One of the great mysteries of the legal market today is why law firms are growing so slowly. Large corporations are awash with profits. Importantly, they also face many risks. Political volatility is high, global trade is becoming more complex, and operational risks like cyber-attacks and #MeToo disputes, seem to be increasing. So why aren’t law firms seeing an uptick in demand?
To answer this question, many legal market observers point to the “new”. The growth of in-house teams, the emergence of a new raft of non-law firm competitors, and the new, cost-conscious mentality of law departments. These forces have surely had an impact, but a more likely culprit lurks in the background – the broader macro-economic environment in which law firms exist.
Explaining Law Firm’s Weak Growth in the Post-Downturn Period
Law firms, like any business, are influenced by the broader economy. When the economy grows, law firms typically grow with it. When the economy shrinks, law firms suffer. This can be seen clearly in Figure 1, which shows inflation adjusted annual revenue growth for Am Law firms alongside real US GDP growth.
Three trends are evident in the data presented in Figure 1. Firstly, growth has slowed significantly since the heady days of the pre-downturn period. Between 2002 and 2008, Am Law firms averaged 7% annual growth. In contrast, in the post-down period, between 2010 and 2016, firms have averaged a more modest annual growth rate of 2%.
The second finding is also fairly intuitive. Law firm’s businesses are cyclical – they ebb and flow along with the broader economy. This makes sense. Demand for legal services grows when the economy expands and contracts when it shrinks.
The third finding is that there is a clear hangover after each downturn. Revenue doesn’t return to pre-downturn levels immediately. Instead, a lull sets in. In this period, revenue doesn’t necessarily contract, but it remains at a low level for several years. This trend is most evident in the period directly after The Early 1990’s Recession, in which revenue for the Am Law group contracted for three consecutive years. It can also been seen after The Early 2000’s Recession, which was a milder downturn, and in the period after the most recent recession. Could this hangover effect explain law firm’s current difficulties? Are law firms still reeling from the 2008 downturn?
Looking at the data in Figure 1 slightly differently helps highlight the hangover trend that occurs after each downturn. Figure 2 graphs The Early 1990’s Recession alongside the Great Recession on the same timeline.
In both of the recessions shown in Figure 2, there is a clear hangover period. Revenue growth for Am Law firms remained at a low level for four consecutive years after the peak of each downturn. Law firm’s recovery after each of these recessions, however, differs in years five through seven. A half decade after The Early 1990’s Recession, law firms were accelerating back to double digit growth. Why hasn’t that performance been repeated in the post-down period of the most recent recession?
Explaining Law Firm’s Weak Growth in the Post-Downturn Period
There are two broad explanations for why law firms have rebounded so slowly from the Great Recession. One camp – the ‘New Normal’ believers – point to rising competition from law firm substitutes. The second camp points to the macro-economic environment that underpins the demand for legal services.
Evangelists for the New Normal perspective would argue law firm’s weak growth is ultimately a function of lost market share. Law department in-sourcing and the expansion of the alternative service provider segment of the legal market has created a substitute for law firm services. These new competitors, it is argued, are stealing market share previously owned by law firms and, in turn, limiting law firm’s growth potential.
The New Normal argument has strengths and weaknesses. That law department in-sourcing has taken a toll on law firm growth rates is likely. A forthcoming analysis, in the March issue of The American Lawyer by Hugh Simons and Gina Passarella entitled, The Rise (and Fall?) of In-house Counsel makes a compelling case that in-sourcing has come at the cost of law firm revenue growth.
Other aspects of the New Normal storyline are less convincing. The argument, for example, that alternative service providers (ASPs) are taking a significant chunk of law firm’s revenue growth is questionable, at least so far. ASPs represent approximately 1% of the global legal market. In the US, ASPs earned around $1bn in revenue last year. Assuming that the segment is growing by 15% per year, this amounts to approximately $150m in new revenue last year. If all of that new revenue came at the cost of law firm growth, which is a questionable assumption, then law firm revenue growth would have been reduced by 0.2%. It is difficult to believe this is what is keeping law firm leaders up at night.
A Macro-Economic View
A macro-economic view of law firm’s weak rebound from the Great Recession offers two potential culprits – the severity of the most recent downturn and the weakness of the recovery.
The Great Recession was significantly more severe than the two recessions which it followed. As seen in Figure 3, The Great Recession lasted 18 months. In contrast, the previous two recessions each last 8 months. Additionally, the economy fell farther in the Great Recession. GDP shrank significantly more deeply and unemployment rose far higher than in either of the two prior downturns. The severity of The Great Recession suggests that one explanation for the long period of slow growth law firm are now experiencing is that a deeper recession triggers a longer hangover for law firms. If that were true, law firms’ performance over the past several years might be explainable.
A second, connected, issue to consider is that the recovery after the most recent recession has been milder than previous recoveries. As shown in Figure 3, GDP growth in years five through seven after the most recent downturn has averaged 2.3% as opposed to 4.2% in the same period after The Early 1990’s Recession. Given the historical connection between GDP growth and law firm growth rates, established in Figure 1, the sluggish growth in the broader economy over the past several years is almost certainly to blame for some portion of law firm’s weak growth performance. But responsible for how much?
An analysis which compares actual Am Law growth rates against expected growth rates suggest weak macro-economic conditions are probably responsible for a significant amount of law firms’ recent woes. Figure 4 uses a regression analysis, which incorporates data on US GDP growth and law firm revenue growth from 1986 to 2007, to predict an expected Am Law growth rate for the past six years. While Am Law firms’ actual growth rates under-performed their expected growth from 2010 to 2013, they did so by less than a percentage point. Interestingly, over the past three years Am Law firms have performed significantly better against the expected benchmark. This data suggests law firm’s recent growth rates are largely in-line with historical trends and any performance gap is closing as opposed to widening.
Reconciling Different Interpretations
Of course, neither argument – the New Normal story line or the macro-economic view – is entirely correct or incorrect. A complete explanation of law firm’s sluggish growth over the past several years would, almost certainly, require data points from both sides. That said, the macro-economic analysis does raise questions about an important assumption of the New Normal camp – that law firm’s sluggish growth is “here to stay”. If the past is any sign of the future, that assumption looks shaky. Law firms have tended to return to strong growth once the economy fully recovers. To believe this time is different requires an assumption that the legal market has fundamentally changed. As a rule of thumb it is typically a good idea to be skeptical of arguments that begin with the phrase “this time is different”. These arguments are often – although not always – wrong.
Nicholas Bruch is a Senior Analyst at ALM Legal Intelligence. His experience includes advising law firms and law departments in developing and developed markets on issues related to strategy, business development, market intelligence, and operations. He can be reached by Email, Twitter, or LinkedIn.