Prepare for a long harsh winter
Updated: Nov 6, 2020
Tuesday 3 November, I read a slightly bewildering article on Bloomberg. In Europe banks are lobbying regulators to restart dividends and bonusses while we are still in the worst economic recession in living memory. The tone struck by Europe’s lenders is in stark contrast with a deteriorating backdrop of new infections and restrictions that threatens to bring more economic pain. Coming at a time when taxpayer money is being used to soften the impact of lockdowns that could bankrupt companies and throw millions out of jobs, the dissonance risks putting bankers on a collision course with regulators. The banks look extremely good at the moment because governments take the biggest burden of the crisis. Thanks to governments, the biggest banks in Europe in Q3 set aside the least amount of money for doubtful loans since the onset of the coronavirus -- at a combined $7.2 billion, it’s a fifth of the $36.7 billion provisioned in the first half.
Reading this, it seems that the banks are completely out-of-sync with reality. It is a question of when, not if, banks’ asset quality will deteriorate in this crisis. This is interesting as there are some striking similarities with what we see happening in the legal industry right now.
For many law firms 2020 will be a bumper year.
When the crisis first hit back in March, generally law firms feared for the worst and immediately started taking measures to brace for the impact. Cashflow was for most the first concern. All available credit lines were drawn to the max. Some firms put staff and lawyers on government furlough schemes. Some firms – temporary – reduced salaries of lawyers and staff. Payments to creditors were deferred and partner payments were halted or reduced. Anything to save cash and secure liquidity if revenue would drop. There was huge concern that clients would pull back on collections or would defer work. Some law firms anticipated no less than a 30% drop in revenue.
Today it is November and we are seven months into the crisis and we have seen that the legal industry so far has steered clear of the worst case scenario. Very few clients pulled back work or adopted substantially longer payment terms. Looking at the tier-1 segment of the legal market, there have been surprisingly few discount requests from clients. Like the banking sector, the legal industry has taken all precautions and braced for an impact that did not come. Production so far has been on par with 2019 Year-on-Year or sometimes even better. Law firms have taken large provisions for client fees that they would not be able to collect, but clients are paying and paying on-time. Things are looking particularly bright right now.
At the same time costs are down YoY compared to 2019. There is almost no travel and expenses, no events and lower cost of marketing. Many firms have asked part of the furloughed assistants and staff to leave and have been lowering their salary costs. Some partners have been ushered into early retirement or asked to leave the firm. With a healthy revenue, normal collection rates and lower cost, profits are expected to be higher than in 2019. Despite the pandemic and the economic crisis, many law firms are in for a bumper year.
The impact is yet to come!
[ source OECD data by 31-10-2020 ]
With the rapid rising number of Covid-19 cases in Europe and the United States and many economies back in lockdown, all hopes for a rapid V-shaped economic recovery have evaporated. On top of that we have the US-elections which took place on 3 November which adds further to the uncertainty, then there is Brexit and in 2021 Angela Merkel will step down.
As the graph shows, the European economy is projected to contract by 11.5% over 2020 and the US economy by 8,5% and this does not yet take into account the outcome of the elections. With such numbers, it is unavoidable that many companies will be affected. Many SME are going out of business as a consequence of the forced closures and mandatory lockdowns. The hospitality, travel- and airline industry, the retail sector, the car industry, just to name a few and all their suppliers are facing hard times. Millions of jobs will disappear and the damage does not stop here. Also large multinationals that still make a more than decent profit are shedding jobs. On 29 October Royal Dutch Shell Plc reported $955 million of net profit over Q3. This beat even the highest analyst estimate. The company reported lower net debt and strong cash flow. Still 9000 jobs at Shell are to disappear and Shell is not exception, they are just an example.
In an article that I published on 9 April 2020, I predicted that the 2020 legal market in a worst case scenario would shrink by 10%. At that time the article was meant to dampen the ‘panic’ at law firms and the fear that the market would collapse. My prediction back then was that this was unlikely to happen and with today’s knowledge I was right. My forecast today, seven months down the line, is less optimistic than back then. I fear that things will get much worse before they will be getting better. It is unlikely that revenue and profitability for law firms in 2021 will be as good as they will be in 2020.
I would advise to err on the side of caution.
For those law firms where the fiscal year ends on 31 December, I would advise not to distribute all the profit as usual, but make provisions for the year to come. If this is not possible for tax reasons or just because the partners do not trust the firm with their money, then at least manage expectations and prepare the partners for weaker results. It would also be advisable to take an extremely conservative approach as it comes to advance payments to the partners. You do not want to end up in a situation where partners have to refund payments received.
I think law firms could learn from the banks. Just as the banks right now are pushing to pay dividend and bonusses to keep shareholders and traders satisfied, law firms are under pressure to distribute all profit in full to keep their partners satisfied. Just like the banks seem out-of-sync in their demands, law firms will be out-of-sync if now they do not save for a rainy day. For the banks there is no doubt that their asset quality will deteriorate in 2021, just as for the law firms it is hard to imagine that they will once again be spared from the effects of the economic crisis. Just like the 2008 financial crisis led to a 5% contraction of the legal market in 2009, the current economic crisis will again lead to a drop in demand and revenue. Only this time the economic crisis is much deeper and more wide spread and not limited to the financial sector, so the impact will likely be more severe. Get ready for a long dark winter!