The dramatic consequences of the coronavirus (COVID-19) pandemic is forcing all involved in the management of professional services firms to confront significant financial issues as a result of the sharp decline in business activity across the UK and global economies. There currently is no "new normal".
The key concern of management teams, at least in the immediate short term, has to be managing working capital balances. As all businesses come to terms with the impact of the pandemic on their business models and markets, many firms will find it difficult to fund working capital requirements as cash collection from clients tightens. Invoices will likely take longer to get paid and, unfortunately, some debts will not be paid at all due to business failures.
The imperatives of cash collection, income and hence future profit are unavoidable hard realities which must come into even greater focus.
In this note, we explore the key issues that management are grappling with and what measures firms can take to mitigate the worst effects of the pandemic.
Reducing or delaying business costs
Given the sudden economic impact of the pandemic, it will be difficult to reduce a firm's cost base in the space of a matter of days or even weeks. The key fixed operating expenses of a professional services firm (e.g. staff costs, rent and material supplier contracts) are almost invariably subject to contractual arrangements that may not be able to be set aside or renegotiated quickly.
The UK government has provided some relief for firms in the form of temporarily deferring VAT and 31 July income tax payments but other measures, such as business rates relief, have not been applied to the professional services sector.
However, our specialist teams have been addressing measures that firms can take to address costs in each of these key areas:
- for real estate issues (including advice on the withholding of rent), please see our Real Estate COVID-19 Update
- for employee issues (including details of the UK government's job retention scheme), please see our Employment Law COVID-19 Q&A
- for an analysis of the application of COVID-19 to force majeure clauses in commercial contracts, please see our Force Majeure Toolkit
- for more information on VAT deferrals, please see our VAT Deferral Note
Reducing or delaying partner distributions
As well as tightly managing the costs of the business, another lever that management will want to utilise to conserve cash is reducing or delaying partner distributions.
The options available to management will depend on each firm's constitutional arrangements, but short term reductions in drawings should be considered, as well as delays to the distribution of profits already allocated and divided to partners, whether usually distributed quarterly or otherwise. The risks of borrowing to pay partner drawings is a lesson of the last recession which should not be forgotten.
Payments to recently retired former partners may also impose a significant strain on the financial resources of a firm (including in some cases annuity obligations). These payments usually consist of undistributed profits and capital, with the timings for such payments prescribed in the firm's constitutional arrangements. Firms may wish to explore delaying these payments, whether under their constitution or under the terms of any undertakings given to banks in respect of partner capital loan schemes.
Firms which make distributions to partners gross of tax may also consider retaining amounts distributed on account of partners' tax liabilities, given the deferral of income tax payments due on 31 July 2020 for the self-employed until 31 January 2021.
A key consideration for management will be how these powers can be exercised. If a firm's constitutional documents require such matters to be put to a partner vote, then it is likely that implementing any policy to reduce drawings or delay distributions will be more difficult. Maintaining trust and confidence in management in making these difficult recommendations and decisions for the benefit of the whole business (and importantly its staff) is fundamental to securing confidence and partner "buy-in".
Partner capital and external funding
Firms may also consider raising funds to bolster balance sheets by increasing capital contributions of partners or raising external debt funding. It has already become clear that increasing working capital by these routes will be key in stabilising the position of many businesses. Firms which spent the last decade since the financial crisis improving their balance sheet position and capital management will be looking now to utilise facilities which were negotiated with their banks (many on a revolving credit basis) in easier times.
In determining which approach to take, it is likely management will need to consider the personal risk tolerance of their partner groups, management's powers to increase capital contributions or external funding without partner approval and the terms of current financing arrangements.
Although many firms will have headroom to drawdown on current finance facilities, it may be the case that new lines of funding will need to be put in place. One option that may be open to firms is to access funds being made available under the newly introduced UK government-backed funding schemes. If so, management should be engaging with their existing lenders at the earliest possible opportunity to see if incurring additional indebtedness is prohibited under their current arrangements in terms of threshold levels as well as authority.
For more information on the UK government’s financial support for businesses, please see the following updates: Government Financial Support Package for Businesses, Updated Guidance from the Bank of England, The Effect of the COVID-19 Pandemic on Funding Arrangements and Coronavirus Business Interruption Loan Scheme – Update.
Firms should also not forget the possibility of being able to make claims under their existing insurance policies for COVID-19 related losses. Relevant policies that may respond to claims include business interruption and employer's liability policies.
Firms should take steps now to check their insurance policies for relevant coverage and to ensure compliance with policy terms. This may include notification obligations and conditions requiring compliance with guidelines issued by relevant governments or other bodies.
For more information on making insurance claims in respect of COVID-19 losses, please see the following updates: Does your business insurance cover COVID-19? and Coronavirus and Business Interruption Insurance.
Whatever business challenges arise as a result of the spread of COVID-19, we are actively monitoring risks and responses, and are here to help. You can access all of our COVID-19 resources here.
Our market leading Professional Practices Group has unrivalled experience, built up over more than three decades, in advising firms on the difficult challenges (and opportunities) ahead and are determined to help guide our clients through these troubled times.