In Defence of Partnerships

Who would have thought it? I have spent a fair bit of time crtically evaluating partnership structures. Yet now I feel the need to come to their defence!

The reason for this is simple. The best partnerships do tend to focus on their clients on one side, their staff on the other.

Note I say the best partnerships. Too many partnerships actually combine the worst elements of corporate structures on one side with the weaknesses of partnership structures on the other.

A key advantage of partnership structures at a time of economic downturn is that partners as owners can choose to reduce their own incomes in a way that senior managers in corporate structures cannot or will not.

This comes about because to partners as owners, reductions in remuneration flow (a partner loss) can improve capital performance (a partner gain).

I do not think that this detracts from the validity of my previous arguments. However, it does demonstrate the need to take a broad range of issues into account when considering firm structures.

Corporatisation, Corporate Structures and the Law - The Case For

I mentioned in my short previous post on the Slater and Gordon float that I had lost a much longer post looking at the issues raised by this post.

Since then, the float itself has been much discussed, and I see little point in replicating that discussion. Instead, I though that I should focus on one issue, some of the commercial reasons why corporate forms and indeed public listings can make sense in law. I do so because there seems to be a degree of confusion on the matter.

The core of the confusion can be simply stated: what is there about a corporate structure that makes commercial sense? How can this change add value to an already well managed practice?

The answer can also be simply stated. There are structural inefficiencies built into the current partnership system, inefficiencies that can be resolved by adoption of a corporate form.

A list of key inefficiencies follows. In writing, I am not trying to be absolutely rigorous, simply pointing to issues to be considered.

Professionals vs Managers

In many practices, the senior partners are also the key managers. As exemplified in the two case studies I used in my depression series (Free at Last, Jan's Story) many of them are very bad managers. I looked at some of the reasons for this in a post last July, People management in professional services - professionals vs managers.

Firms can address this one by introducing professional management as many have done, but the story does not end there.

Role Confusion within Partnerships

In many partnerships, the different roles played by partners (managers, owners, professionals) are all mixed together.

In my post On role clarification within partnerships I argued strongly that role clarification was essential if the partnership form was to survive.

My key point was the need to separate equity returns from payment for work. Once this was done, the definition of roles and the remuneration to be attached to those roles could then be dealt with using conventional job analysis and remuneration principles.

My experience has been that partnerships are often unwilling to address the issue of role clarification because the current role confusion benefits individual partners. This builds another weakness into the partnership approach.

Abolition of Goodwill

"It is something of a misrepresentation to suggest that there is goodwill at all", said one senior Perth barrister. "Who in the legal profession recognises goodwill? The big firms do not recognise goodwill." Quoted in the Australian Financial Review, 27 October 2006, in a response to the proposed float of Integrated Legal Holdings

To suggest, as this Perth barrister did, that goodwill has no value is absurd. Worse, it is one of the key factors sounding the death knell for partnership structures.

I discussed this issue last July in Professional services: mergers, acquisition and goodwill. Partly because of the difficulty of attracting partners, many firms abolished the goodwill component in valuing partnerships.

This action has had a number of adverse impacts.

It treats the true value of the firm - the client base, accumulated intellectual property and business systems - as though it has no value. The reality is that it does, thus opening the firm up to acquisition offers that allow equity partners to realise at least some value from an asset otherwise counted as zero value.

The approach also has often unrecognised behavioural impacts.

In Self-employed professionals vs business builders, I looked at the behavioural differences between self-employed professionals and those trying to build a business. I suggested that the first group, the majority by number, focused on return from cash flow. By contrast, the second focus on building a business looking for a return from the combination of cash flow and business sale.

This is not just a semantic difference. There is a very real difference in business decisions focused on short to medium term cash flow maximisation as compared to decisions concerned with building longer term business value. There is no point in the second if you cannot realise value from the investment.

In abolishing goodwill, partnerships moved themselves from the longer term business building category to the cash flow maximisation class to the detriment of firm and client.

Economies of Scale and Scope

Economies of scale arise where the unit costs of delivering a particular good or service fall as volume increases. Economies of scope are similar except that volume relates to increases in volume spread across a number of goods or services.

Economies of both scope and scale have become more important across professional services over the last fifty years. Reasons include greater investment in IT systems and knowledge management, as well as increasing insurance and compliance costs. This will continue.

All this drives firms in the direction of growth. This is another area where corporatised law firms have advantages, especially when it comes to acquisitions.

Take, as an example, the approach of the WKK Group to tuck-in acquisitions, acquisition of smaller firms whose business can be tucked in to compliment the broader business. I know of law practices that follow this approach. However, it is just much easier to make this work in a corporate structure.

A particular advantage for listed firms is that they can offer shares that have a clear value without all the problems that can be involved in slotting new partners into a partnership structure. This links to a broader issue, the way in which staff shareholding schemes can be used to reward staff for growth in ways not possible in partnerships.

Risk Management, Multidisciplinary Working and New Business Activities

I have grouped these three together because while they are very different, they also share some common issues.

As we saw in the case of Courdert, if something goes wrong in a partnership, the results can be disastrous for all. Corporate structures can help quarantine risk.

This is especially important if firms want to enter into new, linked, business activities.

The question of whether law firms should enter into activities outside legal services or stick to the knitting raises different issues. The reality is that many firms have diversified, often turning related activities into new revenue sources. Again, corporate structures facilitate this, while also quarantining any risks that might be involved.

This also links to the question of multidisciplinary working, the grouping of different, normally related professionals, so that they combine their different skills in an integrated approach.

I discussed this area some time ago in a preliminary way (here and here). Depending on local regulatory structures, these forms of working can be accommodated within partnerships. However, corporate structures can make the process easier.

Conclusion

As I said at the outset, the analysis in this post is not intended to be rigorous. My objective has been to point to some of the reasons why corporate forms can make sense compared to traditional partnership structures.

On role clarification within partnerships

As a professional adviser, one of my core arguments has been need for change within many professional practices to better delineate otherwise conflicting roles and to facilitate more effective governance and management. I believe that this is critical to improved performance and indeed survival in some cases.

Partnerships Under Challenge.

The partnership is the traditional organizational form within professional services and remains important today. In this form the world is dominated by the equity partners who essentially own the game. The practice grows by admitting new partners generally recruited from within the ranks who pay a price for partnership. In turn, this facilitates exit by existing partners. Partners receive their return from the profit pool, the pre-tax net remaining after deduction of expenses.

This traditional model is under strain. Risks associated with equity partnership have increased. There is growing reluctance among younger professionals to accept partnerships. At the same time, the availability of partnerships has also declined for those that are interested. Increasingly, partners themselves want more flexible life styles.

There is not scope in this type of post to canvass all these changes and their implications. Instead I want to focus on one thing drawn from organizational theory, the way in which role clarification can assist a partnership to manage change.

Confusion in Roles

All of us who have been involved as managers or advisers on people issues know that clarity in job role is critical to performance. People need to know what they have to do, how their performance will be measured. This is also critical when it comes to remuneration. Lack of clarity about the links between role and pay can and does create significant management problems.

Unfortunately, the traditional partnership approach breaches the clarity principle. Partners traditionally receive an agreed share of the profit pool. In return, they are expected to do a range of things that may have little direct connection with either the size of the profit pool or their share of it. This can create significant tensions within the practice and may make it hard to easily address performance problems at partner level.

Clarifying Roles

In my view, the first key step in addressing this problem is to make a clear distinction between the partner's equity and work roles.

Equity partners in the firm should receive a return on the capital invested in the practice, while their work roles should be remunerated with payments directly related to those roles and associated contribution to the practice. These payments should then be counted as a cost from a management accounting perspective, creating a notional profit directly related to equity.

Once this separation principle has been established, the definition of roles and the remuneration to be attached to those roles can then be dealt with using conventional job analysis and remuneration principles.

Impact of Clarification

This simple approach to role clarification offers a number of very real performance gains.

To begin with, it makes partners more directly accountable for their own work performance. In turn, this makes it easier to assess partner contribution and vary remuneration accordingly.

It also makes it easier to admit staff or non-equity partners in that they can be paid using the same principles as applied to equity partners for their work.

Finally, it can increase flexibility for equity partners in managing their own affairs.

Take leave as an example. An equity partner on leave would still be entitled to a return on his/her investment. Any other payments can then be handled on the same basis as applying to other staff.