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December 10, 2010 6:00 AM

Cost Reduction Is Good, Cost Certainty Is Better

Posted by Ed Shanahan

By Dan DiPietro and Gretta Rusanow

As we reported last month, the Citi Private Bank Law Watch Third Quarter 2010 results indicate that firms continue to experience flat revenue growth. The current state of the legal industry has been aptly described by a number of managing partners we've talked to as: "a smaller market with more competitors." These factors, together with an increasing willingness on the part of general counsel to branch out beyond their traditional law firms, are forcing many law firms to compete on price, and others to innovate in order to be profitable and sustainable in this changed market.

Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and over 35,000 individual lawyers. Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey. These reports, together with extensive discussions with law firm management conducted on an ongoing basis, provide a comprehensive overview of financial trends in the industry and insight into where it is headed.

Over the past three months, having traveled throughout the U.S. and London conducting roundtables with managing partners of over 150 firms, meeting with individual law firms, and learning how firms are responding to this flat market, we heard two themes. The first relates to the constant pricing pressures firms face, and how they are responding to these pressures. The second relates to how firms are seeking to differentiate themselves in ways other than just price.

New low-cost competitors.
We hear continually from law firms about the unrelenting pricing pressures from clients. As a cost center, the corporate law department faces pressure internally to reduce its outside legal costs. General counsel have been open to other options given the availability of offshore legal service providers, and Am Law Second Hundred firms prepared to offer services at a lower cost than the traditional law firms. Am Law 100 firms have commented to us about the increased competition from these alternative providers, as well as from smaller firms who are able to provide legal services at significantly lower rates because of lower cost structures.

Alternative fee arrangements-pricing and project management.
In addition to simply discounting fees, we see an increased focus on alternative fee arrangements (AFAs) As we wrote in "Trench Warfare" in September, we see this as a direct reaction to the war on pricing. While we are not predicting the end of the billable hour, we are seeing firms turn their attention to alternative fee structures, not only as a defensive strategy, but also as a means of strategically shifting their business model.

In so doing, firms have described two key challenges to us. The first is how to accurately price services at the outset. Firms have started to consider how they might mine data in their practice management systems and knowledge management systems to create accurate cost predictions for matters. Some firms have formed committees composed of IT, finance, knowledge management, and practice group representatives working together to identify the common characteristics of various matters, and in so doing, improving the predictability of matter costs. In other words, these firms are moving from a reactive stance to a more strategic, scientific approach to pricing of legal services.

The second challenge firms confront is, once they have agreed to an AFA, how can they ensure that the work will be completed within the agreed scope and to budget. To do so, some law firms are retaining professional project managers. Other firms are placing that responsibility on lawyers by conducting project management training sessions for partners and attorneys in the firm.

The "apples to oranges" dilemma.
Despite all the noise in the industry around AFAs, and general counsel asking for innovative fee structures, we also hear how, for many firms, their experience has been that clients are using AFAs as code for seeking a deeper discount to the hourly rate. Firms describe responding to a client's request for a more creative fee structure, only to find that the client is then unable to compare the proposed creative solution with other alternatives in the market. This "apples to oranges" problem can result in the client, who is unable to assess the value of what is being offered, simply reverting to a request for a deeper discount.

Lowering the law firm cost structure.
To compete on price, we've heard a lot about how firms are lowering their cost base, focusing on operational efficiencies, or simply taking a hit to their profit margins (hopefully as a short-term solution with longer-term benefits).

Some firms have moved back office functions to cheaper locations, either within the U.S. (inshore) or overseas (offshore) in an effort to lower their cost structures. On this latter trend, we've seen firms outsource to third-party offshore service providers, and others have created their own captive offshore operations mimicking the outsourcing model. While back-office functions were typically the initial focus of these initiatives, firms are now beginning to outsource basic legal work.

Firms also have told us that they are looking at creating categories of lawyers at a lower cost structure than the traditional partner-track associate. This can enable firms to produce work at lower cost, but it also raises a number of "social contract" issues in firms where there have traditionally been just partner-track associates. Firm will need to consider several issues with this category of lawyer: exposure to clients and partners, professional development opportunities, and a longer-term career path.

Two long-term approaches to generating profit.
We have been hearing firms take a "loss leader" approach to pricing their services. Firms describe how, in markets where clients differentiate legal service providers based solely on price (not on quality), they are heavily discounting their fees during the initial stages of a relationship, just to get their foot in the door. Firms have taken this strategy, in the hope that eventually, clients will begin to see the difference in quality, and will then be more prepared to pay higher fees for higher-quality work.

Firms also are taking a "venture capital" approach to winning work in markets outside of their traditional client base. We've heard how certain Am Law 50 firms are offering discounted services to start-ups, in an effort to start what they hope will become a long-term, and ultimately profitable, relationship with the next Google or Microsoft.

Who is your client?
We hear regularly about the increasing presence of the procurement team in client discussions about fees. Law firms describe how a discussion with procurement is much more focused around price than on the value of a long-standing relationship between the company and its external law firm. Nevertheless, with procurement at the table, law firms now need to consider who their client is--is it the general counsel or procurement? And what factors will drive a decision on which law firm the company chooses to use?

It's not always about cost reduction.
We recently heard a firm describe how it entered into an arrangement with a client to work under a fixed budget for 2010, with the proviso that during the 2011 budget season, the client and law firm would meet to discuss whether the actual cost of legal services provided in 2010 (based on an agreed upon hourly rate) was higher or lower than the 2010 budgeted amount. The adjustment would then be made to the 2011 budget. What the client here was looking for was cost certainty, rather than cost reduction. By understanding its client's need for certainty, the law firm was able to maintain its fee structure--and keep its client.

Underscoring this focus on price certainty, we recently heard about a corporate client, who, having invited law firms to tender for work under an AFA, did not select the lowest cost bid. In selecting a more expensive law firm rather than the lowest-cost option, the general counsel explained how she was concerned that the low-cost provider would not deliver at that price. She went further to say that she did not want to be embarrassed in front of her CEO, so opted for the higher bid, because she felt comfortable that the bid was more realistic...This story illustrated to us that while clients care a lot about cost, they are prepared to pay a premium for cost certainty.

Shifting the discussion to "value beyond price."
Beyond the focus on cost, clients also care a lot about the "value beyond price" that we are hearing firms offer to clients. Recognizing that their corporate law department clients have limited resources and budget, law firms are seeking out ways that they can assist their clients beyond the delivery of core legal services. Where a client has a short-term need for extra in-house resources, law firms are offering to second associates to a client for a period of time at a negotiated rate that works for both the firm and the client. Where a client has a need for better knowledge tools, firms are offering knowledge management products and services to clients, such as databases of client work product, access to library/research assistance and CLE programs. For major cases and matters, law firms are conducting end-of-matter debriefs with clients at no charge, to identify what went well and what could be done better the next time. Law firms are also offering a set amount of "free" telephone advice--where the in-house lawyers can comfortably pick up the phone and talk to their law firm about basic issues without fear of seeing a bill for it.

We've observed that the most successful programs are those where the law firm understands that, as an internal cost center, its corporate client may lack basic law practice tools, and actively engages their client in understanding what they lack, and how they can benefit, at no cost, from their law firm. While these initiatives may not be fee-generating, they strengthen the ties between law firm and client--and create opportunities for new fee-generating work.

It's clear to us that in the process of figuring out how to compete on price, firms are looking more broadly than just offering deeper discounts to their hourly rates. The discussions we've had make us hopeful that firms are beginning to realize they will need to manage differently to maintain profit growth in this client-centric world. Even beyond AFAs, the increased focus on who is their client and what does their client want, suggests to us that firms are embracing the challenges they've faced in this soft demand market. In the process, they are being innovative in how they run their law firms, positioning their firms for future growth.

Dan DiPietro is chairman and Gretta Rusanow is senior client advisor at Citi Private Bank's Law Firm Group.

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