Do Firms Need to Restructure Due to Recession?

The UK is facing a period of considerable economic uncertainty. Compared to the past decade, everyone is feeling the effects of increased living costs, high inflation, high interest rates and a recession is on the way, if it is not already here.

In this article, first published in IFA Magazine, Partner Corinne Staves considers how wealth management firms can bolster their business during difficult financial circumstances. These themes and ideas apply equally to all professional services firms.

While wealth management firms are not as desperately affected as the most vulnerable in society, they will not be immune to the impact of economic uncertainty and the cost-of-living crisis. Firms should consider how they will weather the storm.

Firms are facing  a number of new financial risks: Inflation is rising and costs are increasing, including energy costs. Interest rates are also increasing, and look set to increase further, so existing facilities have become more expensive and new borrowing is the most unattractive it has been for over a decade. The firm’s people are feeling the strain personally. COVID placed a huge burden on the firm’s workforce and now they face increased personal costs and the associated worries that brings, especially those in the organisation who are least well compensated. Some international firms are also grappling with the effect of a weak pound.

The first step is to try to avoid revenue and/or profits declining as a result of the economic crisis. If firms are nimble and/or willing to evolve with a changing economic backdrop, there may even be scope to increase revenue and/or profitability: Change represents opportunity for many professional advisers.

1. Strategic focus. Firms and Partners need to understand their strategic objectives to achieve success and how they plan to achieve those goals. This applies when times are good, but even more so when times are leaner. (And for firms that have not identified and articulated their strategic goals, they need to do this!) The firm’s management should critically review the business, at regular intervals, to assess the extent to which each area of the business is working towards the firm’s strategic goals and if more can be done. This exercise should enable the firm to decide where the firm’s resources, especially cash, are best deployed.
2. Identify risks. Robust risk management is vital to protect a firm and to enable the firms to grow and thrive through taking informed decisions.  Firms need to understand the key risks and where continued investment is always necessary, for example people, IT and PI insurance.  Active risk management will also serve as an early warning system if economic uncertainty starts to have a serious impact on the firm. As well as enabling the firm to take active steps to mitigate risks, this will also enable firms to engage early with key external stakeholders (such as the banks, landlords or regulators).
3. Cash. Cash. Cash. Cash is King. Despite this, many firms extend credit to clients and counterparties, whether deliberately through agreed arrangements or accidentally by delaying invoices or being too polite in requiring payment, usually for services already provided.  This may worsen as everyone feels the squeeze of economic uncertainty. It is essential that the internal finance teams and client facing teams work together to manage these risks and improve lock-up.

Cash preservation measures seen during COVID may be less welcome now. Partners were prepared to reduce or delay distributions faced with an unprecedented global pandemic, but lockdown meant fewer spending opportunities and lower costs for most professionals. By contrast, personal costs are now increasing and Partners are unlikely to welcome distribution restrictions so soon after the last time. 

Cash prudence may however be needed.  Partners at firms structured as partnerships/LLPs and with a year-end which does not align with the tax year end (i.e. not 31/3 or 5/4) are facing significant additional cash pressure as HMRC introduce basis period reform.  This is complex but effectively accelerates Partners’ tax payments. The transitional year 23/24 will involve most Partners being liable for two years’ tax at the same time (albeit that non-retiring Partners can spread payments of one year’s tax over 5 years if they choose). If a firm reserves for tax, the firm will need to ensure it has cash to meet the higher tax bills.

As well as commercial steps to address revenue and profitability, the firm needs to make sure that it is structured correctly to support the business through a period of economic uncertainty. There are many strands to this, including structure, profit sharing arrangements and culture, although they are all intertwined.

Are those arrangements designed and operating to promote the firm’s strategic objectives?  Profit sharing is a good example. Some firms operate a merit-based compensation system. These take many forms but the basic principle is that Partners are compensated by reference to their personal performance and contribution.  By contrast, other firms operate a model which compensates Partners by reference to overall firm success – often by way of a lockstep sharing system.  Obviously each will drive very different behaviours and firms often choose a hybrid between the two.  The firm needs to be confident that their chosen model promotes and supports the behaviours which generate optimum revenue and profitability in their business, as well as supporting and promoting the firm’s culture and values.

Whichever system is used, the most important element is to ensure that everyone feels that it is the right one for the firm and is broadly fair, so that internal arrangements are not causing division or distraction from fee-earning activities.

The firm’s systems and their effective operation may require scrutiny again when the firm’s fortunes change.  For example, if a Partner’s practice specialism is less busy due to the economic downturn, what is the impact?  If they are in a merit-based system, s/he might try to work outside their specialist area to protect their earnings. That may be a serious business risk and/or drive resentment between Partners if the actual specialists lose the opportunity to do that work.

In a system where collective success is rewarded, everyone suffers if the firm’s profits drop. Many will feel that is right, but this relies on mutual trust and strong perceptions of fairness.  If anyone is perceived as a ‘passenger’ – perhaps seen as working less hard at trying to improve the firm’s success –  resentment and division may creep in.  In extremis, the strongest performing Partners may leave.  Clients may follow, unless there are post-exit restrictions to protect the business.

Economic uncertainty may impact directly on Partner exits:

• Firms who have been struggling with effectively managing Partner underperformers will now need to grasp that nettle.
• Even if Partners are not underperformers, if their practices are no longer aligned with the firm’s strategic objectives, it may be time for those Partners to leave.  A no-cause removal power will be essential to support these steps.
• Firms may conclude that the partnership is saturated.  A headcount reduction may be proposed (either leaving the firm or demoting Partners to lower status roles or back to employee status). This is likely to be very unpopular, as it is likely to be perceived as an attempt by the continuing Partners to protect their own levels of compensation, instead of sharing the pain. However, if the commercial reality is the exit of rainmaker Partners, this may be a necessary evil.

This highlights the importance of culture. Firms that have a strong culture and strong shared values are likely to pull together and find workable solutions in challenging times. By contrast, divided partnerships will disagree and fragment more easily, drawing focus away from fee-earning activities and worsening the firm’s economic position.

Economic uncertainty may also impact on succession planning.  Good succession planning is vital in all firms. A strong pipeline of opportunity incentivises talented new people join or remain in the business and they help drive the firm’s success. Retiring Partners need to ensure a strong team of successors to ensure their valued clients are in good hands, and also to ensure that the firm is financially able to make payments to them as retired Partners. This applies to Partners receiving a return of capital and payments of accrued but undistributed profits, but even more so to firms where a payment is made for goodwill on exit.

Some Partners nearing retirement may decide to delay their planned retirement date due to the current economic climate, including increased personal costs, reduced pension pots and relatively low annuity rates. The firm may welcome this if the Partner is a strong contributor and will continue to be an asset. However, this may create issues if the next generation is prevented from progressing and/or if that Partner has already started to implement a succession plan and their contribution or performance has already starting to reduce. Likewise, the firm will probably want to ensure retirements are staggered at regular intervals, rather than a bulge of retirements in one year, which may have a destabilising effect and put significant pressure on firm cashflow.