August 21, 2008 9:45 AM

Worst Year for Big Firms Since 2001, Says Citi Expert

Posted by Ed Shanahan

Originally posted on August 20, 2008  at 2:35 PM

By Dan DiPietro

Since 2001, the legal industry has been characterized by double-digit profit growth, strong demand, solid productivity, and controlled expense growth. That all started to change in the second half of 2007, and now, the first half of 2008 looks very different from the previous six years. In a trend that started last year, expense growth this year has stayed relatively high, driven largely by continued growth in lawyer head count. But revenue growth was the weakest it's been in the seven years since we began tracking quarterly results. Demand for legal services was also the weakest seen in the period from 2001 to 2008.

Because law firms continued to add lawyers to their ranks despite the drop-off in demand, firms experienced a slowdown in productivity comparable to the second quarter of 2001 and lower than every other second quarter between then and now. All told, for the first two quarters of 2008, profit margin compression--that is, expenses increasing faster than revenue--was the greatest it's been in the last eight years.

The slowdown is hitting the most profitable firms the hardest. In the first half of 2008, demand dropped off even more dramatically and expenses increased at a more rapid pace at the top firms, resulting in even greater margin compression and a steeper drop in productivity than experienced by their less profitable rivals. The practice areas that normally provide a lift in a downturn--restructuring, bankruptcy, and litigation--have not helped cushion the drop-off in transactional work.

There is a silver lining. A bad year (and the numbers suggest 2008 will be even more trying than 2001, when partner profits were down slightly) will enable firms to take steps that partners would resist in a good year--winnowing out unproductive lawyers and applying greater discipline to expense control.

At Citi Private Bank, we provide financial services to more than 650 U.S. and British law firms and over 35,000 individual lawyers. For 28 years, Citi Private Bank Law Firm Group has confidentially surveyed firms in The Am Law 100 and Second Hundred, along with a number of smaller firms. These reports, together with extensive, ongoing discussions with law firm management, provide a comprehensive overview of financial trends in the industry and insight into where it is headed. The report for the first half of 2008 uses data gathered from 165 firms—75 Am Law 100 firms, 55 Second Hundred firms, and 35 smaller firms.

Our report found that, across the industry, revenue growth was a tepid 4.8 percent, less than half the compound annual growth rate (CAGR) of 10.6 percent for the previous seven years. The slumping revenue growth was driven largely by a falloff in demand, measured by gross billable hours (which declined by 0.3 percent). That's in sharp contrast to the seven-year demand CAGR of 3.9 percent.

Despite the falloff in work, leverage actually increased during the first half of 2008. Total lawyer counts rose by 5.6 percent, more than three times the rate of equity partner growth. But the controlled approach to making new equity partners was not enough to counter the lack of demand, and firms saw profits per equity partner (PPEP) drop by 9.1 percent in the first six months of 2008. There's no question that it's a dramatically different economic environment from the previous seven years, during which PPEP had a CAGR of 9.3 percent.

It may seem paradoxical to see an increase in head count while demand drops, but law firms are not like corporations in this regard. Firms generally set their new associate hiring goals two years in advance. They are also much more reluctant than corporations to resort to mass layoffs, since they need to keep on enough junior associates to ensure that they won't suffer from a lack of mid-level talent when business picks up again. And when the economy goes soft, lawyers are less inclined to leave their firms. This has definitely been the case over the last six months. Although we don't track lawyer attrition on a quarterly basis, anecdotal evidence from conversations with managing partners suggests that associate attrition has dropped dramatically.

This unique aspect of the legal industry is already causing short-term pain. The uptick in total lawyer counts, coupled with the decline in demand, caused productivity, or average hours billed per lawyer, to drop by 5.5 percent in the first half of 2008. The decline is comparable to the falloff in productivity that firms experienced in the first half of 2001, where their business got slammed by the burst of the high-tech bubble. This time around, the profit pie is being sliced even thinner as a result of an increase of 1.8 percent in the number of equity partners, up from 1.5 percent in the comparable period last year, although still trailing the seven-year CAGR of 2.9 percent.

Firms are feeling the squeeze from both sides. At the same time that revenue growth has fallen, expenses have stayed high. In the first half of 2008, expenses grew by 10.1 percent, which is down from the 13.7 percent increase in the comparable period last year, but still above the seven-year expense CAGR of 9.5 percent. Associate compensation, which accounts for about 23 percent of firm revenue, continues to be the primary driver of expense growth. Compensation costs rose by 15.2 percent, again down from the 17 percent rise in the first half of last year, but still well ahead of the seven-year CAGR of 10.1 percent. Firms did manage to get operating expenses under control, slashing increases in occupancy charges and overhead to 6.9 percent, notably down from the almost 12 percent increase in these expenses during the comparable period last year.

TOUGHER AT THE TOP

When firms are broken out by profitability, our data produced an interesting finding. The firms that soared in 2002 through 2007 were harder hit in the first half of 2008 than their less profitable peers. From our sample of 165 firms, we broke out 63 top-tier firms (defined as those with profits per equity partner above $650,000 in the year 2000). Over the past six years, this group has consistently produced higher growth in revenues and PPEP than other firms.

That changed dramatically in the first half of 2008. Growth in PPEP for 51 of the 63 top-tier firms that reported their results to us plummeted from an 11.7 percent increase in 2007 to an 11.8 percent drop in the first six months of 2008. In contrast, their less profitable rivals experienced a 5.3 percent drop in PPEP in the first half of 2008. After reaching a seven-year peak of 7.4 percent growth in 2007, demand at top-tier firms actually dropped 1.6 percent in the first half of 2008. Again, this decline compares unfavorably with the 1.1 percent rise in gross billable hours at the other firms in our sample.

Top-tier firms experienced even greater profit margin compression than their peers, with revenue growth of 4.3 percent and an increase in expenses of 10.9 percent. In contrast, the other firms we surveyed had revenue growth of 5.5 percent and a rise in expenses of 9.1 percent. Demand at top-tier firms declined in both the first and second quarters of 2008, in contrast to their less profitable competitors, for whom demand dipped in the first three months  but increased in the second three months.

What's going on? Simply put, top-tier firms tend to rely on certain kinds of transactional work, such as high-end private equity deals, securitization, and structured finance, and also tend to have a higher percentage of clients in the financial services sector. That client base served top-tier firms well during the prior six years. But since the second half of 2007, the deal environment has languished, and top-tier firms are paying the price.

These firms also have had a tougher time turning off the expense spigot. When times were flush, top-tier firms experienced higher associate attrition rates than average, due to lawyers leaving to work for clients and other opportunities in the financial industry. To make up for this, top-tier firms typically hired more new associates than average, since they expected more to leave. In fact, at top-tier firms, head count grew by 7 percent in the first half of 2008, versus 4.2 percent at their rivals. This continued head count increase, coupled with an abrupt decline in demand, resulted in productivity (measured by hours per lawyer) dropping 8 percent at top-tier firms in the first six months of 2008, versus a 2.9 percent decline at the other firms.

Our data points to another interesting finding: International firms—those with between 10 and 25 percent of their lawyers based overseas—experienced greater profit margin compression than any other group of firms. Like top-tier firms, last year international firms outpaced their domestic counterparts across virtually every key financial benchmark. Their rather abrupt reversal of fortune suggests that the economic slowdown in the United Kingdom and Western Europe that has followed the slowdown in the United States is disproportionately affecting international firms, which typically have a heavier presence in those regions than their peers. On the other hand, global firms—those with more than 25 percent of their lawyers based overseas—have experienced the least profit margin compression of the group. Global firms tend to have a wider reach than their International counterparts, with more lawyers in Asia, Eastern Europe, and the Middle East. The relatively stronger performance of the global firms suggests that simply having an international presence is not enough to ensure success. Rather, what matters is the extent and location of a firm's global footprint.

LOOKING AHEAD

As I write this, all signs point to the second half of 2008 continuing the trends of the first half. The common wisdom is that this economic slump is more akin to the downturn of 1991—deeper and more complicated than the downturn of 2001, which was largely limited to the high-tech industry, coupled with the disruptive effects of 9/11. Although firms with a big technology client base suffered in 2001, growth was largely flat across the legal industry overall, with the top tier slightly down. In contrast, the numbers we are seeing now suggest a much more significant decline.

Typically, inventory—accounts receivable and time worked but not yet billed—serves as an excellent predictor of future revenues, and higher inventory levels should suggest strong revenue momentum in the third and fourth quarters. In the first and second quarter of 2008, inventory levels rose by 8.2 percent. This should be good news, but in this case, the inventory increases are attributable in large part to slowing collections, which does not augur well for revenue growth in the second half of 2008.

Early this year, in a joint advisory issued by Citi and Hildebrandt International, we projected that profits would increase by 3–5 percent. Based on the six-month results and our sense of the dynamics in the market, we now believe PPEP will be flat, or even down by as much as 10 percent, in 2008. The top-tier firms will have an even tougher year, with profits down by 5–15 percent.  Our reason for providing a range is that there is an elephant in the room: How will firms, particularly the top-tier firms, handle associate bonuses this year? The rational approach would be to pare them back, but, while lawyers display rationality and dispassion in the practice of law, they have exhibited “irrational exuberance” on this issue in the past.

MANAGING THROUGH THE SLUMP

Tying associate bonuses to the firm's performance —which would create a smaller bonus pool—can help somewhat. Firms also need to manage the expectations of their partners, particularly the more junior partners who had not experienced a downturn until now. There are several other steps firms can take to stay financially healthy.

First, firms should make an effort to get in front of their clients and engage in active dialogue about their business. This is especially true for firms that rely heavily on clients in the financial services sector because the nature of deals is going to change, and firms don't want to be behind the curve when that happens.  Second, firms should consider sending a tough message to unproductive lawyers at every level. When demand was high, firms often let their unproductive lawyers slide. In a time of soft demand, such lawyers become a real drag on profitability. Third, firms should start their year-end collections push now. The higher the mountain of unpaid bills, the more formidable a climb it becomes. Keeping inventory low makes the collection process much more manageable. Finally, firms that haven't already done so should conduct a systematic expense review to eliminate redundant or nonessential support staff and functions. Firms that have grown by bringing in groups of lateral partners and small firms, in particular, may be surprised at the impact that inefficient staffing can have on expenses. The results of an expense review conducted now will not be felt until 2009, but it's still a good idea.

There's no doubt that 2008 will be the most challenging year the legal industry has had since 2001 (and perhaps even earlier). But downturns present opportunities. The dislocation in the market and dissatisfaction among partners offers law firms the chance to gain market share by bringing in select lateral partners. However, when hiring in a soft economy, it's particularly important to vet candidates to differentiate between laterals who are looking to move because they’re not happy and those who are looking to move because their firms are not happy.

At the end of the day, law firm management should take heart that the legal industry is, in fact, healthy and resilient. There are a lot of other business sectors who would love to be able to define a bad year as profits that are flat to down by 10 percent.

Dan DiPietro is client head of the Law Firm Group of the Citi Private Bank. E-mail: [email protected].

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