The latest annual UK Legal Benchmarking Report from Henderson Loggie in conjunction with MHA, the UK-wide group of accountancy and business advisory firms, reveals a third year of growth across the sector.
Overall, firms with five or more partners have experienced significant income growth rates of between 8% and 20%, fuelled by mergers and the volume of corporate transactions.
Most firms saw increases in net profits of between 2% to 5%, their highest levels in the last three years. While large firms saw a 4% increase fuelled, in the main, by a 20% increase in fee growth in the year and greater control on expenditure and overhead reductions, those with between 2 and 10 partners achieved an increase of 5%, reflecting decreases in non-salary overheads and fee income increases. In marked contrast, sole practitioners showed a 4% decrease in net profit.
However, firms with four or less partners saw a reduction in income in 2016 (-2%) reversing a trend of low levels of growth in the preceding two years of between 5% and 8%. This reduction reflects the significantly competitive market these firms operate in, and increased regulation and compliance requirements. Alongside the reduction in net profit, they faced significant increases in overheads, including professional indemnity insurance costs.
The performance at a profit per equity partner (PEP) level showed a decrease in the smaller firms. Sole practitioners saw the first decrease in PEP performance for five years as it dropped 30% compared to 2015. The largest firms saw a recovery in their PEP performance from a drop of 16% in 2015 to an increase of 36% in 2016, as strong overall profit performance filtered down to the partner level.
Equity own partner investment continues to be the favoured method of finance; in 2016 the amount of fixed capital invested in smaller firms was £87,000 and £215,000 in the largest practices. The percentage of total equity partner investment compared to fees increased in 2016, demonstrating a fall in return on capital. In addition, increases in equity funding point to moves to become less reliant on external sources. Total funding per equity partner for the smallest firms has grown from £135,000 in 2015 to £156,000 in 2016. For the largest firms it has increased from £355,000 to £506,000 in 2016.
The growth in fee income has hit lock-up levels and practices are reporting a rise in lock-up as working capital is needed to pay new fee earners and fund work in progress. Despite a move toward greater control on lock-up resulting in a year on year reduction in the number of days, 2016 revealed a worrying increase with firms of 11-25 partners seeing lock-up increasing by 31 days from 129 in 2015.
The majority of firms have seen a stable level or reduction in salary costs in 2016, with only firms of between 2 and 4 partners experiencing a small increase. This position is in contrast to a broad pattern of increased costs in 2015 for all but the largest firms. In addition, smaller firms have experienced a sharp decline in the percentage of fee earning staff while larger firms continue to see an increase in the ratio which helps to add income onto the top line.
The risk of inadequate succession planning continues to be a challenge for the sector. As the financial performance rates of small and larger firms widen, it will become increasingly harder for small firms to attract new equity partners without adequate levels of profit available to be shared. For sole practitioners, an ageing equity partner base and the lack of appetite from younger solicitors to become sole practitioners in the future, is placing a greater emphasis on succession and investment in the fee earning staff.
David Smith, Managing Partner & Head of the Professional Practices sector at Henderson Loggie explains:
“The report reflects a sector in good financial heath, however the increase in lock-up days for all multi partner firms is concerning. Succession planning continues to be a challenge for the sector although the ongoing trend of merger activity does provide a short-term solution for this problem.
“Profit is the lifeblood of any professional practice and provides the vital funds required for investment into growth. Across the UK the most profitable firms in our survey show increasing ratios of fee earners to equity partners, which drives up income per equity partner. The successful firms focus on profit.”