There is good and bad news in the third quarter results for the legal industry. The metrics that matter improved compared to first-half results, but the cumulative results still show demand in negative territory and excess capacity worsening.

The industry started the year in a bit of a hole, as a surge in fourth-quarter 2012 collections effectively pulled into 2012 revenue that might otherwise have been booked in 2013. Through the first six months of this year, revenue growth was still anemic and lagged expense growth, thereby putting pressure on margins. Through nine months, however, revenue growth was stronger and actually outpaced expense growth for the first time this year.

These results are based on a sample of 173 firms (78 Am Law 100 firms, 46 Second Hundred firms, and 49 additional firms). Twenty-nine of these firms fit our definition of either “international” (less than 25 percent but more than 10 percent of lawyers based outside the United States), or “global” (greater than 25 percent of lawyers based outside the United States). 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.

Through the first nine months of the year, revenue was up 2.7 percent, evidence that the trend has improved each quarter (up 0.2 percent and 0.5 percent in the first three and six months, respectively). There were several factors at work. Underlying demand relative to last year picked up as the year has progressed. Down 3.3 percent in the first quarter compared to the similar period in 2012, demand had moderated to a 0.6 percent decline by the end of the third quarter. While demand was digging itself out of that early-year hole, rate increases have been solid, if unspectacular, clocking in at 3.9 percent through the first nine months of 2013. Timing of collections also came into play, as the collection cycle (the number of days it takes to convert billable hours logged into cash receipts) shortened by 1.6 percent. Breaking the cycle down into its two stages reveals that the average number of days between when work was logged to when it was billed actually lengthened, and it was the time it took to convert accounts receivable into cash that shortened. It’s not surprising, therefore, that while total inventory (accounts receivable and unbilled time) was up 2.1 percent at September 30, all of the increase was in unbilled time.

While revenue growth picked up as the year progressed, expense growth slowed, from 3.4 percent in the first quarter to 2.3 percent after nine months, easing the pressure on margins. Although growth in both components of expense—attorney compensation and operating—decelerated during this time, attorney compensation experienced the greater slowdown of the two. The primary reason for this compensation slowdown was a decrease in attorney head count growth. Up 0.5 percent after three months, total attorney head count was up only 0.1 percent after nine months, and the rate of attorney compensation expense growth fell accordingly.

As firms were paring back the growth in attorney head count, they continued to tightly control equity partner head count, which was actually down 0.3 percent through nine months compared to the same period last year.

Although the industry as a whole enjoyed an easing of the pressure on profit margins, closer examination shows that the Am Law 100 firms and, in particular, those with the greater international presence, were responsible for these positive margins, whereas the rest of the industry actually saw their margins squeezed. While it’s true these larger and more international firms benefited from comparison to a weak first nine months of 2012, it’s also true that as early as the first quarter of this year they had positioned themselves better than most to weather any continued weakness in demand. During these first three months of the year, on average, this group logged larger effective rate increases and did a better job managing costs, especially overhead, than the rest of the industry.

With demand down relative to last year and head count up, however slightly, productivity for the industry as a whole continued to slide. The Am Law 1-50, however, did manage to keep productivity flat, while the global firms (which are essentially, but not exclusively, a subset of the Am Law 1-50) actually experienced an increase in productivity. Not only did these global firms have the only increase in demand through nine months, they also had the only notable reduction in lawyer head count.

With only a couple of months left in 2013, the question remains whether the industry will match last year’s low single-digit profit growth. On the one hand, nine months of revenue growth has exceeded expense growth, which wasn’t the case last year. On the other hand, last year’s fourth quarter benefited from a greater build-up in inventory at September 30, as well as the spike in tax-driven revenue, an unusual situation that won’t be repeated this year. So, our best sense is that 2013 will fall short of last year but not by much.

Regardless of how the year turns out, however, the underlying challenges facing the legal industry remain: tepid demand and excess capacity. Beyond this year, the performance of the industry will hinge to a large extent on how well firms adapt to the new realities.

This article was written by John Wilmouth, senior client advisor, Citi Private Bank’s Law Firm Group, with contributions from Dan DiPietro, chairman; Gretta Rusanow, senior client advisor; and Andrew Godwin, lead analyst.