March 11, 2011 12:01 AM

Signs of a Rebound?

Posted by Ed Shanahan

By Dan DiPietro and Gretta Rusanow

Law firm profits and lawyer productivity rebounded in 2010--good signs that the market has turned a corner. However, demand was flat and revenues were up modestly compared to a weak 2009. Translation: The increase in profitability was largely driven by expense cuts, which--as we have written previously [“Trench Warfare,” October 2010]--have gone as far as they can. To maintain these profit gains in 2011, firms will need to find ways to increase top-line revenue.

First, a look back at 2010: Firms continued their efforts to shrink their way to profitability, with a better outcome in 2010 than in 2009. Despite cutting expenses by 5.6 percent in 2009, firms experienced a slight decline in profits per equity partner (PPEP) of 0.3 percent. Contrast that with 2010, when profits rose 7.4 percent. While demand was essentially flat, and revenue increased only modestly at 1.3 percent, 2010’s profit growth can best be attributed to a 2.2 percent reduction in expenses and an industry-wide drop in equity partner head count of 0.7 percent.

Our results are based on a sample of 179 firms (84 Am Law 100 firms, 50 Second Hundred firms, and 45 additional firms). Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and more than 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.

The modest uptick in revenue in 2010 was driven by equally modest rate increases. We believe rate increases were caused in part by a shift to more senior people doing the work. We’ve heard three reasons for this: Clients demanded more senior people, partners may be hoarding work, and firms’ associate ranks have become "older," due to head count reductions, particularly among younger associates, deferrals of incoming classes, and reductions in size of incoming classes. Despite all of this, the rate increases we saw in 2010 are roughly half the size of the annual rate increases we saw in the boom years prior to 2008.

Realization is another area we have closely watched. In 2008 and 2009, we saw steep declines, indicative of severe discounting pressure. Our preliminary analysis indicates that realization declined only marginally in 2010—another positive sign that the bleeding may have stopped.

With demand flat and head count down by 2.7 percent, we saw an improvement in productivity, with average hours per lawyer increasing to 1,638 hours, up 2.9 percent from an average of 1,591 in 2009. This increase is good news, although 1,638 hours is still well below the average of 1,740 hours per lawyer we saw in 2000–2007.

In our quarterly survey, we group firms by their geographic presence, as well as by their Am Law 200 position. Global firms (those with more than 25 percent of their lawyers working overseas) had stronger demand in 2010 than others. This is a reversal of the trend in 2008–09, and a return to the trend we saw in 2001–07 when global firms' demand (at a compound annual growth rate of 5.7 percent) far outpaced the industry’s (4.0 percent).

Another trend worth noting is the continued strong performance of Second Hundred firms in 2010. The results show that demand at Second Hundred firms increased at rates similar to Am Law 50 firms (0.7 percent and 0.6 percent, respectively). Since in 2009, Second Hundred firms outperformed Am Law 50 firms (Second Hundred demand fell by 1 percent, compared to a 5.5 percent decline for The Am Law 50), the continued increase in demand in 2010 demonstrates that the Second Hundred is still holding strong.

Moving beyond the averages, we looked at the range of performance at firms both before and after the global financial crisis. In 2005–2007, there was a narrow band of performance, with 90 percent of firms experiencing positive PPEP growth. In 2008–2009, we saw a strong shift toward PPEP declines (more than 50 percent of firms had them), with wide variance in firm performance. When we looked at how firms performed in 2010, we saw a positive movement, but there is still a fair amount of variance, with roughly 20 percent of firms experiencing PPEP declines. This wider band of performance has deep implications for retention and attraction of top talent.

Collections were strong during the fourth quarter. We also found that demand was up during that quarter, as was unbilled time. This signals a positive start for collections in the first quarter of 2011, particularly when compared with the first quarter of 2010, when they were relatively weak.

Having met with many of our clients during the first two months of 2011 to talk about 2010, we've had the opportunity to hear a good deal about how they viewed their performance last year, as well as their outlook for 2011.

Momentum in demand continued to be strong in the first quarter of 2011. In our conversations with clients, we’ve heard that the momentum has come more from transactional practices than from litigation. While litigation is not weak, it was much stronger a year ago. This may bode well for margins, since transactional work tends to be less price-sensitive than litigation. 

Here are high points from our conversations:

•Realization. The pressure to discount is not over, but the pressure to discount fees further may have abated. Some firms are noting a shift in who pays their bills, which may affect pressure on realization. Specifically, firms are seeing clients pass on their law firm costs to their own client (for instance, a bank might pass on the legal costs of a mortgage transaction to the mortgagor). This trend may ease the pressure on law firms to further discount fees.

•Shifting demographics. Deferred first-year associates will arrive at their firms this year. In the short term, they won’t generate much revenue, but they will lead to an increase in expenses. We have also heard that the level of unwanted attrition among midlevel associates is too high. This may lead to upward pressure on overall compensation for midlevels, as well as an increase in recruiting costs.

•Expense cuts and profit growth. When we looked at the reductions in head count and expenses that firms took in the second half of 2009, we felt good about the impact this would have on firm profitability in 2010, as the above results show. However, we don’t have the same positive feeling about 2011. To the contrary, we foresee expenses increasing, due in part to head count changes described above and in part to critical projects, such as technology upgrades, that cannot be delayed much longer.

•The lateral market. The variability in law firm performance, as noted earlier, affects the ability of firms to attract and retain talent, and suggests that there will be momentum in the market for lateral partners. We expect that 2011 will be another year in which variance in law firm performance will be significant, although the number of outliers on the negative side will lessen. Still, it’s possible that we will see some weaker firms try to latch on to stronger ones or fail altogether.

•Equity partner head count. While the decline in equity partner head count was 0.7 percent, among Am Law 50 firms, the drop was bigger—2 percent. This is a meaningful difference from growth rates of 2–3 percent in prior years. Since expense cuts relating to associates have gone as far as they can go, we will be watching equity partner head count closely.

For 2011, we predict single-digit growth in profitability, driven more by top-line revenue growth than in 2010. This is due to the upward drift in expenses, which has not been helped by the recent round of spring bonuses.

To increase top-line revenue, we anticipate firms taking a range of approaches. Some will concentrate on how best to partner with the clients to address their clients’ cost pressures while maintaining profitable relationships. Others will focus their growth on specific practice areas, industries, or regions. To support these growth strategies, we expect to see an increased emphasis on lateral movement of groups of partners, as well as large firms merging with boutiques. 

A final cautionary note: Because many firms rebounded nicely in 2010 for reasons that are largely not repeatable, a possible unintended consequence is a return to complacency on the part of law firm partners (something we've heard at several partner retreats where we have spoken). Will Rogers had a quip that speaks to the dangers of complacency. To paraphrase: You may be on the right track, but if you're standing still, you'll quickly get run over. Nimble firms that continue to embrace change should do just fine in 2011. 

 

Dan DiPietro and Gretta Rusanow are chairman and senior client advisor, respectively, at Citi Private Bank's Law Firm Group. E-mail: [email protected]; [email protected].

 

 

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