Squeeze Is On When Becoming A Partner

I’ve drawn comparisons between law firm management and audit firm management many times before.

Forgive me one more indulgence.

Audit professionals are making a significant investment in their firms when they become a partner, according to the report provided by the Center for Audit Quality to ACAP in January of this year.  In addition, the firms have a high dependence on this source of capital. The worst case scenario comes, as usual, from the experience of Arthur Andersen’s failure.

Given the average capital contribution per partner (as of the most recent fiscal year end) of $418,365 (defined as total contributed capital for the six firms as a whole divided by the total number of partners for the six firms), a partner’s capital investment in the firm is frequently that individual’s most significant financial commitment other than his or her home. This capital is different from an individual’s other investments, however, in that it does not appreciate yet it can be lost in its entirety. Indeed, that is what happened to the capital of the individuals who were partners in Arthur Andersen.

I wouldn’t agree that the capital doesn’t appreciate. Interest rates paid by the firms for funds on deposit are usually pretty high in comparison to market rates. But it is true that the capital contributions, and partner cash distributions left on deposit with the firm, are considered unsecured in the event of bankruptcy.

In particular, for individuals with less tenure as a partner, the capital contribution to the firm is a very substantial financial obligation that frequently is financed through personal loans provided by third parties, typically a bank. This is particularly true because partners must fund their capital contribution with after-tax income. To the extent that a partner must supply required capital out of current income, he or she is put in the position of paying tax on income that is not “received,” but rather is immediately used to fulfill the capital requirement.

This capital contribution is an obstacle to someone becoming partner at a late stage in their life, especially if they join a firm as an experienced hire. At PwC, for example, I saw a number of examples where the firm did not offer partnership to entrants that were 50 years of age or older, given their mandatory retirement at age 60. The capital contribution requirement and the fact that there was not enough time to make enough to repay loans or make the whole thing worthwhile for either the firm or the individual effectively precluded this option.