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PPEP levels are doomed without re-invention

5 September, 2012

. Law. Strategy

If Bruce’s MacEwen’s recent analysis of the historical trend in revenue, demand and realization doesn’t worry you as an owner of a BigLaw firm, then don’t read any further.

Beaton Capital has modeled a forward look at the drivers of BigLaw PPEP, profit per equity partner or equity point. The picture isn’t pretty.

Adam Smith Esq, Bruce MacEwen’s blog name, delivers a robust microeconomics 101 tutorial to BigLaw in a recent post ominously titled ‘Growth is Dead, Part 1’. The early paragraphs make scary reading:

“If you want to deny things have changed, you would point to Equity Partner Rates and PPEP, but for purposes of this discussion I disagree. The time series I would call out are Revenue, Demand and Realization – all down. I focus on those three series because equity partner rates and PPEP are internal financial reports essentially under the control of firms (at least in the short run, and three years still qualifies as the short run). The ones I prefer to focus on are creatures of the market and reflect market forces.”

Bruce draws on the Hildebrandt/Citibank time series, which by definition is based on actual historical data for a substantial sample of large US law firms.

A ray of hope appears to lie in the economic variables under the control of law firms – charge out rates and equity points on issue. These indicators are still tracking in positive territory for law firm proprietors.

Any hope is, however, dashed by making some basic assumptions, all grounded in well-documented trends in market forces, and applying these assumptions to a 10-year forecast of what will happen to PPEP in a steady state law firm. Let’s face it, as I have argued elsewhere almost all large law firms are practising in a business-as-usual way.

We have modeled a firm starting with annual revenue of $100million and 2,500 equity points on issue. Then we assume revenue decreases at 5% each year, lawyer salaries increase 3% annually for five years (and then stabilise), other overhead costs increase 1% per year for five years (and then also stabilise) and, finally, this firm holds its equity points at 2,500 for each of the 10 years. Here’s the result: PPEP halves in less than 10 years.

Beaton Capital_PPEP halving scenario

Now you might want to argue no firm will make such small adjustments for this long. Surely, you might say, this firm will further cut staff and reduce space and also reduce the points on issue and/or cut the number of equity partners. Partners accustomed to incomes of these levels are not going to be passive in the face of a decline of this magnitude. Yes, of course rational business owners will do these things. And the result, depending on your assumptions of how rapidly and decisively the firm acts, will be less of a disaster than the chart suggests.

But will this fictitious firm really be quick off the mark and decisive? We know several firms that are already on this slippery slope. And, guess what? These firms are not acting in any manner that could be described as strategic and decisive. The partnerships are stuck. Some partners deny the forecast. Others believe the ‘good old days’ will return–provided they hold their nerve. After all, the bank hasn’t coming knocking yet. And aren’t there are sufficient senior associates in the ranks signalling an interest in becoming equity partners. Such graphs are the fiction of scaremongers they will say.

We invite you to judge for yourself. Send us an email and we’ll give you the spreadsheet so you can plug in your own assumptions.

Remember the frog in the beaker over the open flame? Poor frog only realised the water was too hot for life once it was too late. The result wasn’t pretty, similar to the lines in the chart above.

Like Adam Smith Esquire, we urge law firms to make up their own minds about the future and how their business models need to change to ensure they can continue to serve their clients and prosper at the same time.

By George Beatonis a director of Beaton Capital and Beaton Research + Consulting. You can find George on Google+ at +George Beaton.

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