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.

The exception might be when someone was moving from another firm where they were already a partner. In that case, they could take capital from one and transfer to another. In other words, they had already earned up to the level to afford the price of the ticket. The title of “Managing Director” was created, instead, for average working stiffs coming in from the outside or those that did not or could not shoulder the financial commitment and potential liability that partnership in an audit firm entails. This is a “partner level” position in terms of potential responsibility and, to some extent, participation in managing staff and practices. But, in the end , non-equity leadership at PwC were not allowed to make final decisions in any case.  It was always a partner who made any final decisions.
Poor, poor auditors. They’re really suffering.
High risks.
Big financial commitments.
Not getting paid as much as their law firm “equals.”
Quite a pickle for such sophisticated, normally risk-averse financial professionals, eh?

Executive Compensation Advisors analyzed the compensation levels in several alternative career paths that could be pursued by auditors. It found that several alternatives – consulting firms, law firms, and some corporate financial roles – lead to significantly greater compensation, ranging from 30 to 50 percent more than audit partners. See Appendix B. Moreover, each of those career paths carries much less risk in terms of litigation exposure than serving as an audit partner.

So, if the CAQ report is totally non-partisan, objective, and independent, you have to ask:

Why would anyone still want to be a partner in an audit firm?

Will the credit crunch and fear of a potential collapse of another firm lead to less credit available for partner loans and less credit available to the firms themselves to fund their cash flow requirements? With fewer partner promotions as a result of global economic slowdowns and more partner exodus, will firms’ cash position become less positive or even squeezed?

From Monday’s WSJ Law Blog:

Just Made Partner? Time to Take Out a Loan

In the face of tighter lending markets, law firms are looking increasingly to their partnerships to raise capital rather than relying on other lending sources, according to this story in today’s NLJ.

Another factor weighing on capital reserves: longer client payment cycles. As clients suffer through a slowing economy, they take longer to pay their bills. “When that happens,” writes the NLJ, “the revenue gap becomes longer and law firms need more capital to meet their compensation obligations to partners and highly paid associates.”

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