- Date
- 27 July 2023
Business of Law Firms:
2023 Financials Season
By Jake Rickman |
What do you need to know this week?
It is that time of the year: while it may not be a sunny July, it is the time when the largest UK firms release their preliminary financial results for the financial year ending April 2023. We will take a look at them in this week’s Business of Law Firms series.
Here are the numbers for three of the UK’s largest firms, Linklaters, Clifford Chance, and Allen & Overy (courtesy of The Lawyer)*:
*Note: Travers Smith's financials were released today as this article was going into publication.
Below are the financials of certain other UK firms grouped by colour to indicate that they are loosely considered part of the same market segment:
It helps to acquaint yourself with how law firms talk about their financial performance and to work on analysing what these figures mean.
Why is this important for your interviews?
Revenue: an overview
A common interview question is, “How do law firms make money?”. This can be a deceptively simple question: the answer is the fees they bill their clients for their legal services. The total value of these fees is generally referred to as “revenue”. You may also hear it referred to as the “top-line figure” to describe the fact that revenue is the first line-item on a profit & loss statement.
Analysing revenue figures
As we can see, all but one firm posted a year-over-year (YoY) revenue increase. This means that they generated more client fees than in the previous year, which is a sign of resilience given that businesses in most other sectors are seeing YoY revenue decreases due to market uncertainty and inflationary factors. Only Macfarlanes saw a YoY revenue decrease, which management suggests was in response to these unfavourable market conditions.
Of note is the fact that firms on the smaller side of the market such as HFW and WFW had some of the largest YoY revenue increases compared to the bigger UK firms. In HFW and WFW’s case, it may be helpful to note that they operate in more niche areas of the legal market, specifically in shipping/maritime, commodities, and litigation. Both of these areas saw an increase in market activity, whereas the volume of big-ticket M&A and financing transactions has plummeted in the past 12 months. This therefore at least partially explains why these firms posted better revenue figures compared to the wider market.
PEP: an overview
Profit per equity partner (PEP) is a common financial metric specific to the legal profession. That is, you will not hear public or private companies discuss PEP, whereas you will hear all businesses discuss revenue figures. This is because law firms are structured as partnerships — specifically limited liability partnerships (LLPs) — rather than companies limited by shares.
PEP is an industry shorthand to discuss how profitable a law firm is. PEP starts with the firm’s profits, which is the figure you get if you subtract from the firm’s revenue all its operating expenses, such as wages, rent, and other overheads. You then divide this figure by the total number of equity partners.
Despite its wide use, PEP has certain limitations:
- Importantly, a firm’s PEP figure does not actually tell us what each partner in a law firm is taking home each year. Profit sharing agreements differ between firms and each firm typically treats these agreements as closely guarded trade secrets. But generally, the more senior you are as a partner, the more you take home each year. Likewise, most firms factor a partner’s performance into their remuneration, so that partners that generate more fees are comparatively rewarded.
This is to say that a junior equity partner at Allen & Overy likely takes home less than £1,820,000 each year, and a senior partner likely quite a bit more. - Another key feature of PEP is that it applies to equity partners and not salaried partners. This reflects the fact that most law firms these days have two tiers of partners: salaried and equity partners. Salaried partners are partners in name only. They do not generally participate in the law firm’s profits, nor will they have contributed capital to the law firm, which is usually a condition for becoming a partner.
Nonetheless, provided PEP figures across firms are calculated using the same methodology, it can give a general sense of if a law firm is more or less profitable than its peers. Likewise, you can use PEP to benchmark a law firm’s current performance against its historical financials.
Analysing PEP figures
PEP is generally down across the board, from which we can infer that profitability in general is likewise down at an industry level. The exact cause depends on the firm in question, but a dominant factor is likely the fact that last year, most firms went on a hiring spree in response to increased deal volumes. To stay competitive, they increased associate salaries. Now that the deal market has slowed, firms are seeing proportionately less revenue against higher salaries. This can make profit negative for the years.
There are other factors as well. Try and think of other factors that might increase expenses in the short-term and drive down profitability.
