Third Year of Successive Growth Across the Legal Sector, Large Firms Dominate
The latest annual Legal Benchmarking Report from MHA, the UK-wide group of accountancy and business advisory firms, reveals a third year of growth across the sector. However, while large firms continue to dominate the market, the fortune of small firms is more mixed as income and profit levels reduce and their cost base increases.
Overall, firms with five or more partners have experienced significant income growth rates of between 8% and 20%, fuelled by mergers, the volumes of corporate transactions and the improving economic conditions.
As a result, the gap in growth rates of the largest firms (more than 25 partners) compared to those of mid-tier firms (11-25 partners) continued to widen in 2016. Large firms are now nearly three times the size of their mid-tier competitors. The trend for mergers in mid-tier and large firms appeared to accelerate during 2016, and is expected to continue through 2017.
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.
In 2016, the average income per equity partner in larger firms jumped to nearly £1.4million, from around £750,000 in the previous two years. The performance for those firms with 11-25 partners saw a reduction of 12% compared to 2015. Firms with 5-10 partners continued the trend from last year, with higher levels of average income compared to mid-tier firms, suggesting a drive for consolidation and increased efficiency in this group rather than adding new equity partners to drive growth.
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 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.
Karen Hain, Head of the Professional Practices sector at MHA explains: “While our report reveals a sector in financial health, with performance in 2016 pointing to a positive outlook for the future, firms continue to face a challenging environment. With potential cost implications from areas such as the government’s new Apprenticeship Levy, pension Auto Enrolment, the National Living Wage and business rate assessments, firms will need to maintain control of expenditure if profitability is to be increased.
“There is a level of momentum in new work generation from corporate and property sectors in the economy at present. We expect this to continue, even after factoring in any negative impact from Brexit talks or with the up and coming general election. Competition in the sector is ‘hotting up’ with firms needing to be able to resource new work quickly and efficiently.”
Karen went on to say: “If firms are planning to grow income at similar levels for 2017, they must consider how to fund this growth. We have already seen lock-up increasing so plans need to be made now for additional bank finance or partner contributions before cash runs out.”
(Source: MHA)
