Law firm floats: not as lucrative as you thought

Senior partners in major Australian law firms could be forgiven for daydreaming about retirement in the south of France after reading the recent AFR article “Lawyers float a multibillion-dollar idea”.

This article by Marcus Priest appeared on the front page of Friday’s edition and sought to assess the value that the market may place on Australia’s largest law firms if they were to undertake IPOs.

Before booking their tickets to Nice, law firm partners would do well to double-check the arithmetic that saw Priest conclude that “Based on the number of partners at the top 10 law firms, the average value of equity per partner is $10 million”.

In arriving at this figure, Priest started with current partnership profitability, as sourced from the “AFR Partner Profit Survey (2006)”, before assessing firm value by adjusting profits to reflect the salaries that would be paid to “partners” as employees of a listed entity, and then applying a Price Earnings Multiple of 14x.

Presumably in a rush to meet print deadlines, Priest looks to have made two sloppy errors that combine to see the value of partnership interests overstated by more than 100%.

The first error is that, while Priest purports to have adjusted profits for “a base partner salary of $400,000”, my reconciliation of the figures suggests that he may have inadvertently included a salary of just $30,000 per partner. Further, any assessment of value performed using a “Price Earnings multiple” requires that the multiple be applied to post-tax earnings, and the AFR looks to have neglected to adjust for tax – as partnerships, law firms currently do not pay tax.

Once these two errors are corrected, the value of the largest law firm, Freehills, is reduced from $2.65 billion to just $1.094 billion. For less profitable firms the effect of the arithmetic errors is more pronounced; the value of Phillips Fox reduces from $900 million to just $247 million as set out in the table below:

If a reduced valuation of around $3–6 million per equity partner is enough to tempt any of the major firms to consider a float, they would do well to think hard about the possible downside of a public listing. The major risk of an IPO for a major corporate firm would come from the effect that reduced earnings opportunities for senior employees post-listing would have on the business’s ability to attract and retain the best staff.

At present, the lure of equity partnership and the significant annual income (around $600k-$1m based on AFR figures) that accompanies it provide a significant incentive for senior associates and more junior, salaried, partners to work long hours for relatively modest incomes.

If the “size of the prize” for getting to the top of a listed law firm was reduced to a salary of, say, $400k per annum (with any profits above that distributed to external shareholders), it would be hard for lawyers with a realistic claim on equity partnership to continue working for a listed company for so long as other firms retained a partnership structure with its relatively more attractive income potential.

It is this risk – that floating a law firm would line the pockets of the partners of today while crippling the business’s ability to pay market rates to the senior lawyers of the future – that the proponents of law firm IPOs are choosing to ignore.

While identifying the key risk of listing is straightforward, it is much harder to identify significant benefits that a law business would derive from a public float. A law business does not require significant capital and, other than providing current partners with the opportunity to cash out, one of the few benefits discussed in the Priest article is the role share and option plans could play in assisting law firms to retain middle and senior level staff.

On this topic, Priest quotes Bill Beerworth, a law firm IPO exponent, stating that the opportunity to participate in equity plans is a significant factor driving some lawyers to defect to investment banks.

This analysis overlooks the fact that investment banks are able to offer employees greater reward for their labour not because they are listed, but because they currently achieve annual revenues of more than $2 million per professional employee in their investment banking divisions (as compared with law firms, whose more restricted, hourly chargeout model struggles to generate $500k per fee earner).

With at least 4x the revenue per professional employee, the investment banks are able to pay their staff much more generously than a law firm could ever manage, while also having plenty left over for shareholders.

Until law firms find a way of transforming their business model to achieve a huge uplift in revenue per employee, the limited staff equity plans that a listed law business could offer would only tinker at the edges of this imbalance.