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For the legal industry, 2004 financial results should tell a tale of two coasts, or more specifically, New York and Northern California. The latest look at the state of the profession from the Law Firm Group at the Citigroup Private Bank brings good news for both regions: For the first time in three years, New York firms are growing faster than their peers elsewhere. And the tech-focused firms of Silicon Valley and San Francisco, while still underperforming the industry, are not dragging down the averages as much as they did in 2002 and 2003. In fact, things are looking up for U.S. law firms overall. Building on last year’s modest recovery, law firms are reporting even stronger numbers in 2004. We expect this trend to continue into 2005, although much will depend on how firms handle associate compensation at year-end and whether transactional work gets a second wind after the slowdown in the latter part of 2004. The Citigroup Private Bank provides financial services to more than 600 U.S. and British law firms, as well as 35,000 partners and associates on an individual basis. Each quarter, the law firm group surveys firms in The Am Law 100 and the Second Hundred, along with several smaller firms, on their finances. These reports offer a snapshot of current trends and insight into the direction of the legal industry. The year 2003 provided relief to a legal industry concerned about the post-bubble recession, with moderate increases in such key indicators as revenue growth, lawyer hours and inventory. This year is shaping up to be even better. According to 2002 through midyear 2004 data, compiled from 55 Am Law 100 firms, 45 Second Hundred firms and 21 other firms, key indicators all point to the best year for large law firms since the crash of the high-tech market in March 2001. This year’s data show that big-firm profits are continuing their upward trend. If everything remains on track, profits per equity partner could increase 12 percent to 15 percent from 2003 levels. Most notably, average gross revenue growth in the first six months of 2004 rose 10.3 percent, up from 8.3 percent during the same period in 2003, and 5.9 percent in 2002. That is well ahead of the current rate of inflation of about 2 percent. The upward momentum points to revenue growth of 10 percent to 12 percent for all of 2004. At the same time, inventory — accounts receivable and hours not yet billed to clients — saw a slight uptick. This statistic, an effective forecaster of future revenue collection, rose 7.5 percent in the first six months, up from 7.1 percent for the same period in 2003. Big-ticket litigation remains the driving force behind this revenue growth. But transactional work is coming back as well. While not robust, mergers and acquisitions and initial public offerings work actually had a pulse in the first part of 2004. Intellectual property is on the upswing, and many large firms are aggressively building this practice area, taking in boutique practices and lawyers with sizable books of business. Bankruptcy, which helped carry large firms through 2002 and 2003, is the only practice area that has begun to pull back as the economy rebounds. Revenue growth in 2002 and 2003 was driven almost exclusively by rate increases. In 2004 there is a healthier balance between rate increases and higher demand. Billing rates increased 6.2 percent in the first half of 2004, holding from a 6.3 percent increase in the first half of 2003. And gross billable hours are sharply up: Hours logged increased 4.4 percent in the first half of 2004, compared with 1.8 percent in the first half of 2003 and 0.5 percent in 2002. Firms have become smarter about hiring and firing. In the most recent recession, many large firms chose not only to forgo economic layoffs, but to continue hiring new associates, although not at the same feverish pace as in the late ’90s. (The tech firms, whose work dropped off especially precipitously, were the exception to this trend.) Recruiting and retaining legal talent in a downturn is a direct result of lessons learned in the recession of the early ’90s. At that time, across-the-board layoffs left firms in the lurch when things picked up. This time most firms kept their attorney ranks up during the dry season, banking on a turnaround. The strategy is paying off through improved productivity. Instead of having to hire lawyers to handle the increased demand, firms are tapping their existing talent. As a result, the increase in head count remained steady at 2.3 percent, compared with 2.2 percent in 2003. And as one would expect, given the greater demand for legal services, the first six months of 2004 saw an increase in hours per lawyer of 2.3 percent, compared to the 0.3 percent decline in hours per lawyer in the same period during the previous year. On the expense side, firms are keeping costs in check, largely because of a lack of upward pressure on associate salaries. Expenses, comprised mainly of associate compensation, but also including such operating costs as staff and paralegal salaries, rent and insurance, grew by 6.0 percent in the first half of 2004, slightly down from the 6.5 percent rise during the same period in 2003. Firms are also carefully managing the size of their equity partnerships, both making them harder to join and de-equitizing underperforming partners. Among Am Law 100 firms included in our survey, equity partner growth was 1.8 percent in the first half of 2004, compared with 3.5 percent in 2003 and an annual average of 4.6 percent for the previous five years. For those who do get a cut of the profit pool, this is good news: If expenses remain at their current rate of increase and growth in the number of partners stays low, profits per equity partner could increase by 12 percent to 15 percent in 2004. (The wild card here is how firms handle year-end associate bonuses. History suggests that firms worried about losing associates to investment banks and other employers will sharply increase this expense item.) Partnership is slightly more accessible at Second Hundred firms than at larger firms: In the first six months of 2004, equity partnership growth at Second Hundred was 2.2 percent. Smaller firms were even more generous, increasing their partner ranks by 4.3 percent. Our survey numbers back other commonly accepted beliefs about big firms: Am Law 100 lawyers make more money and work longer hours than do lawyers at Second Hundred firms, and the larger firms generate relatively more revenue. In the first half of the year, revenue at Am Law 100 firms grew 11.2 percent, compared with the Second Hundred’s 9.9 percent. The difference stems largely from a jump in billable hours per lawyer at the bigger firms. At the Am Law 100 firms, hours per lawyer went up by 3.3 percent in the first half of the year, compared with 1.0 percent at Second Hundred firms. At the same time, the increase in expenses was higher at the top — 7.0 percent for the Am Law 100, compared with 6.3 percent for the Second Hundred. This difference doesn’t result from an increase in attorney compensation — at Am Law 100 firms, compensation rose only 6.4 percent, less than the 6.9 percent increase at the Second Hundred. Instead, operating expenses account for the disparity. At the Am Law 100 firms, operating costs jumped 7.3 percent in the first half of the year; at Second Hundred firms, those costs rose 1.3 percent. Our survey shows regional disparities in revenue and expenses. For the first time in three years, New York firms outperformed the national average, enjoying higher revenues and lower expenses than firms elsewhere. With revenue rising 11.6 percent and expenses increasing only 5.2 percent, New York firms are finally recovering from the drop-off in transactional work during the recession. (In 2003 New York firms had revenue increases of 8.1 percent, lagging behind the national average of 9.1 percent.) More business is coming in, especially litigation work, but instead of hiring, New York firms are looking to their existing lawyers to take on the extra work. As a result, New York lawyers are working harder, billing more and boosting profits. The Northern California firms, hit hardest by the tech recession, are starting to emerge from their slump as well. Although still performing below the national average, they are not doing nearly as poorly as they did in the prior three years, reporting revenue growth of 7.7 percent and an increase in expenses of 4.6 percent. (In 2003 revenue at the Northern California firms rose 5.4 percent.) Like firms in New York, the Silicon Valley firms are having their existing lawyers handle new work rather than hiring, which keeps compensation costs down while revenue increases. Chicago and New England also merit note. Law firms in both areas saw their revenues spike sharply, although their expenses were comparably high as well. The surge in litigation, especially securities class actions, has boosted revenues by 16.5 percent at Chicago firms and 14.6 percent at firms in Boston and other New England cities. At the same time, Chicago and New England firms are hiring lawyers and staff to keep up with the work, resulting in above-average increases in expenses of 9.9 percent and 9.4 percent, respectively. On the down side, Washington, D.C., firms reported revenue increases of 5.2 percent, significantly below the norm. Expenses also increased 5.2 percent, slightly below the national average. Although the Sarbanes-Oxley Act has generated plenty of regulatory work, it’s not all going to the Washington firms. New York and national firms that have increased their presence inside the Beltway are siphoning off some of this business, to the detriment of the local firms. It’s a happy confluence of events that has firms the busiest they’ve been since the tech crash. Private equity, typically a harbinger of a broader recovery, remains robust, and litigation has not let up. But I wouldn’t be a banker if I didn’t point out the possible down sides. While our economists project reasonable economic growth in 2005, it’s not clear how strong transactional work will be. What is clear is that the slowdown in deal flow in the second half of this year will translate into slowed revenue growth in the first part of 2005. I’m also hearing from a few firms that some bet-the-company litigation is winding down, with little on the immediate horizon to replace it. Finally, firms may face pressure to increase associate salaries as investment banks and others entice associates to leave their firms. Still — for 2004 at least — it’s not a bad time to be a big-firm lawyer. Danilo DiPietro is the client head of the Law Firm Group at the Citigroup Private Bank.

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