First-half 2013 results suggest that the legal industry faces an uphill battle to match 2012’s low-single–digit profit growth. Expense growth outpaced very modest revenue growth, causing margin pressure. That modest revenue growth was due more to rate increases than any improvement in demand. In fact, demand declined. Yet despite declining demand, head count grew, leading to a worsening of the excess capacity we have witnessed in recent years—a major contributor to industry pricing pressure. Given the current demand environment and the likelihood of ongoing pricing pressure, it will be a challenge for the industry to achieve enough revenue growth during the second half of 2013 to ease the margin pressure we saw during the first half. Rather than seeing a repeat of last year’s result, we think it’s more likely that we will see a flat year.
Revenue growth of 0.5 percent, while an improvement over the 0.2 percent growth seen in the first quarter, is tepid, relative to the six-month growth in recent years. The increase in revenue was due primarily to growth in billing rates of 3.7 percent. This rate growth is comparable to 2012, and is more than we saw during the prior three years. However, it remains well below the rate increases we saw prerecession.
Demand declined 1.3 percent, though this was an improvement over the 3.3 percent decline seen during the first quarter. This would support our view that the first quarter suffered as some transactional work was accelerated into the fourth quarter of 2012. Certainly, the second quarter of 2013 saw an improvement in demand; however, a decline of 1.3 percent is still a decline.
These results are based on a sample of 172 firms (81 Am Law 100 firms, 45 Second Hundred firms, and 46 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.
Expense growth slowed to 2.4 percent, from the 3.4 percent growth rate seen during the first quarter. Despite this slowdown, expense growth continued to outpace revenue growth through the first half, resulting in continued margin pressure. It’s interesting to note that the increase in total expenses was driven more so by compensation expense growth than an increase in operating expenses—a reversal of the trend we saw last year. While head count growth and a more senior demographic would be driving the compensation expense growth, the results also suggest that the period of catching up on long-delayed infrastructure expenses may have played out.
Lawyer head count increased 0.4 percent for the industry during the first half of 2013, a slight slowdown from the 0.5 percent growth seen during the first quarter. Equity partner head count, on the other hand, grew slightly during the second quarter. A primary reason for this uptick in equity partner head count is attributed to Am Law 1–50 firms, which saw a 0.7 percent increase in equity partners through the first half of 2013 after experiencing a -0.1 percent decline during the first quarter. This segment was also the only Am Law 200 segment to increase both total attorney and equity partner head count in the first half of 2013.
The increase in lawyer head count, coupled with a decline in demand, resulted in lower lawyer productivity during the first half. However, the decline in productivity was less severe than during the first quarter.
As billable hours remain well below historical levels for all segments, we continue to see this excess capacity drive pricing pressure. In July, as part of our 2013 Law Firm Leaders Survey, we asked the managing partners of 48 predominantly Am Law 100 and Second Hundred firms to report on whether realization had changed during the first half of 2013, compared to the first half of 2012. Close to half of the firms responded that realization had declined.
Looking forward, inventory growth of 2.7 percent and a slight lengthening of the collection cycle during the second quarter, suggest that more favorable collections results are likely in the third quarter of 2013. However, there are revenue challenges ahead, given the demand environment. Even if demand improves during the third quarter, the industry faces the looming challenge of beating a strong fourth quarter of 2012. Even if expense growth moderates during the latter half of 2013 from its first-half growth rate of 2.4 percent, the industry would still have to see a strong acceleration in revenue growth from the 0.5 percent seen so far, to ease the margin pressure experienced during the first half. It’s the combination of these challenges that has caused us to revisit our 2013 forecast of low single-digit profit growth. We think it is more likely that firms will see a flat year.
So, while the industry is no longer in free fall, as it was in 2009 and 2010, tepid demand and intense pricing pressure continue to plague most firms. Managing partners would be wise to calibrate the expectations of their partners. It's not doom and gloom, but it's also not the golden era.
Gretta Rusanow is senior client advisor at Citi Private Bank’s Law Firm Group. Andrew Godwin is lead analyst. Chairman Dan DiPietro and senior client advisor John Wilmouth contributed to this article.