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Although law firms are not quite ready to pop the corks on the champagne bottles, their performance so far this year makes the coming year look more promising. According to research conducted by the Law Firm Group at The Citigroup Private Bank, key indicators such as revenue, gross hours, and inventory suggest that 2003 will shape up to be a good year, especially considering the sluggish economy. As the economy slowly picks up, so does the outlook for law firms in the months ahead. The Citigroup Private Bank provides financial services to more than 500 American and British law firms. The Law Firm Group conducts quarterly surveys of firms in the AmLaw 100 and AmLaw 200, along with a significant number of smaller firms. These confidential surveys provide a comprehensive view of trends and indicates the future direction of the legal industry. According to the data for the first nine months of 2003, compiled from 81 AmLaw 200 firms around the country, revenue has risen by 8.7 percent. This compares with an 8.6 percent rise for the same period in 2002. Revenue per lawyer, however, has grown at a slightly faster clip this year, increasing by 5.5 percent, compared with 5.2 percent last year. Revenue growth so far has been modest, yet it is on an upward trend, and we expect gross revenue to end up between 8 percent and 10 percent higher for the year. RISING INVENTORY As businesses betting on an upturn in the economy slowly loosen their purse strings and become willing to take on more ventures, law firms will see their own work escalate. Recently, a pickup in activity has been indicated by a rise in inventory, which we define as accounts receivable plus unbilled time, or work in progress. Inventory is a good indicator of future revenue collections, and it has been rising significantly this year. As of Sept. 30, inventory had grown by 8.3 percent, as compared with 4.1 percent for the same period in 2002. Law firms have reported to us that they are experiencing a slight rise in demand. As their billable work increases, the gap between growth in lawyers and growth in gross hours is narrowing. For the first nine months of 2003, gross hours, or hours logged, have risen by 2.5 percent, while last year they rose only 1.4 percent during the same period. Meanwhile, the number of full-time lawyers has increased by 3.2 percent, as opposed to 3.3 percent in 2002. Another factor that should relieve managing partners of the pain they felt during a good part of 2002 is a bottoming of declining productivity. The decline in productivity that plagued firms last year is nearing a halt. Whereas hours worked per lawyer had declined by 1.8 percent a year ago, this year the decline slowed to 0.6 percent. This is good news because, during this recession, many firms have decided to continue hiring associates rather than letting some go in order to cut expenses. Although associate salaries account for a large part of firm expenses, managing partners deliberately made the call to retain most associates in order to not be left short-handed when the economy rebounds. This was a painful lesson law firms learned from the last recession: In the late 1980s and early 1990s, law firms laid off large numbers of associates and found themselves scrambling for lawyers when the economy picked up. Unable to hire qualified associates fast enough, many firms could not keep up with renewed demand and lost market share as a result. HIGHER EXPENSES A decade later, managing partners do not want to find themselves in a similar predicament. The decision to retain associates even as work has slowed down is seen by managing partners as an investment in the future. But the cost of this investment is high. Law firm gross expenses, as well as per-lawyer expenses, increased more in the first nine months of 2003 than during the same period in 2002. This increase is driven largely by management’s decision to continue adding lawyers. So far this year, gross expenses have grown by 7.2 percent, while expenses per lawyer have risen by 4.1 percent. This compares with a 5 percent rise in gross expenses and a 1.8 percent increase in expenses per lawyer in 2002. Although expenses for 2003 are higher than anticipated, they are in line with higher revenue growth and are likely to hold at that level. Another reason for the spike in expenses is the rise in malpractice insurance costs — although, as a percentage of revenue, insurance expenses are much lower than those for associates. Until recently, insurance companies had mostly held premiums steady for firms. But in the wake of the corporate scandals and Sarbanes-Oxley, insurers have become wary of potential liability for legal advice and have increased their premiums. Firms are reporting that while the number of claims has not gone up, the dollar amount of claims has shot up significantly. LOOKING AT TRENDS The promising trends for 2003, so far, have not brought any radical changes to the legal industry. Some things, such as the practice groups driving firm revenue, have stayed constant over the last two years: Bankruptcy and litigation are still the heavyweight practice areas at most large firms. Those departments have seen the largest rise in demand and have brought the most profits over both 2002 and 2003. Do not discount the corporate departments, however. Unlike the previous 18 months, capital markets work has recently begun to show signs of life, report managing partners. We’re told that corporate lawyers are gearing up again and are currently busier than they have been since early 2002. Another holdover trend is that revenue growth is still driven by rate vs. volume, according to our research. Although gross hours have increased by 2.5 percent in 2003, billing rates have increased by 6 percent, slightly less than the 6.1 percent increase during the same period in 2002. An emerging trend that became evident last year is that law firms are paying closer attention to their equity partner ranks. Among the AmLaw 100, equity partner growth was 3.5 percent as compared with 4.6 percent annually for the previous five years. Although it has never been easy to make partner, firms are now making it even more difficult in order to manage the growth of their equity partnership more carefully. Not only are firms extending the associate track, but firms with two-tier partnerships have limited equity status to a select few. Despite the poor economy, profits per equity partner are strong so far this year, and are expected to increase by 7 percent to 10 percent for 2003, slightly better than in 2002. With 2004 on the horizon, we will soon find out whether some of these gains will carry over, and whether modest gains will be replaced by stronger growth. Will firms, conscious of rising costs and anxious to increase their per-partner profits, continue to restrict growth in the equity partner ranks? Will they continue to hire more associates if the work does not increase at a faster clip? And will capital markets work continue to keep corporate practices busy? As long as the economic recovery continues, we think most firms can pop those champagne corks. Danilo DiPietro is the business head of the Law Firm Group at The Citigroup Private Bank, a business of Citigroup Inc. He may be reached at (212) 559-8645.

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