The broad trend for the year just ending is one of record profitability and we expect our own figures to show record increases. It is important, however, that we use this platform to seek a more balanced view in the future.
I argue that PEP is not an appropriate measure of the success of a law firm and should be replaced with measures which take account of sustainable profitability, client satisfaction and staff motivation.
I suggest that, in seeking to create the conditions necessary to motivate staff, we must answer the question: “What kind of firm do we want to be?” Similarly, in pursuit of true client satisfaction we must address the question: "What kind of firm do our clients want us to be?"
At the same time I argue that, properly defined, the pursuit of sustainable profitability and the application of financial disciplines are nevertheless essential pre-requisites for the long term health and independence of any commercial law firm and for the independence of the profession as a whole.
The context
We are in the middle of the US law firms' reporting season when the financial results for the calendar year 2006 are informally released by those firms to the press. This reporting usually takes the form of an annual turnover figure followed by a figure for PEP. These figures are normally unaudited and the basis on which the PEP figure is calculated is not clearly stated.
The financial year for US law firms commonly ends on 31 December whereas for London-based firms the financial year end is normally 30 April. The reporting season for London-based firms will therefore normally begin when the US season ends.
Law firm reporting in London has traditionally taken the form of unofficially leaked figures for turnover and PEP, both of which are normally unaudited. Allen & Overy is the principal exception to this rule because, as an LLP, we have an obligation to report audited figures in the form of a full profit and loss account and balance sheet.
This has meant that we are unable to release final figures in early May because we have to allow time for the full accounts to be prepared and audited, a process which takes two or three months. We are also constrained in our use of estimated figures to provide statistics to the market because our auditors need to check and approve them.
We are now seeing other firms converting to LLP status and it is probable that our style of audited reporting will become the market norm in two or three years' time. This will be a welcome development because it will lead to greater transparency and consistency which should, in turn, lead to greater accountability.
A dangerous and undesirable metric
The style and content of financial reporting are clearly important issues but they do beg a more fundamental question: what is the proper measure of a law firm's success? We find ourselves in the middle of a reporting industry which points almost exclusively to PEP as the measure of success. It is my belief that PEP is not merely an inappropriate star by which to navigate, it is in fact a dangerous and undesirable metric for the legal profession to follow.
There are four basic reasons for this view. First, it ignores the two audiences that determine the success or failure of a law firm: its clients and its people.
Second, it tells you almost nothing about the underlying performance of a firm in terms of efficiency and sustainable profitability.
Third, it is out of touch with a world which increasingly requires a demonstrable level of corporate responsibility and a broader contribution to the communities in which firms operate.
Fourth, it is a calculation in which both the numerator and the denominator have become more impressionist than real.
Our clients and our people
Let us look at these criticisms in turn. The principal problem with PEP as a metric is that our clients have very little interest in it. It shows them a profession which is preoccupied with its own narrow financial interests and which appears to have forgotten that the service of the interests of clients is the starting point and the finishing point of any firm's existence. This is not a wise position to adopt.
Equally, it is a metric which does not touch any of the areas that preoccupy many of the people who work for law firms. It does not answer the questions posed about quality of work, career development, flexible working, work life balance, diversity or training, which dominate any discussion about law firms as seen by those who work within them.
In simple terms, the most successful firms will be those who stand highest in the esteem of their clients whilst at the same time persuading the most talented people to join them and remain with them. The pursuit of PEP does not take account of either of these goals.
Measuring true law firm performance
The second problem with PEP is it does not evaluate the underlying performance of a firm. We are currently in a global marketplace which is shifting as many partners as it can from equity status to salaried status. If this can be done whilst short term profitability is maximised, the result can be spectacular for the shrinking class of equity partners.
It does little, however, for investment in training and teamworking, investment in smarter use of IT, investment in client relationships, greater levels of flexible working, community involvement and the myriad other things which affect today's profit and loss account but offer possible future benefit.
It also provides no insight into the sustainability of a firm’s profitability because the leveraging effect of a sharp reduction in equity partners can mask the quality of underlying earnings.
An improvement in profitability which is based on sustainable workflows from major global clients is a very different proposition from an improvement in profitability dependent on ever-shrinking numbers of equity partners. Quality of earnings is not assessed by the PEP figure.
It also runs counter to the general rule that the motivation of any group will increase if that group shares in the results of its endeavours – in other words, performance would probably improve if more people were to share in the equity.
Corporate responsibility
The third objection to PEP is connected to the first. There is an irresistible move towards greater corporate responsibility in all areas of business and professional life and our profession is no exception.
This trend may owe something to the personal beliefs of the people who occupy positions of responsibility, but the frail platform offered by those beliefs is underpinned by the rather more robust insistence of clients and employees that a more responsible and responsive stance is taken by all firms. This should now be a central part of evaluating the success of any firm.
The question "What sort of firm do we want to be?" will produce an answer which embraces wide areas of corporate responsibility. I will return to this question in a further article but it is sufficient to observe here that a preoccupation with PEP does not help to answer it. Indeed, the preoccupation with PEP can sometimes give the impression of a profession which has lost sight of anything beyond its self-interest.
Impressionistic financial results
I will leave the fourth objection to PEP to the imagination of readers. It is sufficient to say that in the US it is widely acknowledged that the treatment of unfunded retirement benefits can often distort PEP results whereas in the London market it is often difficult to reconcile the sum total of equity and non-equity partners with the number of partners in existence. If a financial calculation is to be made at all, it should be made on the basis of audited figures.
What, then, should replace PEP as the barometer of law firm success?
Sustainable profitability
The starting point should be an acknowledgement that sustainable profitability must sit at the heart of any measure of success. Indeed, sustainable profitability sits at the heart of the success of the whole legal profession and the maintenance of the rule of law because no profession can hope to be independent if it is financially unsustainable.
Professionalism and sustainable profitability are therefore inextricably linked; they need not be contrasting forces pulling in opposite directions.
What constitutes sustainable profitability for a modern law firm? Most analysis of this question will identify various proxies for sustainable profitability. Let me offer two such proxies which, taken together, provide a proper measure for success: satisfied clients and motivated people. I would dispense with PEP as a measure of success.
Its proper replacement should be a graph on which the x axis represents client satisfaction and the y axis represents staff and partner motivation. Where is the money in such a graph? Anyone smart enough to satisfy their clients and motivate their people will undoubtedly have most of the money.
Will this measure replace PEP? Certainly not, because it is too difficult to chart. There is, however, no simple financial metric which provides transparency and comparability. The differing capital and remuneration structures of law firms make it extraordinarily difficult to provide a true comparison.
This is probably just as well because the profession needs to get its sights refixed on the things that will sustain it in the long term; PEP is not one of them.
Further information
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