Many law firms are seeing a slowdown in work and a lengthening in their client payment cycle. At the same time, banks that provide lending to law firms to help cover their revenue gaps and fund bigger projects are implementing more onerous requirements for doling out credit.
The upshot is that just as law firms need more money, they are having a harder time getting it.
While Dan DiPietro, client head of the law firm group at Citi Private Bank, doesn’t expect interest rates to climb, he does see a change in the terms, or covenants, under which law firms borrow.
“We are looking at the number of partners who leave in a given year,” he says. “We are looking at cash flow coverage and asset coverage ratios.”
Perhaps taking a cue from the demise of San Francisco’s Brobeck Phleger & Harrison, which had $90m (£45.6m) in bank debt when it collapsed in 2002, law firms have generally reduced their borrowing in recent years, according to the latest data provided by Citi. In 2000, firm liability was 19.8% of net income, compared with 14.1% in 2006.
Despite the overall decline, the average borrowing for Citi’s clients so far this year has ballooned, says DiPietro. Borrowing was up 32% in January, compared with the same month in 2007, he said. In February, borrowing rose 26% and in March it climbed 22%, compared with the same months in 2007.
Extending shortfalls
A slowdown in client work - and in the time that many of them are taking to pay their legal bills - is exacerbating the revenue shortfall that law firms routinely experience at the beginning of the year, DiPietro said.
In addition, many firms are feeling the full weight of the salary increases implemented last year for associates, including a market rate of $160,000 (£81,155) for first-years.
“We are being much better about practising fiscal hygiene,” says Stephen Colgate, executive director of DLA Piper, the US’s largest law firm. “We are being more careful to make sure our bills get out the door.”
The 3,623-lawyer firm in the last seven years has doubled its partner capital contribution amount to avoid acquiring debt for expansion, Colgate said. He adds that law firms seeking financing these days to cover expenses may well find stricter terms, although he is not “losing any sleep” over DLA Piper’s financial picture.
But, according to law firm consultant Richard Gary, principal of Gary Advisors in Tiburon, California, many firms “are very nervous right now” about their financial situation.
“All you have to do right now is look at what firms are doing in terms of layoffs, summer hiring freezes and extension of first-year start dates by several months,” he says.
Just as the ramifications from the subprime mortgage mess are creating a slowdown in law firm work, they are also prompting Citi and other banks to tighten the credit reins as they try to balance their own books. Citi alone posted a $5bn (£2.5bn) loss during the first quarter of 2008, although the loss was relatively good news compared with the $10bn (£5bn) punch it took in the fourth quarter of 2007.
Citi is the largest lender to law firms and has “relationships” with about 600 firms, DiPietro said, including most of those in the AmLaw 100, a list of law firms with the highest revenues published by The American Lawyer. Other national lenders to large law firms include Wachovia and Bank of America.
Nearly all big law firms borrow money through lines of credit to cover the first-of-the-year gap. And most firms pay off the money borrowed when they collect their fees during the second half of the year. Many law firms also borrow for expansion into new markets, updates to technology and office furnishings.
In general, a law firm’s collectable value of unbilled time and accounts receivable should run about five times its total bank debt, advises James Cotterman, a consultant with Altman Weil.
He also suggests that debt should account for no more than 100% of the net book value of fixed assets and that law firms should not use credit to either pay partners or as the first source of working capital.
Rules are changing
When borrowing, law firms can lock in terms for a certain period of time, but as they come back to a bank with additional capital needs they are discovering that the rules have changed.
For example, if a bank in the past limited a borrowing base to 85% of accounts receivable less than 180 days old, a bank now may reduce that base to 80% of receivables less than 120 days old, says Andrew Johnman, head of the US professional services team at Barclays Capital.
In addition, a covenant that previously required law firms to retain 80% of their partners from one year to the next may now require them to retain 85%, says Johnman. A large number of partners departing is a “lead indicator of distress”, he adds.
Indeed, the loss of capital created by defecting partners has prompted at least one law firm to change its policy in order to hold on to the money longer. Mayer Brown last summer revised a provision in its partnership agreement to allow the law firm up to six months to return partner capital contributions, as opposed to returning it immediately.
The Chicago-based firm has lost more than 20 equity partners in recent times and last year demoted about 45 partners to non-equity status.
Other firms could follow Mayer Brown’s lead and adjust their partnership agreements to retain partner capital longer, says DiPietro.
On the whole, law firms are a good bet for banks. Their work is steady, they pay their bills consistently and the industry in general has grown. And as large US lenders start to clamp down on credit, Johnman sees opportunity for banks such as Barclays. While not immune from the subprime cancer, some foreign lenders can forge new relationships in the current climate, he said.
“We are getting a warmer reception,” he adds.
A version of this article first appeared in The National Law Journal, Legal Week’s US sister title.
