Thoughts on ways to improve the management of professional services firms

Friday, March 16, 2007

Performance Measurement - Profit Per Equity Partner (PEP)

People love pecking order measures. I suppose that this is only normal.

I was reminded of this by a recent post Bruce MacEwen’s blog about the vexed question of the use of Profit per Equity Partner (PEP) as a measure. There Bruce discusses an article by Guy Beringer, a senior partner at Allen & Overy, criticizing the use of PEP as a measure. Bruce then suggests a number of alternative measures.

My problem with the way that PEP is used is that PEP, at least as I understand it, is grossly misleading because it combines and confuses two very different things, the return from work and the return on capital. This confusion is deeply embedded in traditional partnership structures and ways of thinking.

In earlier posts (here and here) I argued strongly that we needed to establish a clear demarcation between returns on work and capital. This links to my main problem with PEP, I don’t actually know what the measure means.

To begin with, it seems to imply that all partners have equal shares. This may but need not be true.

Then problems can arise where firms derive revenue from services other than legal services. These may include back office services as well as revenue from training and publishing operations, to name just three. These can work to increase PEP in ways that have nothing to do with supply of legal services.

Moving on, there can be problems with accounting processes. I know of firms that express the profit pool in terms of cash available to partners after meeting all cash out costs including development and capital costs because that is the real measure to them. Some firms on growth trajectories are prepared to take lower “profits’ now in expectation of higher returns later. The profit pool measures on which PEP depends are not necessarily consistent between firms.

PEP is also affected by the markets in which a firm operates.

Senior legal salaries are far higher in some markets than others. So to the degree that a firm operates in a higher salary sector you would expect PEP to be higher because the salary equivalent component within PEP is higher. This says nothing about the firm’s real profitability, the return on equity.

Just to amplify this a little.

In practice, we all know that some partners contribute more than they get, others get more than they contribute. That is one of the reasons I support more transparent systems. However, assume for the sake of simplicity that all partners are equally competent, work equally hard and make similar contributions.

In these circumstances each partner can leave the firm and get a salary or salary equivalent some where else. This is the return for labour and will vary between markets. If PEP is not high enough to cover this, then the firm is in fact operating at a real loss. So the varying salary equivalent component in PEP of itself says little about real performance.

1 comment:

ilanit said...
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