The primary financial risks to law firms include foreign exchange risk, interest rate risk and inflation risk.
Foreign exchange risk
Large multinational corporates tend to have sophisticated treasury operations that often operate as profit centres within the organisation, frequently acting as a bank within the group. A handful of law firms have a treasury function but none that we have identified have the level of sophistication shown by multinational corporates. Whether a treasury function should be run as a profit centre is debatable and not for discussion here.
In theory the business is simple, as law firms all operate as a single entity globally in terms of accounting, even though there may be legal structures in place for regulatory, tax or firewall purposes. All profits earned are translated into the firm’s ‘home’ currency and all partners receive a share of the profits in that currency.
Currency fluctuations have a direct impact on profits as all income is translated into the home currency at the average exchange rate for the year. Of course, to the extent that costs are incurred in local currency this provides a natural hedge, so it is only the gross margin that is affected. A good example is the useful boost in profits to
The partners located outside the home country will naturally want to receive their income in local currency and this is where a difficulty is encountered. At a high level, firms fall into one of two areas:
the partners knew when they joined that this was the case and this is a risk the partner must take; or
the firm endeavours to provide some relief for affected partners from the effect of currency fluctuation and therefore the firm takes some or all of the risk.
For those falling into the lattercategory, there are three common ways of providing relief to FX fluctuation:
a) the firm offers an average rate over a period and partners must decide at the outset whether to opt in or out;
b) the firm pays partners their distributions based on the exchange rate for the period it relates to rather than at spot on the date of distribution; or
c) the firm agrees to pay in local currency and absorb all the risk itself.
Both have an upside and a downside. In the first there is a danger that partners living in a country with a currency that has strengthened against the home currency will become disenfranchised. In the second example, the home partners may be unhappy that an increasing share of the profits is being absorbed in compensating the overseas partners. This is becoming far more of an issue as firms become increasingly multinational and therefore have a greater proportion of their partners based outside the home currency. For the largest law firms, it is normal for less than half of partners to be based in the home country.
There are two distinct risks here: the value of the currency to the firm and the value of compensation to the partner. In neither of these scenarios are all interested parties fully protected from currency fluctuations.
Banks have always been happy to provide hedging products to firms and partners, but the rates available to the firm tend to be much better than those available to individuals. There are a number of reasons for this, including lower deal sizes, greater regulatory requirements, manual delivery mechanisms and competition. At Barclays Commercial Bank we are developing a hybrid product that allows partners in the larger firms to ‘piggy back’ on the firm’s internet-based dealing service. The partner remains the bank’s counterparty, but the deals are done at rates much closer to the corporate than the personal tariff. The firm undertakes to pay the home currency equivalent to the bank. This does not completely protect partners from moving exchange rates, but it does provide certainty of rates for up to 12 months forward.
As mentioned in the introduction, the budgeting process this year will be far more difficult for global firms in trying to predict what rates to use for their overseas earnings because of the volatility and uncertainty facing the major economies. Therefore firms should consider their hedging strategies with care.
Interest rate risk
A simpler concept, and for many firms that have a low gearing, changing interest rates do not pose a significant risk. The turmoil in the credit markets over the last nine months has led to a significant increase in the price of debt across the board and the spread between LIBOR and Bank base rate remains at an all-time high. Barclays Bank PLC is forecasting
Inflation risk
Traditionally, law firms have prospered during periods of inflation as it tends to be easier to pass on inflation-linked increases in costs to clients and also inflation has tended to be linked to periods of prosperity in the economy. As clients increasingly focus on charge-out rates and the increasing tendency in some areas for fixed price contracts, then inflation may become a cost that is difficult to pass on.
While inflation remains at low levels and under control, this is not a major factor in law firm profitability. However, particularly in low margin, high-volume work, it is worth considering seeking some protection against inflation increasing. It is of note that Barclays is forecasting inflation to increase to more than 4% in the
In summary, there is no one size to fit all and it is essential that the bank and the law firm really understand the risks specific to the organisation. It is important when considering any form of hedging that firms think about what protection they are seeking and have a detailed conversation with their bank to ensure they clearly understand what they are entering into.
A final word of warning — too often the benefit of hedging is measured by comparing what would have happened had the hedge not been entered into. This is like measuring the benefit of insurance by comparing premiums paid against claims made.
Nick Anthony is global head and David Berragan relationships director in the professionals and public sector services team at Barclays Commercial Bank.
FinancialManagementJuly2008
