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September 22, 2011 2:51 PM

Citi's Midyear Report: Firms' Expenses Outpace Revenue Gains

Posted by Ed Shanahan

By Dan DiPietro and Gretta Rusanow

Building on the positive signs we started to see during the first quarter of 2011, demand and rates were even stronger at the midyear point, while revenue (cash collections) held steady throughout the first six months.

This is a promising outcome, but we have seen expenses grow so quickly that they are now increasing at a faster rate than revenue, putting a squeeze on profit margins. Even before the current market uncertainty, firms told us they were planning for slow growth. While it’s hard to forecast what the impact of today's conditions will be on law firms, we believe it could disrupt law firm work pipelines and deal flow, at least in the short term. 

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. 

For the first half of 2011, revenue was up 3.7 percent across the industry. The increase was driven by strong inventory levels coming into 2011, increased rates, a 1.8 percent growth in demand and likely improvement in realization. These results are based on a sample of 178 firms—80 Am Law 100 firms, 54 Second Hundred firms, and 44 other firms.

Rate increases and realization stood out as positive signs during the first half. In 2009 and 2010, we saw rate increases that were less than half of those in 2001–07. In the first six months of this year, we've seen that trend begin to reverse. We also asked managing partners, mostly of Am Law 50 firms (the nation’s 50 highest-grossing firms), how realization at midyear compared with last year, and they said it had stabilized, if not improved. These two findings suggest that we could be seeing an easing of the pricing pressure of the last two years.

Countering the positive impact of the uptick in revenue, rates, and demand is growth in expenses—at a 4.7 percent increase, expenses grew more than revenue, squeezing profit margins. Reasons for those expense increases varied. Some firms increased their operating expenses because they commenced long-overdue infrastructure projects. Many saw a notable increase in compensation expenses, due to spring bonuses. 

As was the case in the first quarter, head count remained relatively flat, so the increase in demand has translated into a 1.6 percent uptick in productivity. Since expense increases are outpacing revenue increases, flat head count means that growth in expense per lawyer is outpacing growth in revenue per lawyer. So on one measure of profitability—contribution per lawyer—firms are feeling the pressure. On a brighter note, the material increase in inventory (work that is completed but not yet billed) is a good sign for near-term collections. 

Given all of this, will firms maintain the contribution per lawyer and profit per equity partner results they saw in 2010? As Citi Private Bank chief investment officer Richard Cookson has been saying for more than a year, the economy appears to be in for a protracted period of slow growth or no growth, given the systemic issues it is facing. These include sovereign debt concerns in the Euro zone and the potential for ripple effects throughout the banking sector; deficits in the United States and the lack of political bipartisanship to reach a credible solution; and the stubborn, high level of unemployment in the U.S. It's hard to see any way that this environment is good for law firms in the short term. There's a good chance that M&A, private equity, and IPO work will slow as companies and investors seek some clarity before doing deals, and a spike in litigation seems unlikely. 

Because growth is unlikely to come organically, lateral hiring is becoming more of an imperative for firms. The increasingly wide dispersion in financial performance among firms is a key factor in the active lateral market. We recently analyzed the performance of firms in the top tier and middle tier of profitability from 2007 to 2010 and noted a material widening in firms’ financial performance. We believe this dispersion will further encourage rainmakers at underperforming firms to more actively look for opportunities elsewhere, while top-performing firms will seek to leverage their market advantage to buy talent for their weaker practice areas. 

Our forecast from the fourth quarter of 2010 was that 2011 would show some growth in profits per equity partner, although not as much as in 2010 because of expense pressure. We also predicted that revenue metrics would improve only slightly. While we are hedging our bets a little in light of the disruption we've seen in the markets since then, we’re generally sticking to that forecast. 

Dan DiPietro and Gretta Rusanow are chairman and senior client adviser, respectively at Citi Private Bank's Law Firm Group. E-mail: dan.dipietro@citi.com; gretta.rusanow@citi.com.

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