in the upper quartile by more than 50 per cent to €264,000, while in Italy the same figure rose from €280,000 last year to €319,000 this annum. This data is reflected in the strength of M&A work in those jurisdictions revealed by the percentage of that income attributable to different work sectors (Table 3). But the impact of leveraging on profit is clearly visible from Italy’s unassailable position as the chief eat-what-you-kill jurisdiction, backed up by its astonishing figures for highest-paid partner profits taken as a multiple of the average (Table 4).
The net partner profit figures from Sweden and Finland indicate that Scandinavia remains the exception to the leverage trend – outfits there employ fewer fee-earners per equity partner and distribute profits on a more equal basis than other countries. Tomas Lindholm, managing partner of Helsinki-based Roschier, explains that the leverage of his practice (about 1:4) is higher than average among Finnish players and comments that law firms’ cultural identity across Europe impacts on how far they are prepared to leverage: “In Southern Europe, there tends to be more focus on the individual partners rather than the firm as a brand, and in these circumstances higher leverage makes sense. But in Finland the pure lockstep approach endures.”
There is certainly a correlation between pure lockstep and lower leverage. But, in keeping with the trend for higher leverage, the survey (Table 5) demonstrates the decline of the pure lockstep system as a form of management. High-profile names such as German firm Haarmann Hemmelrath adopted lockstep in recent years – and indeed Germany remains a jurisdiction in which it remains relatively strong, with more than 20 per cent of respondents maintaining the arrangement. But the dramatic slump in the pure lockstep approach indicated by the table (down from a total of 42 per cent last year to 26 per cent now) indicates that such examples are exceptions to the rule. Unsurprisingly, the inverse is true of performance-based approaches (which have more than doubled their showing from 22 per cent last year to 50 per cent today).
These results could reflect the growing influence on the traditional law firm structure of age discrimination legislation, introduced last year. Jane Mann, a partner with employment specialist firm Fox Williams in London, explains that higher payments made to partners on the basis that they have served a longer period of time in the partnership may be deemed ageist under the new legislation. Similarly, an attempt by the partnership to squeeze out a partner who is advancing in years may be deemed discrimination on the basis of age. In both these cases performance-related pay structures give vital evidence upon which partnerships can base employment decisions.
It seems inevitable however that with leverage increasing, the lockstep system is dying out. More assistants and junior lawyers lead to the need for greater flexibility regarding employment and increased emphasis on performance-related systems. In Italy there has already been a significant human resources impact in the legal sector, according to Stefano Sutti: “With higher leverage there is a more fluid employment market, with assistants and associates moving regularly to try and follow opportunities where partnership may be available.”
In addition, the general personnel and premises expenditure of firms has remained relatively stable. The rise in personnel costs (Table 7) during 2006, up slightly on last year from 53.3 to 55.8 per cent, suggests that players are not cutting back on support staff in marketing, IT and other internal departments. There is a slightly bigger rise in the relative cost of premises, up two per cent on last year to 14.5 per cent. These figures vary greatly across jurisdictions: in the UK – where rents are very high compared with other countries – they are usually above 15 per cent of the total costs, but Italy also seems to post a high figure for the relative costs of premises; up to 21 per cent this year, perhaps because of the Italian preference for lavish office spaces.
If firms have been spending more on their offices, the same is definitely not true of IT. The graph showing the amount spent as a percentage of their income (Table 8) shows a slight decline in the outlay from the previous year. Then the average across respondents was one per cent and 1.5 per cent in the median and upper quartiles respectively; these figures have dropped to 0.6 and one per cent – perhaps reflecting a year in which no indispensable new IT products were launched onto the market.
Nonetheless new figures released this year for the first time as part of the survey, recording which specific IT tools are used by respondent firms (Table 9), indicates room for further investment here. Although there is near saturation of the market in the usage of document management systems, with 81 per cent of outfits claiming to have them, just over half the respondents use client relationship management and knowledge management systems. It is particularly surprising to see that German firms lagged behind other countries (fewer than half the respondents there used any of the basic IT systems) and interesting that it was outstripped by Poland – where three-quarters of respondents used client relationship and practice management tools.
Against such a background, in which there have been few shocks in costs, the high-leverage model firms are increasingly adopting has not been tested against difficult circumstances. Yet, as Tony Williams points out: “All bull markets end eventually and it is clear the current market is in the final quarter of its cycle.” Although there are few predictions there will be an end to these favourable conditions this year, not many pundits are prepared to stick their necks out and predict a continuation next year as well. So if the market climate does change for the worse, how well will Europe’s law firms weather the storm? It is clear that with high leverage, employees would be cast off. This need not be a major problem, according to commentators such as Mr Lindholm: “Although the danger of a downturn is that there would be a threat to the high number of assistants now employed, on the other hand it is increasingly acceptable in the legal market to hire and fire, whereas this was traditionally unheard of, and in some firms is still resisted.” Mr Williams points to the number of staff let go by London firms in the downturn of 2001. “Many Australian and New Zealand lawyers who had been employed to make up the numbers were made redundant and simply returned home, causing relatively little difficulty to the market.” Nick Carter-Pegg, BDO Stoy Hayward’s head of professional services, comments: “The current wave of M&A across Europe appears to have continued during this period, resulting once again in impressive performances from those jurisdictions in which deals activity is particularly strong. With ongoing reports from private equity houses of funds available for investment, this level may well be seen again in the 2007 survey.”
But this year’s survey results show continuing inconsistencies in management approach across European firms and, even though times are currently good, practices are apparently not increasing their efficiency at billing and collecting fees – both issues that would be seriously tested if the tide turned. The survey’s findings indicate there is no clear consensus as to how European firms should be managed (see ‘Management’) while cultural differences persist on the critical issue of how quickly outfits are able to take payments.
Italy has long lagged in this respect, but there are signs the gap is narrowing. It remains the least efficient jurisdiction for firms, with an average of 117 days work in progress (Table 10). But however bad this may appear it represents a turnaround from last year’s figure of 158 days, and perhaps more alarming are the results for Germany and Spain, which have both leapt from 55 and 85 days two years ago to 94 and 103 respectively last year.
Where firms are taking longer to bill clients, this bodes ill for a market universally regarded to be at the top of its game. The amount of time practices take to collect on the other hand remains fairly unchanged on last year’s figure (Table 11); although here too Italy seems to have made an imposing downward revision – from 141 in the upper quartile to 89 – while Finland appears to have let matters slip, increasing its debt collection time in that quartile from 93 days to 166. These problems with efficiency could come to the fore, especially in a highly leveraged market. According to Mr Carter-Pegg, firms should not become complacent during this boom period with regard to cash management practices, which can often suffer during particularly busy periods for partners: “Senior management should be looking ahead and planning for when the market eventually does cool to ensure their firm and partners are prepared for leaner times.”
Nor are these the only challenges to firms revealed by the survey. The fees per partner figures reflect the dominance of City players, with the UK well ahead of the field (Table 16). According to James Harley this presents a challenge to other European practices, since it reaffirms the centrality of London to the corporate legal market: “Firms from other European countries need to consider carefully whether their interests are best served by competing directly with the Anglo-Saxon outfits on their home territories for corporate work, or finding ways to team up with them.”
This observation, together with any problems that might arise from a downturn, should give firms food for thought. However, there are many variables in the legal market. Changes in regulation, both actual and forecast, can quickly alter the outlook for legal practices (see ‘Changing regulations’). Also, on the plus side, Mr Williams says firms will have time to consider their options whatever may happen: “One of the great advantages of the law as a sector is a lagging indicator – which means that it is only affected by a major change in the underlying success of the markets after a period of about a year to a year-and-a-half. In the immediate aftermath of a downturn the legal market can support itself by working on insolvency and restructuring work and litigation.”
Fresh light is cast on the cultural differences attaching to law firms’ use of secretarial support by the inclusion of new data this year relating to salaries. While Germany’s market possesses the distinctive feature of having twice as many secretaries to fee-earners as other countries according to the survey (Table 25), the relative salaries there are lower than average across the board (Table 26). And although Germany’s secretaries are thicker on the ground than in other countries – (as a result of their long training period, qualified German lawyers enjoy the status attached to having a personal secretary) – the level of work they are required to undertake is correspondingly lesser, reflecting the fact that they receive two-thirds or less than their counterparts in Belgium, Italy, Sweden and the UK.
The latter jurisdiction gives rise to misleading statistics in this regard however. Although the UK has an average number of secretaries to fee-earners (about one secretary to three fee-earners across all groups), their salaries are among the highest of all European countries (€53,600 in the upper quartile). Nonetheless this is probably an indicator of the higher costs of employment in the UK capital and may have been a different figure if more respondents had been from the regions rather than London.
Perhaps the most surprising figures emerge from Italy and Belgium, where a similar number of secretaries to fee-earners as the UK are paid the highest salaries in Europe, (an astonishing €65,900 and €60,200 in the upper quartiles in Italy and Belgium respectively). This gives secretaries in those countries €10,000 more pay than their counterparts in the best-paid other European nations and is probably only explicable in terms of the type of work done both by firms in general in Belgium and by those specifically polled for the survey.
One missing field of data that is vital in considering the impact of support staff costs on firms is outsourcing. It is likely that one explanation for a continuing low ratio of secretaries to support staff in countries such as the UK – and their relative good pay – is that bulk and simple work can increasingly be outsourced to India and other places where it can now be turned around overnight at a fraction of the cost to the practice of using home-grown staff. In this context however the figures for Poland are once again interesting. A relatively high ratio of secretaries to fee-earners there (rising to two-to-one in the upper quartile) costs less than €15,000 per head in each of the groups. That makes the cost of a secretary in Poland less than a quarter of that in Italy according to the data and highlights one of Eastern Europe’s key attractions for law firms: costs almost as low as those in outsourcing locations in the developing world.
If the variety of business structures remains an area where law firms differ greatly according to territory, so too is the thorny issue of external finance. Although table 18 indicates there has been a slight increase among practices of borrowing against their goodwill (a rise from 0.2 as a multiple of partners’ capital in the median sector to 1.26), the overall figures remain largely unchanged; indicating the paucity of countries where such external finance is commonly, if at all, used. Nonetheless this is a statistic that should be keenly watched, especially following the introduction of the Clementi reforms in the UK, which create the possibility for firms to bring in external finance using a number of avenues.
Certainly changes in regulations can have a direct impact on legal practice, as the results showing firm expenditure on professional indemnity reveal (Table 19). In the UK, where the market for insurance was liberalised and taken away from the collective fund (the Solicitors’ Indemnity Fund) several years ago, the percentage of costs paid by firms has crept up inexorably. This year that figure is 4.7 per cent of total costs, up from 4.1 last year. No table demonstrates more comprehensively the distance yet to be bridged by practices in forging any kind of European model firm. In Finland, Poland, Spain and Belgium, firms pay less than one per cent of total costs on such insurance while in Germany the figure, at 4.2 per cent, is nudging the UK’s. Although some allowance has to be made for the type of outfit profiled by the survey in each country – larger practices pay higher insurance premiums – the UK figures show that liberalisation does not always bring about reductions in costs. But the issue of insurance is also a hot potato among local bars admitting other European firms to their jurisdictions. Currently players are frequently deterred from establishing in other EU countries by provisions requiring them to take out double insurance, or top up their home country insurance in order to establish elsewhere. The discrepancy between the jurisdictions involved in the survey shows there is no common approach among EU member states on this issue yet and, until that happens, all the similarities relating to leverage, profitability and management will remain theoretical.
Firms profiled this year as opposed to last were slightly smaller overall in terms of number of fee-earners, with the exception of the UK (Table 20). This may explain why the number of players indicating they use full-time managers to take strategic decisions for their firms has diminished from last year (Table 12). Then, 80 per cent of outfits claimed they employed a full-time practice manager, whereas this year that figure has more than halved to 37 per cent. Apart from the fact that many of the operations profiled this year were smaller than last, this figure may well be misleading in other ways. Management is an area where law firms across the continent are having to tackle greater challenges: dealing with more transient workforces, adapting to fiercer competition and meeting the demands of a fast-shifting corporate environment, among others. In many jurisdictions it remains impossible under existing bar rules for firms to operate in partnership with non-legally qualified personnel, making the very existence of such non-legal managers a grey area.
The complications of management are greatly exacerbated by the multiplicity of structures under which firms operate, as Table 14 displays. For the first time this year, the survey included a hold-all group of ‘other’ management structures, to cater for the fact that in Poland and Germany not all players fit within the ordinary categories of companies and partnerships, whether limited liability or otherwise.
There is some indication from this year’s data that the limited liability partnership is continuing to make headway as the preferred management structure for European law firms. In Belgium, half the outfits polled now use it, up from a quarter the year before, and all of the respondents from Spain used the limited liability model, whereas only a quarter did last year. But it is still too early in the lifespan of the LLP to declare that it is winning out. After all in Poland, where many firms have started new management systems in the last few years, the unlimited liability partnership remains dominant (75 per cent of practices surveyed).
Differences in approach to management are also reflected in the figures of male to female fee-earners and partners (Tables 22 and 23) which show that against the stereotypes of Scandinavian liberalism, the UK, Italy and Poland all have a higher concentration of women working at all firm levels than in Sweden.
The addition of Poland to those countries under scrutiny gives a valuable insight into the current differences between Western European states and the new members, albeit represented by only one nation. Poland is however a fair example of those jurisdictions which acceded to the EU in 2004, being the largest and most highly populated by commercial lawyers.
A dramatic difference is immediately visible in legal fee income per fee-earner (Table 13): where the rest of the countries showed – with one or two exceptions – increases across all levels, spurred by the rise in M&A activity last year, Poland tails behind fairly considerably at almost 50 per cent of the average median figure (€129,000 as against €249,000). This has had the effect of keeping the total average figure of the eight key nations surveyed down on last year’s, but this is misleading, and four of the jurisdictions posted figures of €300,000 or higher at the median level – whereas only one country reached this benchmark last year.
Poland’s potential is however visible from its net profitability results (Table 15) which at 35 per cent were in line with the average (40 per cent). These profitability figures also give a clue to the state of each particular market, especially those of Italy, which leapt from under 40 per cent last year to 51 per cent this survey, as a result of the increase in M&A activity there.
Figures giving a snapshot of net profit percentage show a broad similarity, other than in the case of Poland. And this exception continues apace on the statistics for partner profits. In terms of legal fee income per partner (Table 16) Poland scrapes roughly a third of the figures of the leading country, the UK. However for reasons apparent elsewhere in the survey, the viability of Poland and similar Eastern European countries cannot be judged on today’s bottom line figures, and detracts from the really significant outcome in these tables, a step rise in profits-per-partner. Poland’s leverage figures show that its firms are adopting an Anglo-American model – in the upper quartile its results are similar to Spain’s. Although it does not yet reflect those
other highly leveraged countries’ lofty profit-per-partner figures, Poland’s current leverage bodes well for future increases in profit.
Tomasz Wardynski, founding partner of Warsaw-based Wardynski & Partners, describes the current Polish market as ‘shallow’ in comparison with other EU states. He estimates it is worth about €350 million in fee income each year – about equivalent to the takings of one top Spanish law firm – spread over 20 or so leading corporate practices. Nonetheless he says that two factors will give it strength going forward: first, a move by clients to use local Polish outfits in preference to multinational practices that have moved into the market and, secondly, heavy investment by domestic firms in their technological and physical infrastructure.
Of course, some profits are not distributed by firms, although the evidence across Europe (Table 17) suggests that the amount being retained remains fairly constant, though there has been a fall-off in the upper quartile in Finland (from 0.2 to 0.05 per cent) and the UK (from 0.9 to 0.4 per cent). These statistics are not always easy to use as a clear indicator since UK offices might make more capital retentions for foreign posts than their continental counterparts. But here the figure for Poland is compelling, as at 0.73 per cent in the upper quartile it is retaining more profits than other European countries by some stretch. This alone cannot explain the relatively smaller profit figures generated by firms in Poland – the value of contracts and labour are much lower in Eastern Europe – but they do suggest that players in this region are thinking ahead and laying the investment groundwork for future profitability, and back up Mr Wardynski’s contention. Such retained capital is often used to fund infrastructure and projects such as IT overhauls. It is a reasonable assumption that many firms in Eastern Europe lag in their infrastructure compared with their Western counterparts and therefore need to spend to catch up. But when they are technologically the match of the rest, the services they offer may represent better value than existing law firms operating in these markets.
The marketing and training figures (Table 24) confirm that in these sectors the Anglo-Saxon model is not higher spending than its continental counterparts. This is the second year that the UK’s expenditure on marketing (2.8 per cent of total costs) has hovered around the average, while other jurisdictions such as Germany and Finland have exceeded it. The Finnish phenomenon of high spending on marketing continues and is explained partly by the favourable tax-deductible status of such costs there. In Spain, meanwhile, expenditure on marketing has more than doubled from 2.2 per cent of costs last year to 4.5 per cent. This may reflect particular campaigns by those firms in Spain covered by the survey, but certainly indicate practices there are spending a lot more on marketing than their other European counterparts. One surprise is that the Polish players, despite registering a more Anglo-Saxon approach on their leverage and management structures, spent comparatively little on both marketing and training, with figures of just over one per cent of total costs in both cases. It will be interesting to see if that figure changes in the next few years.
It is worth bearing in mind when looking at the relative costs of marketing and training, however, that those UK firms included in the survey are much larger than their counterparts abroad (Table 20), and that there are considerable cost savings to be gained from the luxury of employing staff dedicated to these roles rather than relying on external contracts to deal with issues on an ad hoc basis. Roschier’s Mr Lindholm explains that apart from the beneficial tax treatment of marketing costs in Finland, one reason why the figures are relatively high there is that outfits are less sizeable than elsewhere: “It costs the same for a small firm to carry out an advertising campaign as it does for a large one, but the bigger player pays less per capita.”
Nonetheless the low expenditure on training in Italian practices indicated by the survey demonstrates that this is an area where cultural differences remain pre-eminent. Silvia Hodges, the founder of a marketing network in Italy, says she is unsurprised that the country’s firms appear as low investors in marketing: “Much of it is down to the perception of the profession. In Italy there is still a strong notion that lawyers are not businessmen and firms should not foster a brand identity so much as rely on the reputations of individual practitioners. That is changing slowly, but these figures reflect this mindset. Whereas in Spain – as the survey results reveal – that is not the case nearly so much, and brand identity among law firms is strong and growing.”
