Not too small, not too big

Mid-size law firms have been doing reasonably well these past few years, coming out of a tough recession and showing strong resilience in the face of growing competition from alternative providers.

One prediction was that alternative business structures would turn traditional firms into antiquated models as relevant as waxworks of former celebrities in a room full of teenagers chasing Pokemon Go characters via virtual-reality headgear. This has not happened.

But not all is rosy. Sole practitioners are suffering, according to the latest report by accountancy association MHA. Of all law firms, they are the ones that seem most affected by rising overhead costs, including professional indemnity insurance. Fee income is down from last year, as is profitability and profit per equity partner.

This problem is unlikely to go away. As the archetypal example of businessman-cum-professional-services outfit, sole practitioners are spreading their time thinly between doing legal work, chasing invoices, and keeping the work coming in. It’s the nature of this kind of organisation. Competition from other firms and some alternative providers plays a part, but cost increases are a bigger threat because they are more difficult to tackle than competitors.

Smaller practices – those with between two and four partners – are performing marginally better, but only just. Their profitability has gone up but PEP has gone down, suggesting that more lawyers were made partners. This points to one of the big challenges for these firms: succession planning. This is also an issue for firms one bracket up, the five-to-ten partner practices, but the slight increase in size at that level is sufficient for roles and responsibilities to be spread around the partners more evenly, relieving individual partners of some of the management burden in a way that two-to-four partner firms are struggling with.

For small firms, succession planning is far removed from the romantic notion of passing on a legacy. The concern is funding run-off cover, which protects practitioners from claims after their firm has closed down. Long gone are the days when a friendly local firm would take on the bank of wills and pay the run-off bill. Managing risk has become a priority, and that includes not taking on other people’s liabilities. Most deals these days involve the seller agreeing to buy run-off cover. In practice, that means there is no ready-made exit plan for smaller firms.

The thousands of sole practitioners and smaller firms are not about to disappear overnight. Some have shown how specialisation can be a successful growth option. But for many, the model is not sustainable. Sole practitioners and two-to-four partner firms pay the most in PII as a percentage of revenue. Even if the SRA goes ahead with a more flexible approach to minimum requirements, PII will remain a disproportionate cost for these firms.

For the majority, size will be the determining factor. Size brings scale. It need not be large, just enough for the fee earners to focus on fee earning and fund non-lawyers to concentrate on managing. This will also help address the issue of lock-up, which has been going up significantly across the profession, except in the five-to-ten partner firm bracket.

Should that segment be the ideal size for regional firms? Most indicators suggest so. And if the trend continues as it has in the past few years, the next decade will not be so much about ABSs sweeping up the work but about a readjustment of firm sizes for a more efficient delivery and a more sustainable future.

Jean-Yves Gilg is editor-in-chief at Solicitors Journal

@jeanyvesgilg

jean-yves.gilg@solicitorsjournal.co.uk