Responding to an imminent threat
With the Corona pandemic raging through the world, our healthcare systems are stressed beyond their limits. It is heartbreaking to see the reports from the doctors and nurses fighting at the front line. In an attempt to dampen the outbreak, our governments have halted most of public life. We are all ordered to stay at home and many businesses have been forced to close. As of yet, no one knows how long this will last.
One day however we will be able to claim victory over the virus. The war against the Corona virus is a war we are guaranteed to win. We just do not know at what cost of human lives.
While fighting the pandemic, another MUCH LARGER crisis has been brewing. We are descending into the worst and most severe economic crisis in the history of mankind. Our TGO Consulting Research Team has been monitoring economic indicators from around the world on a 24/7 basis for the past weeks. The outlook is getting darker by the hour. Here are two graphs to help you see what we are seeing:
The graph above shows the PMI (Purchase Managers Index) between 2007 and today. It shows the impact of the 2008 credit crisis. The graph clearly shows by comparison what extreme and steep drop we are seeing right now.
The graph below shows the effect on global trade. Exports from the US have dropped to the lowest level in history. No need to point out that for China the data are similar. The global economy is grinding to a halt. This has never ever happened before. No amount of rescue packages from governments and central banks will be enough to prevent the damage.
The US rescue package is now already worth around 10% of GDP. The blow to output and to tax revenues could also be larger. At least a few economies are likely to find themselves with debt loads well in excess of 150% of GDP. Readers beware, we will be in the most severe economic recession ever. This is going to be really really bad.
Fiddle while Rome burns
When Rome burned, emperor Nero allegedly played his violin. While this obviously cannot be true, the attitude and mood in the legal industry somewhat reminds me of this image.
Our researchers have contacted a number of elite law firms across jurisdictions and almost invariably managing partners claim that their firm is still doing great. Despite the crisis and working from home, they claim to see no substantial dip in billable hours. Observing legal media across multiple jurisdiction seems to support this image. Obviously there is some editorial content around the virus and having to work from home, but for the most part it remains business as usual: great M&A deals and successful lateral hires. On LinkedIn, law firms across Europe still celebrate their rankings in Chambers.
While the economy burns, law firms keep playing the violin...
It is time for a very loud wake-up call
Last week I promised to help you prepare for the economic effects. Over the weekend I have urged you to put in place wartime leadership for your firm. It is high time for law firms to come to grips with reality and to prepare for a MASSIVE economic crisis unlike anything you have seen before. Therefor it is important to move beyond your daily Corona Virus Legal Updates and focus on what is to come. (By the way, do you have any idea how many -almost identical- Corona Updates the average client is receiving just from law firms?)
First things first: cash-flow!
Like any other business, law firms need cash to pay for their monthly costs. We call this Operating Expenditure (opex). Your opex consists of Direct Costs (the red rectangle), these are the salaries and bonuses of the fee-earners (partners not included) and the Indirect Cost (the yellow rectangle) as illustrated below.
Characteristic for law firms is that opex are fixed, it does not vary according to production. Law firms need the roughly same amount of cash every month to meet their financial obligations. In order to meet these obligations, you need at least an equal amount of money coming in from clients paying their invoices.
The first thing you need to do right now is to make a cash-flow analysis and projection. In order to do that you need to make an inventory of:
a) Invoices that are still outstanding and likely to be paid.
b) Billable hours produced, but not yet invoiced to the clients.
c) Ongoing matters and the future billable hours still expected (realistically)
d) Realistic pipeline of new mandates
e) Your firm's financial obligations per month (projected)
Based on this inventory you have a pretty clear picture on how much money might still be coming in. Now you have to factor in at what point in time this money realistically will be received, bearing in mind that clients will extend their payment term and some clients might not be able to pay at all. The cash-flow analysis might be your most important indicator to monitor. You need to keep on top of this and do a new analysis based on the most recent data every week.
Second: your bottom line
Profit is an opinion; cash is a fact. That is why we emphasize cash-flow before profit margin. However, for law firms profit margin equals partner compensation and this is always a super sensitive topic.
We know the economic slump will depress demand and slow client payments, but don’t know when it will kick in, how bad it will get, or how long it will last. Once partners will start to realize, just how bad things might be, they will start to feel anxiety about their income. Within a matter of weeks/days from now law firm leaders will be under pressure from partners to take all necessary measures to protect the income of the partners.
At the time of the 2008 financial crisis cutting costs was pretty easy and law firms turned to their usual playbook: they made some staff redundant, skipped planned investments, scaled down on marketing, tried to renegotiate occupancy and other costs, reduced recruitment and raised the quality bar for lawyers, firing those who did not meet the new threshold. Reducing the number of equity partners at the same time, most law firms managed to limit the damage to partner income. Some firms even ended up with higher PEP during the crisis than before. The problem now is that it following the same playbook once again will not have the same effect. We did it all a decade ago, today there is far less left to cut.
There might be a big elephant in the room
The average profit margin for law firms is around 35%, while some elite law firms are around 50%. This means that between 50 and 35% of all revenue is allocated as compensation for the partners. Reducing that number would have more impact on the available cash position than any other measure. Discussing the possibility of temporary reducing partner payments to help the firm through harsh times has until now been considered a taboo as it could open Pandora’s box.
We have written an entire book on this topic: Death of a Law Firm (2015).
Partner compensation is a complicated multi-faceted topic that goes way beyond what can be covered in this article. So for now it seems wise for law firms to remain on the side of caution and reduce monthly payments to partners. This would be preferable to a capital-call at a later stage. It seems only fair that also partners show that they are prepared to bear part of the burden. Just dismissing some associates and staff and negotiate a lower rent does not look good. When the whole economy is collapsing, we will all be better off if we share the impact. We should all behave like decent people and not put our individual interests before those of others.
We are here to help
TGO Consulting is there to help you navigate the crisis. We are currently writing a book on this topic that will be finished by end April. This book will be made available for free to all our clients. We will also continue to publish weekly articles on topics that are most relevant to you right now.
Our experience with law firms in China gives us a two month head start in knowing what best to do. There will however remain many important unknowns and things can change really fast. This is where our unparalleled creativity has proven to be extremely valuable. We have a proven track-record to find effective solutions faster and better than anyone else. In the meantime, our TGO Consulting Research Team keeps to monitor the state of the economy literally 24/7 to ensure that our approach always remains fact-based.
Please do not hesitate to contact us to find out how we could help your firm navigate these challenging times.