PKF Francis Clark partner Andrew Allen and director Janet Taylor have co-authored an updated guide for law firms on complying with the Solicitors Regulation Authority (SRA)…
Andrew Allen looks at how the debt profile of many law firms has changed since the start of the COVID-19 pandemic, how this has affected the relationship between law firms and banks, and what firms can do to address their debt and funding now.
Law firms have always enjoyed a special relationship with banks. The banks were attracted by the client funds, which provided their own balance sheets with capital to lend, as well as the symbiotic relationships at an individual customer-base level. Law firms, conversely, were attracted by the interest on client funds, availability of debt, and the same customer referral potential. Will this long-lasting special relationship continue in the future?
Banks and law firms pre-COVID-19
If we cast our minds back to pre-coronavirus (COVID-19) times, the relative enthusiasm of banks for the legal sector has varied at times, but there has always been an underlying level of support and a close relationship between the two.
During the last 25 years that I have been working with law firms, I have spoken with many bankers concerning the extent to which they are prepared to lend to law firms. While there is often a lot more detailed analysis in these discussions, a recurring off-the-cuff comment would be that banks are prepared to provide funding to a law firm to the same level as partner investment – typically, £1 of debt for every £1 of partner funds.
Of course, in those conversations, being clear on what debt includes and what banks mean by “partner funds” can be more challenging. For example, do partner funds include current accounts (undrawn profits) and taxation reserves, as well a capital account? Does debt include all forms of external debt, as well as the bank’s debt?
Either way, this rule of thumb gives us a clear steer on what banks feel is a manageable level of debt for a law firm to accrue. It is also interesting to note at this point that the majority of law firms I see in practice actually ran their debt levels at a much lower than this £1 for £1 rule of thumb; in fact, the most common level of debt I saw pre-COVID-19 was in the range of 40p to 60p of debt for every £1 of partner funds in the business. So, most law firms had a good deal of headroom in their borrowing capacity.
Consequently, banks have generally viewed law firms as low-risk borrowers, strong providers of capital (client) funds, and a potential source of private client referrals through their client base.
In this post-COVID-19 landscape, the level of debt facilities afforded to law firms now far exceeds the rule of thumb set out by banks in the past, with many firms having taken out Coronavirus Business Interruption Loans (CBILs). Fundamentally for banks, there is limited risk in issuing these loans, because they are substantially underwritten from a risk viewpoint by the government.
During 2020, I spent a great deal of time with law firms looking at these types of facilities and helping firms with their applications. My experience is that following this debt-raising, the debt profile in many law firms is now very different. Taking into account facilities that have been secured under CBILs, if firms used those facilities, the level of debt would typically be in the region of £1.50 for every £1 of partner funds in the business – a long way above the 40p to 60p typical level pre COVID-19 and, crucially, above the £1 rule of thumb that banks feel comfortable with. In more extreme cases, I have seen potential debt levels rise to up to £2.25 for every £1 of partner funds.
In 2020, I facilitated the LawNet group of independent law firms’ annual financial benchmarking survey. We asked a number of questions around their approach to COVID-19, which included additional debt facilities. The results are informative.
- 62% of respondent firms have taken out a CBIL.
- £500,000 was the average loan secured.
- Only 31% expected to use the loan.
- 2.27% was the average rate on the loan after the interest-free period.
Perhaps one of the most interesting points is the fact that only 31% intend to use the funding; this then begs the question as to why they wanted the facilities in the first place. Here are some of their interesting responses.
- “Just in case” – a lack of certainty over the trading outlook in the legal sector. Despite a very strong first half-year for many law firms in their 2020/21 financial years, there is a continuing concern about what 2021 may bring for the sector.
- “Insurance policy against the banking sector” – a concern that the appetite for lending to law firms may decline if we head into a recession and there are law firm failures.
- “A war chest” – more ambitious firms seeing opportunity on the horizon from turbulence and an opportunity to acquire firms, teams or people. At the same time, there’s a concern that the banking sector may not be acting “as normal” towards the legal sector in 2021/2022, and consequently, there’s a need to secure the funding upfront.
These are telling signs about firms’ expectations of both future performance of the legal sector and the role in which banks may (or may not) play in this.
Returning to the relationship with the banking sector; it is worth considering the following.
- Banks have less appetite for client funds due to constraints on their own balance sheets and lending ability.
- Banks now have increased debt facilities with firms under the CBIL scheme, so additional lending by the banks under their own risk is likely to be less appealing – i.e. most are already exceeding the £1 to £1 borrowing rule mentioned above.
- The law firms using the CBIL facilities in practice are more likely to be those struggling financially. This is likely to lead to law firm failures in 2021/22 and will potentially undermine banks confidence of the sector.
- Succession remains a problem for many law firms, which are increasingly struggling to find incoming partners to replace retiring partner capital funding.
We have already seen considerably less investment by banks in the last couple of years in terms of the resources set aside for providing services and support to law firms, which perhaps in the past was disproportionate to the importance of the legal sector to the UK economy.
Steps firms should take now
Taking all these factors into account, there are several points for law firms to consider.
- Put in place a plan, in the medium-term, to at least get debt levels back to below £1 for every £1 of partner funds.
- Put structures in place to ensure the firm consciously spends the CBIL monies, rather than just subconsciously absorbing them through funding losses, lower profits levels, lower productivity or poorly managed lock-up.
- Don’t assume usual lines of bank funding (or external funding) will be as easy to secure in the short to medium term, even if your firm is a good prospect as a borrower.
- Try to develop a funding policy which determines the mix of partner funds in the business compared with external debt.
- Think about succession early, including what the balance sheet needs to look like to assist that process. High partner capital accounts and no debt may not be a winning combination to attract the best future partner talent into your business.
The emergence of government-supported funding for the legal sector will have provided a much-needed lifeline for some firms, and for others a windfall of a cheap source of future risk capital. Equally, it seems probable that there will be some law firm financial failures over the next couple of years and it is possible that banks may react adversely to this.
Law firms need to ensure they plan to manage (or take best advantage) of what might be “the new normal” in terms of the special relationship between banks and law firms.
This article was originally published by The Law Society Law Management Section.