Chris Marston: The red flags for banks when lending to law firms

Growth is on the strategic agenda of many UK law firms, and a strong relationship with the firm's bank is critical to achieving those ambitions.

Today, everything from a firm's profit forecasts to its succession plans is taken into account by bankers in determining whether to extend existing facilities, says Chris Marston.

"One of the things a lot of law firms tend to be surprised about is the extent to which banks look at non-financial aspects of their business," he reflects.

Chief executive of LawNet and formerly head of professional practices at Lloyds TSB Commercial, Marston has inside knowledge of how both lawyers and bankers think.

For him, reliable profit and loss forecasts are "absolutely critical" when a law firm goes into a meeting with its bank, as they provide a strong indication of the firm's future funding requirements.

Being risk averse, managing partners may be tempted to adjust revenue forecasts to make them seem less ambitious. However, Marston warns against doing so, as bankers will be doing the same as a matter of course.

"Give it your best shot in terms of what you're aiming at and what your budget is," he suggests.

For him, good business management which results in a high position in annual benchmarking reports is key to getting the best outcome from a meeting with the bank.

"If you're a top 100 firm, expect to be compared against PwC's benchmarking report, because that's what good looks like. And, if you're in the SME space, expect to see your bank manager comparing your performance with either the NatWest annual survey or the Law Society's annual law management section survey," says Marston.

Ranking in the top quartile for financial management can often be critical in getting a bank to step outside of policy to help a firm to "do something extraordinary", he notes.

Red flags

The high-profile collapse of several leading law firms in recent years has caused many banks to tighten their purse strings and cast a more critical eye on their clients.

Law firms can now expect to have every aspect of their business scrutinised, including their partnership.

"Bankers will look at the profile of the partnership, how long the firm has been around and how well equipped it is to succeed in the new environment," says Marston.

A big factor which will be examined in firms of all sizes - from the magic circle down to sole practitioners - is succession planning.

"If the top partners are going to retire and take their capital out in the next few years, that's a really big issue."

Bankers will be looking to learn about the age mix of the ownership group, their strengths and capabilities, and if is there a good balance of practice areas and skills, says Marston.

They will also ask if the firm has insured against the loss of top rainmakers or business managers.

"If you lose one of your top rainmakers or internal managers, getting a locum in won't replicate what the rainmaker can do for you and you'd only have a temporary solution to having a chief operating officer out of action," he says. "So, insuring against that is critical."

Another red flag is a lack of diversification in the firm's income streams, particularly overreliance on a single practice area.

"The fact is, if you don't have another string to your bow, then a big change can wipe your firm out," he says.

"And, if you have a real dependence on a particular team that has a stellar reputation for the work it does, that team may well be tempted to go off and set up on its own."

Other warning signs are partner drawings exceeding profits and a lack of internal transparency on the firm's financial performance.

Asks Marston: "Does a small group or maybe just an individual have exclusive access to important information about the firm's financial performance which is not shared with the rest of the ownership group? That's a red flag."

He admits that these people can be "pretty intimidating" at times, but emphasises that "it just doesn't make sense to be an owner of a business and not know what's going on".

Another big concern for banks is how far a law firm has limited the liability of its owners, as that is considered a sign of how committed the partners are to the firm's success.

"Banks have a right to expect that the owners suffer at the very least some inconvenience if their business fails," he says.

He adds that banks don't want to own law firms, so banks will not want to have more money at risk in a law firm than its owners.

"Bankers expect the leadership group in a law firm to lead by example. So, discussions about an appropriate level of personal commitment from the members of an LLP or the directors of a limited company are increasingly on the agenda."

Law firms' professional indemnity insurance and claims records are also being scrutinised by banks as part of the loan approval process. Increases in premiums are seen as an indicator that firms may be in trouble.

Also important is the firm's relationship with its regulator and whether it is under particular scrutiny.

"One simple question is all you really need to ask as a banker: Are you in an intensive supervision relationship with the Solicitors Regulation Authority?"

While some firms may avoid sharing such information with their banks, Marston says having a tripartite meeting with the regulator is critical to obtaining the best outcome for the firm.

There also needs to be a commitment by law firms to communicate to their banks any business changes which can affect their profit forecasts.

"Bankers hate surprises - they really do. They'd rather you tell them really bad news than you keep it up your sleeve. They can help you to deal with the bad news if they're prepared for it," says Marston.

Nasty surprises

A useful way to avoid unexpected bad news for the bank - or, indeed, the firm's partners at year-end - is to keep a close eye on liquidity throughout the year.

"A regular analysis of working capital is absolutely critical," comments Marston.

"You need to understand what work-in-progress looks like, how much of it will actually be charged to clients, who the debtors are and how old they are.

"You need to know if the firm is making disbursements on behalf of clients for matters and is not getting cash upfront.

"You also need to understand creditors; you especially need to know if money is on the road to other parties."

Balance sheets should be updated on a monthly basis in order to measure and manage progress against the firm's full-year targets, he notes.

Other information which is useful to bankers when determining whether to give the firm the funding it seeks is a breakdown of new instructions.

"These can provide an advanced check on what the effect on cashflow might be going forward," suggests Marston.

For him, the best way to present the firm's financial information to the bank is through summary statements, supported by detailed commentary; he says the words are "at least as important" as the numbers.

"Some of the best information I've seen from law firms is quite simple summary dashboard-type information, with words and actions attached to the areas where there were variances with their original plans," recalls Marston. "So you knew they were doing something about it and were using this as a tool within their business."

He says the worst kind of report is voluminous, with the accounts department having likely "pressed every button available" on its practice management software.

"Almost invariably, the more information there is in a report, the less well the firm understands it."

Business as usual

Many hard lessons in business management were learnt by law firms during the global recession. But, as lawyers return to business as usual, there is a risk that those lessons will be forgotten as the economy and confidence picks up.

"The last recession of the early 1990s taught us very clearly that professional service firms tend to suffer more on their way out of a recession than when they are in it," warns Marston.

In the excitement of getting busy again, many fee earners will be more focused on winning new instructions than on collecting monies due for previous work, which could lead to trouble for their firms in the coming months.

It will be up to managing partners to take a broader view and to monitor how much cash their firms can afford to have locked up. If they don't, "these exciting times could be the end of them", as Marston puts it.

Manju Manglani is editor of Managing Partner (www.managingpartner.com)