Financial decisions of professional partnerships

Partnerships are important and they are different

According to the Partnership Act 1980, a partnership is “the relation which subsists between persons carrying on a business in common with a view of profit.” While traditional finance literature has predominantly focused on corporations, partnerships – another business structure with significant economic impact – have received less attention. In fact, many firms operate as partnerships rather than corporations, especially in professional sectors such as law, consulting, accounting, medical practice, and architecture.

Take KPMG UK, for instance: it operated as a general partnership (GP) before evolving into a limited liability partnership (LLP) in 2002. The well-known international law firm Slaughter and May currently operates as a general partnership. US tax return data show that partnerships in 2009 held $18.8 trillion in assets and generated $410 billion in net income (Monroe (2012)). According to National Statistics from the Department of Business and Trade, there were 365,000 partnerships in the UK in 2023, constituting 7% of the private business sector population.

Partnerships differ from other business structure in various dimensions, such as taxes and liability structure. The key feature that distinguishes partnerships from other business structures is the joint ownership and management of the business. Specifically, partners in a partnership not only own the firm together but also jointly share the profits, losses, and management duties of the business. This contrasts with corporations, where ownership is often separated from management. Profits and losses in a partnership are passed through to the individual partners and taxed at their personal level. When it comes to liabilities, partners in a general partnership face “unlimited liability” for the firm’s debts, whereas partners in a LLP have their liabilities capped at their contribution to the firm. These fundamental differences mean that partnerships often operate in ways that are different from other business entities.

Different objective

The paper entitled “The Optimal Size, Financing, and Personal Liability of Professional Partnerships” by Shiqi Chen and Bart Lambrecht builds a theory model to examine the unique institutional characteristics of partnerships and their effect on the financial decisions of  professional partnerships.

In professional partnerships, partners’ human capital is crucial for the firm’s operation and production. However, the productivity of human capital varies among partners due to differences in age, career stage, expertise, etc.  Consequently, partnerships often comprise both senior and junior partners.  Some natural questions arise – what is the optimal size of a partnership, and what is the optimal combination of senior and junior partners within a partnership?

The answer to these questions depends crucially on the sharing rules and objective of the partnership. Since all the partners, regardless of seniority, share profits, losses, and liabilities jointly, each partner tends to optimise based on their own stake rather than total firm value. The paper demonstrates that this behaviour is equivalent to maximising value per share. This unique objective leads to different financial behaviours compared to other business structures that focus on total value maximisation.

Building on such distinct objective, the model aims to provide some insights into the following questions: What is the optimal capital structure of a partnership? How do size and capital structure interact, given that partners not only bring in human capital that support the firm’s production but also the startup capital? Should partners provide any personal guarantees and, and if so, for what amount? Under what circumstances would a partnership choose to establish itself as an LLP instead of a GP?

Different financial behaviour

The paper shows that the optimal debt level, degree of liability, and the optimal number of partners are intricately linked and depend on the firm’s financial constraints and the outside opportunities available to partners. The number of junior and senior partners move in tandem such that the marginal revenues per share are the same across all partners.

When partners are not financially constrained, the optimal debt level is always safe, and inside equity is always preferred. This is because, unlike in corporation, debt does not convey an interest tax shield relative to equity in partnerships where profits and losses are passed through to partners and get taxed at the personal level only. Although recruiting more partners can reduce reliance on debt and increase the firm’s total value, partnerships are often reluctant to do so due to the dilution of partners’ stakes. Consequently, all else equal, partnerships tend to be smaller compared to entities focused on maximising total value.

With financial constraints, partners find it optimal to pledge personal assets to support the firm if that allows the partnership to keep debt safe, and thereby avoiding costly bankruptcy upon closure. However, as financial constraints intensify, enlarging the partnership can be beneficial, as additional partners can provide personal guarantees that enhance the firm’s borrowing capacity. For partnerships facing severe capital constraints that necessitate risky debt, a limited liability partnership that ringfences partners’ personal assets from the partnership can be optimal. In such scenarios, the partnership size decreases as fewer partners are needed to cover the capital shortfall. Costly bankruptcy therefore creates a link between the optimal size, debt level, and the degree of partners’ liability exposure when the partnership is financially constrained. Thus, the optimal capital structure of a partnership is determined by balancing expected liquidation and bankruptcy costs against the cost of equity dilution.

The model suggests a pecking order of partnership financing: partners find it optimal to use inside equity first and resort to debt to cover remaining needs. More specifically, to keep debt safe, the partnership raises more equity by admitting additional partners when financial constraints become binding. As constraints tighten, the partnership takes on debt that is fully backed by partners’ personal assets rather than recruiting more partners, which would dilute existing stakes. When existing partners exhaust their personal collateral, additional equity partners are admitted, bringing fresh capital and guarantees for additional borrowing to meet financial constraints and keep debt safe. Consequently, high bankruptcy costs and tight capital constraints can lead to a partnership that is too large and invest too late.

A partnership sometime can benefit from hiring more partners but refuses to do so to avoid diluting existing partners equity share. The model suggests that adopting a two-tier structure, consisting of equity partners and salary partners, can bypass this issue. Salary partners contribute human capital in exchange for a fixed salary. The model predicts that two-tier partnerships are common in large, less capital-intensive professional service sectors such as law, auditing, and consulting.

More to be done

The paper also generates various other predictions that highlight the distinct financial behaviour of partnerships, driven by unique institutional characteristics that are absent in other business structures. Despite these insights, our understanding of partnerships remains limited. The financial behaviours and strategic decisions within partnerships is an interesting area that deserves further in-depth exploration.