Exchange Rate Fluctuation in the Context of Partner Remuneration at the Global Firms

Foreign exchange issues can present problems in the partner remuneration context. Various internal methods can be employed, however, to successfully address the challenges.

The impact of currency fluctuations on partner distributions has caused dissatisfaction within several international firms that operate a global profit pool. U.S. firms tend to struggle more with this issue than their European counterparts. In a typical scenario, European and Asian partners whose pay is denominated in U.S. Dollars, but who have school fees and mortgages to meet in another currency, will demand that the firm make them whole for the depreciation in the Dollar, while U.S. partners at home shake their heads at the increased “cost” to running the firm's foreign operations. Dissatisfaction among management and partners on all sides of the Atlantic and Pacific results; beyond squabbles about overseas investments, for a growing firm this presents an issue for lateral hires and, if left unaddressed, has the potential to cause retention problems.

The combination of currencies in which a firm operates will drive the degree to which the effect of exchange rate fluctuations on partner remuneration needs to be managed. The recent rally of the U.S. Dollar against the Sterling has pacified the situation somewhat, but the significant short-term fluctuations prove the point that a rational, permanent solution is needed for international firms operating under a global profit pool.

Available Options for Addressing Exchange Rate Differences

Global Corporations As an Example

International corporations provide only limited guidance for most law firms: While they operate one global profit pool, international corporations do not distribute substantially all of their profits to senior executives as is the case with most professional services partnerships. Instead, in most simple terms, corporate pay is based on effort (salary), short-term performance (bonuses), and long-term performance (stock grants); while salaries (and in some cases bonuses) of executives living abroad may be indexed to accommodate higher costs of living, these individuals do not share in the global profits of their company. Shareholders do ' and they are left to their own devices in how they protect their foreign investments from exchange rate fluctuations.

Risk Allocation and Complexity

With exceptions, the global partnerships generally do not leave their partners to their own devices. International firms have developed various approaches to this issue, and an informal KermaPartners survey conducted some months ago has established that no industry standard has yet developed around how firms treat currency issues in the partner remuneration context.

While foreign exchange allows for exceedingly mind-boggling economic modeling, it appears that management of foreign exchange in the context of partner remuneration can be most easily analyzed across two dimensions ' risk allocation and complexity. First, the risk that a currency moves one way or another must be allocated rationally among the firm (and thus the partnership as a whole) and individual partners. Second, the method of risk allocation must be sufficiently simple for busy ' and non'economics-minded ' partners and managers to understand both at home and abroad. In this context, any change in the firm's policies around currency related to partner remuneration should be treated as a change in the firm's remuneration system, even if the partnership agreement provides management with discretion to effect changes without partner consent.

The principal alternatives are discussed below.

[IMGCAP(1)]

Arbitrary Reference Rate

Many firms have established a reference rate which they use to convert earnings in the firm's reporting currency as the basis to calculate the amount of distributions paid to foreign partners. The exact methodology varies significantly: Some take a more or less arbitrary rate; some base the rate on a two, three, five or even longer historic average; others fix the spot rate at the beginning of the year to govern the remainder of the financial year or some other period of time.

The key advantage to this approach is its simplicity: One base reference rate is easy to explain to partners at home and abroad. This approach self-adjusts over time and balances foreign exchange risk more or less evenly between the firm and foreign partners: When the firm's reporting currency depreciates, the local partners are advantaged, and when it strengthens, the firm benefits. This approach works reasonably well until there is a rapid fluctuation in the firm's reporting currency. During decline, those partners who get paid in the firm's reporting currency are led to believe that they are “subsidizing” their foreign partners even if performance among the two partner groups is at par, while foreign partners overestimate their financial contribution to the firm in real terms.

Collar or Cap

Some firms have ring-fenced currency fluctuations by floating partner distributions at the spot rate until a chosen reference rate is reached; once the firm's reporting currency depreciates or appreciates beyond that reference rate, the partners are paid in foreign currency at that outside reference rate. The reference rate is reset periodically; the range of exchange rate fluctuation is anywhere between 1% and 2% per annum. The purpose of this method is to limit the exposure of the firm to minor short-term changes in the firm's reporting currency, but it causes similar difficulties as the arbitrary reference rate if there is significant fluctuation over a short period of time.

Some firms combine the collar with a limitation on the amount of currency difference that is paid. There are myriad variations to this approach ' for example, one global firm pays its partners for currency differences out of the firm's bonus pool, with the amount being capped at a percentage of the bonus pool that is available.

Both methods provide some predictability of exposure by both the foreign partner and the firm, and they work well where currency markets are relatively stable. A cap is slightly easier to implement than a collar arrangement, but a collar arrangement may, because of its more reciprocal nature, appear more “fair” to the partnership.

Purchasing Power

Some firms increase the amount of partner distributions on the basis of the purchasing power keyed to the city or the office to which the partner is assigned, and not on the basis of exchange rates. This method can work well in firms where partners are paid a “notional salary” that is adjusted on a cost-of-living basis while allowing distributions above that amount to float with the spot rate.

This method is a little more difficult to implement. First, the relationship between exchange-rate differences and cost-of-living differences is not always apparent. Second, the availability of reliable cost-of-living indices very much depends on the city or the office. For example, a reliable cost-of-living comparison between New York and London is more readily available than a comparison between Birmingham and Mumbai. The risk generally is allocated to the local partner.

Other Options

Other options include a nominal currency basket that is weighted similar to a currency basket used by some countries as a means to fix their exchange rate. Conceptually probably the best solution, it also remains the most difficult to implement.

Separating profit pools on the basis of currency also provides for a simple option, especially for firms that do not have fully integrated operations. Many law firms, and all major international accounting firms, maintain separate profit pools for various reasons, often on a country-by-country basis. Caution is in order: Separate profit pools incentivize partners to act locally, not globally ' likely an inappropriate outcome for firms seeking to achieve global objectives, and even the Big Four accounting firms don't have this quite right yet, with partners of one business often hunting on the grounds of another member firm.

Risk Allocation to a Third Party: Hedging

Some law firms leave currency risk entirely in the hands of their partners ' and let them individually deal with how to best mitigate this risk. Practically speaking, some financially astute partners hedge their currency exposure, but most do not. Similar to how large corporations transfer the risk of exchange rate differences to third parties, recently, international banks have worked hard to provide customized hedging solutions to their global law firm clients and their partners.

For example, Barclays Bank offers a “Vanilla Option,” by which the firm agrees to the future sale of its reporting currency at a fixed rate. This option provides certainty of the rate for budgeted amounts required to meet local currency cash flow and distribution payments to locally paid partners. If there is a favorable movement between the local currency and the firm's reporting currency, the firm participates fully in the benefit. There is a cost for this type of option; numerous other risk-sharing products exist at no out-of-pocket cost for the firm.

Where firms are already paying a differential between an outdated, historically determined rate and the current spot rate, a hedging arrangement of course will not help reduce the difference (typically an expense to the firm). However, hedging can help reduce the burden on a going-forward basis: Misplaced conservatism aside, there is no reason why larger firms should not be hedging their operating cash-flow requirements and their distribution payments to foreign partners.

Firms that are uncomfortable with hedging themselves have begun to educate their foreign partners in the options available to them. Most private banks offer some type of currency hedging, and foreign partners can easily hedge all or a portion of their profit distributions against a decline in the firm's reporting currency for a period of, usually, up to two years.

Firms can also be more accommodating to their foreign partners concerning the administration of a hedge for their distributions. For example, Barclays Bank has made available its existing Internet currency dealing platform to partners and law firms. Each partner who desires to hedge his/her partner distributions is given access to “BARX” as part of the firm's access to undertake fixed-date or option-dated forward contracts to hedge their particular exposure on the given dates. All partners will have the same rate and margin applied, and this rate is better than the equivalent rate Barclays would offer to a personal customer. The partner can elect when to undertake their hedge up to an agreed “closed period” for each profit distribution payment so as to allow time for administration around settlement to take place. While each partner will only see his transactions, the firm is able to see all transactions so as to track deal activity. Barclays will then settle directly with the firm, which can settle with the partners in the normal way in local currency.

Addressing the Impact on Partnership Tiers

We want to highlight, however, that hedging can only mitigate the differences in cash that a partner receives as a result of exchange rate fluctuations. Hedging does not provide a solution to the larger problem of the partnership structure: For example, a Sterling-based partner would still move up the partnership tier if his Sterling performance is translated without adjustment into U.S. dollars and evaluated by U.S. management purely on a U.S. Dollar basis.

Without a significant amount of expectation management and education on all sides, the UK partner will demand recognition for the “higher” contribution to the firm's profits as reported in the firm's management accounts (and the firm's reporting currency). If this demand is accepted, this is likely to have adverse effects on the firm's tiers/ladder, having the potential of formerly underperforming foreign partners' performance suddenly appearing on par with domestic partners who did not enjoy the benefits of a declining firm reporting currency. The reverse is true if the firm's reporting currency were to rise again: The foreign partner would suddenly show sub-par performance for no reason other than the exchange rate, possibly requiring a reduction in points.

A well-structured performance management system that sensibly accommodates foreign exchange rate fluctuations in the context of the partners' contribution to (not remuneration from) the partnership is a prerequisite to ensuring that these disruptions are minimized.

Performance Management in the Multi-Currency Context

Once a firm “goes global,” more will be required than just opening or acquiring its first office. The firm's performance management system must now accommodate the fact that the firm is an international firm, addressing myriad issues, including currency, tax equalization, pricing and rate structures, and many others. For the firm to handle currency aspects related to performance management, several critical issues must be addressed:

Education. Domestic partners who have never had to “think” in a currency other than their own, and whose practice is often entirely domestic, need to be educated gradually in the effect of foreign currency on the firm's performance and that of their partners ' if the firm has an open compensation system. This is to avoid factually incorrect misperceptions that are difficult to cure later. This training is most easily undertaken as part of the firm's financial management curriculum. Partners who have a performance assessment role or sit on the remuneration committee, and leaders of global practice groups also need to be particularly competent to address currency implications related to how performance is reported.

Information management around currency impacts. Often, firms do a suboptimal job of managing information flows about how currency affects performance measurement in the remuneration context. This issue often leads to misunderstandings on all sides: Partners of already profitable foreign offices are made to believe they contributed more to the firm's profits than they actually did, while domestic partners are threatened by European partners moving up the lock-step, chiefly because of an uplift in reported earnings that is due primarily to a favorable movement of the local currency against the firm reporting currency. At the same time, home office partners are led to believe start-up offices “cost” more than they actually do in real terms, while local partners like to “fudge” initial results by pointing to the large gains in revenues shown in the firm reporting currency.

Transparency. Unequal treatment of groups of partners can cause friction unless there is a transparent rationale for this difference in treatment. This often arises where international operations are grown through acquisitions; special arrangements, such as a fixed exchange rate, are made sometimes for senior partners, thus locking in a more favorable rate for them than for other overseas partners. Especially in remuneration systems that purport to be open, it is important that currency adjustment arrangements are transparent.

Treasury and systems. Global corporations tend to have reasonably sophisticated treasury management functions in place that allow the company to address currency management. An experienced treasurer becomes essential for the firm to manage its global cash. In addition, good decision support systems, preferably those that did not “bolt-on” currency modules but that were built around multi-currency business from the beginning are key, as are analysts that are internationally competent.

Finding an Individual, Permanent Solution

It is our personal viewpoint that partners are owners of their firm. They are not paid employees, even though often they consider their remuneration to be their “pay,” their “compensation” for the pain and suffering to which they are entitled as the toil of their labor. In the end, a careful analysis of the partnership's structure, the objectives of its remuneration system, its historic treatment of the issue of currency, and the various structural and third-party options need to be undertaken in order to arrive at a solution that addresses foreign exchange in the context of partner pay in a way that appropriately balances risk between firm and partner, and is relatively straightforward to implement.

No matter how a firm addresses the issue of currency in the remuneration context, it is key that the solution solves the issue in a way that does not have to be revisited as the current Dollar/Sterling/Euro situation reverses (as it has in recent months) or as the global partner complement materially changes. At the same time, it needs to encourage behavior that supports the firm's global strategic objectives.

Michael Roch, a member of this newsletter's Board of Editors, and Clive Zickel are senior members of KermaPartners, an international management consulting firm that exclusively focuses on advising professional services businesses worldwide from its offices in New York, Toronto, and London. For more information visit http://www.kermapartners.com/.

Foreign exchange issues can present problems in the partner remuneration context. Various internal methods can be employed, however, to successfully address the challenges.

The impact of currency fluctuations on partner distributions has caused dissatisfaction within several international firms that operate a global profit pool. U.S. firms tend to struggle more with this issue than their European counterparts. In a typical scenario, European and Asian partners whose pay is denominated in U.S. Dollars, but who have school fees and mortgages to meet in another currency, will demand that the firm make them whole for the depreciation in the Dollar, while U.S. partners at home shake their heads at the increased “cost” to running the firm's foreign operations. Dissatisfaction among management and partners on all sides of the Atlantic and Pacific results; beyond squabbles about overseas investments, for a growing firm this presents an issue for lateral hires and, if left unaddressed, has the potential to cause retention problems.

The combination of currencies in which a firm operates will drive the degree to which the effect of exchange rate fluctuations on partner remuneration needs to be managed. The recent rally of the U.S. Dollar against the Sterling has pacified the situation somewhat, but the significant short-term fluctuations prove the point that a rational, permanent solution is needed for international firms operating under a global profit pool.

Available Options for Addressing Exchange Rate Differences

Global Corporations As an Example

International corporations provide only limited guidance for most law firms: While they operate one global profit pool, international corporations do not distribute substantially all of their profits to senior executives as is the case with most professional services partnerships. Instead, in most simple terms, corporate pay is based on effort (salary), short-term performance (bonuses), and long-term performance (stock grants); while salaries (and in some cases bonuses) of executives living abroad may be indexed to accommodate higher costs of living, these individuals do not share in the global profits of their company. Shareholders do ' and they are left to their own devices in how they protect their foreign investments from exchange rate fluctuations.

Risk Allocation and Complexity

With exceptions, the global partnerships generally do not leave their partners to their own devices. International firms have developed various approaches to this issue, and an informal KermaPartners survey conducted some months ago has established that no industry standard has yet developed around how firms treat currency issues in the partner remuneration context.

While foreign exchange allows for exceedingly mind-boggling economic modeling, it appears that management of foreign exchange in the context of partner remuneration can be most easily analyzed across two dimensions ' risk allocation and complexity. First, the risk that a currency moves one way or another must be allocated rationally among the firm (and thus the partnership as a whole) and individual partners. Second, the method of risk allocation must be sufficiently simple for busy ' and non'economics-minded ' partners and managers to understand both at home and abroad. In this context, any change in the firm's policies around currency related to partner remuneration should be treated as a change in the firm's remuneration system, even if the partnership agreement provides management with discretion to effect changes without partner consent.

The principal alternatives are discussed below.

[IMGCAP(1)]

Arbitrary Reference Rate

Many firms have established a reference rate which they use to convert earnings in the firm's reporting currency as the basis to calculate the amount of distributions paid to foreign partners. The exact methodology varies significantly: Some take a more or less arbitrary rate; some base the rate on a two, three, five or even longer historic average; others fix the spot rate at the beginning of the year to govern the remainder of the financial year or some other period of time.

The key advantage to this approach is its simplicity: One base reference rate is easy to explain to partners at home and abroad. This approach self-adjusts over time and balances foreign exchange risk more or less evenly between the firm and foreign partners: When the firm's reporting currency depreciates, the local partners are advantaged, and when it strengthens, the firm benefits. This approach works reasonably well until there is a rapid fluctuation in the firm's reporting currency. During decline, those partners who get paid in the firm's reporting currency are led to believe that they are “subsidizing” their foreign partners even if performance among the two partner groups is at par, while foreign partners overestimate their financial contribution to the firm in real terms.

Collar or Cap

Some firms have ring-fenced currency fluctuations by floating partner distributions at the spot rate until a chosen reference rate is reached; once the firm's reporting currency depreciates or appreciates beyond that reference rate, the partners are paid in foreign currency at that outside reference rate. The reference rate is reset periodically; the range of exchange rate fluctuation is anywhere between 1% and 2% per annum. The purpose of this method is to limit the exposure of the firm to minor short-term changes in the firm's reporting currency, but it causes similar difficulties as the arbitrary reference rate if there is significant fluctuation over a short period of time.

Some firms combine the collar with a limitation on the amount of currency difference that is paid. There are myriad variations to this approach ' for example, one global firm pays its partners for currency differences out of the firm's bonus pool, with the amount being capped at a percentage of the bonus pool that is available.

Both methods provide some predictability of exposure by both the foreign partner and the firm, and they work well where currency markets are relatively stable. A cap is slightly easier to implement than a collar arrangement, but a collar arrangement may, because of its more reciprocal nature, appear more “fair” to the partnership.

Purchasing Power

Some firms increase the amount of partner distributions on the basis of the purchasing power keyed to the city or the office to which the partner is assigned, and not on the basis of exchange rates. This method can work well in firms where partners are paid a “notional salary” that is adjusted on a cost-of-living basis while allowing distributions above that amount to float with the spot rate.

This method is a little more difficult to implement. First, the relationship between exchange-rate differences and cost-of-living differences is not always apparent. Second, the availability of reliable cost-of-living indices very much depends on the city or the office. For example, a reliable cost-of-living comparison between New York and London is more readily available than a comparison between Birmingham and Mumbai. The risk generally is allocated to the local partner.

Other Options

Other options include a nominal currency basket that is weighted similar to a currency basket used by some countries as a means to fix their exchange rate. Conceptually probably the best solution, it also remains the most difficult to implement.

Separating profit pools on the basis of currency also provides for a simple option, especially for firms that do not have fully integrated operations. Many law firms, and all major international accounting firms, maintain separate profit pools for various reasons, often on a country-by-country basis. Caution is in order: Separate profit pools incentivize partners to act locally, not globally ' likely an inappropriate outcome for firms seeking to achieve global objectives, and even the Big Four accounting firms don't have this quite right yet, with partners of one business often hunting on the grounds of another member firm.

Risk Allocation to a Third Party: Hedging

Some law firms leave currency risk entirely in the hands of their partners ' and let them individually deal with how to best mitigate this risk. Practically speaking, some financially astute partners hedge their currency exposure, but most do not. Similar to how large corporations transfer the risk of exchange rate differences to third parties, recently, international banks have worked hard to provide customized hedging solutions to their global law firm clients and their partners.

For example, Barclays Bank offers a “Vanilla Option,” by which the firm agrees to the future sale of its reporting currency at a fixed rate. This option provides certainty of the rate for budgeted amounts required to meet local currency cash flow and distribution payments to locally paid partners. If there is a favorable movement between the local currency and the firm's reporting currency, the firm participates fully in the benefit. There is a cost for this type of option; numerous other risk-sharing products exist at no out-of-pocket cost for the firm.

Where firms are already paying a differential between an outdated, historically determined rate and the current spot rate, a hedging arrangement of course will not help reduce the difference (typically an expense to the firm). However, hedging can help reduce the burden on a going-forward basis: Misplaced conservatism aside, there is no reason why larger firms should not be hedging their operating cash-flow requirements and their distribution payments to foreign partners.

Firms that are uncomfortable with hedging themselves have begun to educate their foreign partners in the options available to them. Most private banks offer some type of currency hedging, and foreign partners can easily hedge all or a portion of their profit distributions against a decline in the firm's reporting currency for a period of, usually, up to two years.

Firms can also be more accommodating to their foreign partners concerning the administration of a hedge for their distributions. For example, Barclays Bank has made available its existing Internet currency dealing platform to partners and law firms. Each partner who desires to hedge his/her partner distributions is given access to “BARX” as part of the firm's access to undertake fixed-date or option-dated forward contracts to hedge their particular exposure on the given dates. All partners will have the same rate and margin applied, and this rate is better than the equivalent rate Barclays would offer to a personal customer. The partner can elect when to undertake their hedge up to an agreed “closed period” for each profit distribution payment so as to allow time for administration around settlement to take place. While each partner will only see his transactions, the firm is able to see all transactions so as to track deal activity. Barclays will then settle directly with the firm, which can settle with the partners in the normal way in local currency.

Addressing the Impact on Partnership Tiers

We want to highlight, however, that hedging can only mitigate the differences in cash that a partner receives as a result of exchange rate fluctuations. Hedging does not provide a solution to the larger problem of the partnership structure: For example, a Sterling-based partner would still move up the partnership tier if his Sterling performance is translated without adjustment into U.S. dollars and evaluated by U.S. management purely on a U.S. Dollar basis.

Without a significant amount of expectation management and education on all sides, the UK partner will demand recognition for the “higher” contribution to the firm's profits as reported in the firm's management accounts (and the firm's reporting currency). If this demand is accepted, this is likely to have adverse effects on the firm's tiers/ladder, having the potential of formerly underperforming foreign partners' performance suddenly appearing on par with domestic partners who did not enjoy the benefits of a declining firm reporting currency. The reverse is true if the firm's reporting currency were to rise again: The foreign partner would suddenly show sub-par performance for no reason other than the exchange rate, possibly requiring a reduction in points.

A well-structured performance management system that sensibly accommodates foreign exchange rate fluctuations in the context of the partners' contribution to (not remuneration from) the partnership is a prerequisite to ensuring that these disruptions are minimized.

Performance Management in the Multi-Currency Context

Once a firm “goes global,” more will be required than just opening or acquiring its first office. The firm's performance management system must now accommodate the fact that the firm is an international firm, addressing myriad issues, including currency, tax equalization, pricing and rate structures, and many others. For the firm to handle currency aspects related to performance management, several critical issues must be addressed:

Education. Domestic partners who have never had to “think” in a currency other than their own, and whose practice is often entirely domestic, need to be educated gradually in the effect of foreign currency on the firm's performance and that of their partners ' if the firm has an open compensation system. This is to avoid factually incorrect misperceptions that are difficult to cure later. This training is most easily undertaken as part of the firm's financial management curriculum. Partners who have a performance assessment role or sit on the remuneration committee, and leaders of global practice groups also need to be particularly competent to address currency implications related to how performance is reported.

Information management around currency impacts. Often, firms do a suboptimal job of managing information flows about how currency affects performance measurement in the remuneration context. This issue often leads to misunderstandings on all sides: Partners of already profitable foreign offices are made to believe they contributed more to the firm's profits than they actually did, while domestic partners are threatened by European partners moving up the lock-step, chiefly because of an uplift in reported earnings that is due primarily to a favorable movement of the local currency against the firm reporting currency. At the same time, home office partners are led to believe start-up offices “cost” more than they actually do in real terms, while local partners like to “fudge” initial results by pointing to the large gains in revenues shown in the firm reporting currency.

Transparency. Unequal treatment of groups of partners can cause friction unless there is a transparent rationale for this difference in treatment. This often arises where international operations are grown through acquisitions; special arrangements, such as a fixed exchange rate, are made sometimes for senior partners, thus locking in a more favorable rate for them than for other overseas partners. Especially in remuneration systems that purport to be open, it is important that currency adjustment arrangements are transparent.

Treasury and systems. Global corporations tend to have reasonably sophisticated treasury management functions in place that allow the company to address currency management. An experienced treasurer becomes essential for the firm to manage its global cash. In addition, good decision support systems, preferably those that did not “bolt-on” currency modules but that were built around multi-currency business from the beginning are key, as are analysts that are internationally competent.

Finding an Individual, Permanent Solution

It is our personal viewpoint that partners are owners of their firm. They are not paid employees, even though often they consider their remuneration to be their “pay,” their “compensation” for the pain and suffering to which they are entitled as the toil of their labor. In the end, a careful analysis of the partnership's structure, the objectives of its remuneration system, its historic treatment of the issue of currency, and the various structural and third-party options need to be undertaken in order to arrive at a solution that addresses foreign exchange in the context of partner pay in a way that appropriately balances risk between firm and partner, and is relatively straightforward to implement.

No matter how a firm addresses the issue of currency in the remuneration context, it is key that the solution solves the issue in a way that does not have to be revisited as the current Dollar/Sterling/Euro situation reverses (as it has in recent months) or as the global partner complement materially changes. At the same time, it needs to encourage behavior that supports the firm's global strategic objectives.

Michael Roch, a member of this newsletter's Board of Editors, and Clive Zickel are senior members of KermaPartners, an international management consulting firm that exclusively focuses on advising professional services businesses worldwide from its offices in New York, Toronto, and London. For more information visit http://www.kermapartners.com/.