Mini Series: The Business of Law Firms - Calculating Profit Per Equity Partner​

By Jake Rickman​

What do you need to know this week?

Welcome to the ninth article in our series on the Business of Law Firms.

Last week, we considered what exactly equity on an LLP (Limited Liability Partnership) balance sheet refers to and how equity means slightly different things for partnerships compared to companies.

This week’s topic is profit per equity partner (PEP), a term you are likely familiar with but perhaps not certain what specifically it refers to. We will look at the difficulties in calculating PEP and how it compares to other common financial figures used to analyse a company’s performance (rather than an LLP’s).

We have spent the last eight articles studying Clifford Chance. This week, we will look at the reported PEP figures of the Magic Circle collectively, except for Slaughter and May, which by virtue of its general partnership status does not have to publish its figures. To provide some context, we will also include certain other figures derived from the firms’ annual accounts.

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Calculating PEP

Looking back at Clifford Chance’s income statement and balance sheet from the previous week, you will notice neither list PEP as a financial measure. So how is it calculated?

You may be surprised to know the formula for PEP depends on who you are asking. For instance, Law.com calculates PEP as net operating profit divided by the total number of equity partners. Legal Business calculates it as net income divided by the number of equity partners.

Additionally, most firms do not regularly disclose the exact number of equity partners (as opposed to non-equity partners), which can make it difficult to calculate PEP on your own. That is why most PEP figures you see cited are the figures that the law firm in question has reported themselves.

PEP is an example of a commonly used financial figure that is not recognised under the “generally accepted accounting principles” (GAAP), which is a collection of rules and formulas with definitions common to different accounting societies around the world.

Another example of a non-GAAP figure is EBITDA — Earnings Before Interest Tax Depreciation and Amortisation — which investors and market analysts use to measure a company’s ability to service debt (which makes it useful for determining how amenable it is to a leveraged buyout).

Purpose of PEP

You might rightly ask how we can compare PEP figures if they might be calculated differently. In other words, why is PEP so commonly used?

For one, PEP is no indication of how much partners are actually paid on average. Firms using a lock-step model — where remuneration entitlement is based on years of service — will obviously pay senior partners a higher share than junior partners. Other firms that base pay on fees generated (“eat what you kill”) will pay more productive partners more.

Separately, the firm’s management committee is unlikely to distribute all the available profits as compensation. Instead, an undisclosed portion will be reinvested back into the business.

Nor is PEP an accurate measure of the underlying efficiency of a law firm’s business. Firms with more partners will have a diluted profit pool, making their PEP lower even though other measures of profit, such as net profit margin, might be higher.

Instead, we might think of PEP as a reflection of how law firms (or, more accurately, law firm partners) see themselves. Compared to companies, LLPs are more inward-looking. By definition, they do not have outside owners (shareholders), which largely means they are less likely to be bought and sold. In this sense, PEP operates as a crude proxy for the earnings potential of an equity partner. Firms care about their PEP figures because a higher PEP suggests their partners are paid more.

Why is this important for your interviews?

Being able to disassemble the concepts behind PEP in an interview will demonstrate that you have a strong grasp of the business fundamentals of a law firm. It will also encourage you to treat PEP critically.

For instance, say you are interviewing at a firm that, relative to its three closest competitors, has posted the lowest PEP in the most recent year. Rather than take the headlines at face value, you do a bit of digging and determine that the firm has made a substantial investment in its US presence by opening three California offices the past financial year and hiring 15 more partners. As a result, its operating expenses went up considerably that year while also diluting the profit pool. This in turn creates a smaller PEP figure in the short term. But, as you explain, the upside is that the firm has accessed a new market, which may in turn increase profits (and PEP) in the long term.