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For law firms, 2005 is proving to be a Jekyll-and-Hyde kind of year. After a robust 2004, firms posted lukewarm results for the first half of 2005, according to a survey of firm finances by the Law Firm Group at The Citigroup Private Bank. However, business has picked up significantly in the second half. The net effect is a year that will likely fall just shy of 2004′s results, but augurs for a strong start to 2006. Most of Citigroup’s hard data for the first six months of 2005 indicates modest growth. Revenue growth slowed, and gross billable hours were up only modestly, dragged down by the sluggish pace of the transactional sector. Expenses rose at the same pace as revenue, producing flat margins. Big-ticket litigation, though still plentiful, didn’t provide the same kick as in recent years. But conversations with a broad cross-section of managing partners suggests that business accelerated significantly in the second half, especially on the transactional side. In fact, Thomson Financial says that mergers and acquisitions had their strongest third quarter, measured by global dollar volume, since 2000, with announced deals totaling $563 billion on 6,930 transactions. We expect this upsurge to continue into 2006, although much will depend on whether the transactional sector can sustain its momentum. The Citigroup Private Bank provides financial services to more than 500 U.S. and British law firms, as well as 30,000 partners and associates individually. Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and Second Hundred, along with some smaller firms. In addition, the group conducts a more detailed annual survey. These reports offer a snapshot of current financial trends in the legal industry and insight into where it may be headed. The increase in average revenue growth in 2004 — more than 10 percent — was the legal industry’s best performance in four years. It raised hope for more of the same in 2005. But data from the 55 Am Law 100 firms, 36 Second Hundred firms and nine smaller firms showed a more modest pace in the first half of the year. Average gross revenue growth in the first six months of 2005 slipped to 7 percent, down from 10.1 percent during the same period in 2004 and 8.3 percent in the first half of 2003. Nearly all of the increase in revenue growth in the first six months of 2005 was eaten up by expenses, which rose 6.7 percent. Still, first-half numbers offered one piece of good news. Inventory — accounts receivable and unbilled time — spiked up. This yardstick, an excellent predictor of future revenue collection, rose 6 percent in the first six months of 2005, compared to a 1.4 percent decline in the same period in 2004. Major litigation, the driving force behind 2004′s revenue increase, didn’t slow down in the first half of 2005, but it didn’t provide the lift of the last several years, either. By the end of 2004, litigation practices were running at close to full capacity, leaving little room for growth in 2005. At the same time, transactional work took a breather, after a burst of activity in 2004. Private equity, which maintained its brisk pace of 2004 into 2005, frequently foreshadows action in the broader M&A sector, but that didn’t materialize until third-quarter 2005. Viewed broadly, the economy in 2005 has suffered from the effects of high oil prices. The impact of Hurricane Katrina, on the other hand, remains unclear. For the nation, there’s a big price tag attached to the storm, but the redevelopment of New Orleans and other areas that were hit can translate into work for law firms. Lawyer head count growth decreased slightly from a 2.2 percent rise in the first six months of 2004 to a 1.8 percent increase in the same period this year. That is the lowest growth rate in more than a decade. After the high-tech bust, most firms opted to forgo the wholesale economic layoffs of the early 1990s and keep hiring new associates. Last year this strategy paid off. Firms were able to draw on their existing workforce to handle the increased business, and hours per lawyer rose 2.4 percent. So far in 2005, however, lawyer head count growth is on a virtual par with growth in gross hours (1.8 percent and 1.7 percent, respectively), resulting in flat productivity. After several years of single-digit associate attrition rates, 2004 saw a return to attrition rates of around 20 percent, a trend that shows no sign of abating in 2005. Many firm partners I’ve talked to believe that the newest generation of associates no longer views equity partner status as the Holy Grail of a legal career. This cultural shift suggests that associates are less willing to put in the hours needed to bring productivity, as measured by hours per lawyer, up. It also suggests that retaining top talent poses a real challenge for firms, and will continue to do so. Meanwhile, firms have increased spending a notch. Expenses — mostly associate compensation, but also including such operating costs as rent, insurance, and staff and paralegal salaries — grew by 6.7 percent in the first half of the year, slightly up from the 6.4 percent rise during the comparable period in 2004. The increase was driven partly by the higher associate bonuses paid out by many firms in the first quarter of 2005. But law firms are also starting to proceed with projects that were on hold — investing in updated technology and moving or taking additional office space. Big firms have also continued their global expansion. In particular, firms are showing a renewed interest in China, which as a condition of its membership in the World Trade Organization has been gradually relaxing restrictions on foreign law firms. Indeed, China is the country where the legal industry grew the fastest in 2005. China today looks a lot like London did in the 1990s, when many U.S. firms invested in outposts that have just started to show a profit. The movement toward restricting the equity partner pool shows no sign of slowing down. It’s tougher to make equity partner and stay there, as more firms adopt two-tiered partnership tracks and deequitize or cut loose underperforming partners. Among survey participants in The Am Law 100, equity partner growth was 1.6 percent in the first half of the year, compared with 1.8 percent in 2004 and annual average growth of 4.4 percent for the previous six years. Traditionally, equity partnership has been somewhat more accessible at smaller firms. That wasn’t the case in 2005. Second Hundred firms zealously guarded the gates to partnership, increasing their profit-sharing pool by just 1.5 percent in the first half of 2005, down from 2.2 percent in the same period in 2004. And in a sharp reversal of course, the smallest firms in the Citigroup survey have virtually shut the door on equity partnership, increasing their partner ranks just 0.1 percent in the first six months of the year, compared with a 4.3 percent increase in the same period in 2004. At the same time, the trend toward consolidation continues. Ten years ago, a 1,000-lawyer firm was almost unthinkable; today, at least two U.S. firms have passed the 2,000-lawyer mark. But as our comparison of Am Law 100, Second Hundred and smaller firms revealed, size doesn’t necessarily presage success. In the first six months of 2005, the Second Hundred firms we surveyed enjoyed better overall performance than Am Law 100 firms. (For this comparison and for our regional reports, we used data from 137 firms — 57 Am Law 100 firms, 44 Second Hundred firms and 36 smaller firms.) Gross revenue grew 8.9 percent at the Second Hundred firms we studied, well ahead of the 6.1 percent gross revenue growth at the Am Law 100 firms. Meanwhile, the Second Hundred firms kept costs lower, increasing expenses by 6.3 percent, compared with 7.3 percent at the Am Law 100 firms. The difference stems from a steeper growth rate among The Am Law 100 in both attorney compensation (6.8 percent, compared with the Second Hundred’s 5.8 percent) and operating expenses (7.4 percent, compared with the Second Hundred’s 6.9 percent). That said, as firms keep getting larger, critical mass, or what we call throw weight, matters more. Our survey shows that this lack of throw weight is starting to hurt some of the smallest firms in our survey. In the first half of 2005, these smaller firms saw revenues rise less — just 5.5 percent — than either The Am Law 100 or Second Hundred firms. They also stepped up their hiring, increasing their lawyer ranks by 3.7 percent, in contrast to the prevailing trend at the larger firms. As a result, smaller firms saw hours per lawyer drop by 1.1 percent, compared with a 0.2 percent increase in hours per lawyer at the Am Law 100 firms and no change among the Second Hundred. The numbers for the smaller firms on the expense side were not much more encouraging. Spending at the smaller firms shot up 8.2 percent, more than at either of the other two groups. Associate compensation does not account for this disparity. Even though the smaller firms grew the fastest of the three groups, they increased lawyer compensation by only 5.2 percent, below the 6.1 percent average for all firms. Rather, the difference comes from a 10 percent jump in operating expenses at the smaller firms, compared with the 7.9 percent increase for all firms. Still, there are ways to survive — and even flourish — as a smaller firm today. A niche practice is key to success. Smaller firms can decide to focus on servicing midsize and smaller companies or offering an expertise in a specialized industry or practice area. It’s the smaller firms trying to make it as general practice firms that are feeling the squeeze. They simply don’t have what’s needed to compete for business against the legal industry’s heavyweights. In 2004, New York firms outperformed the national average for the first time in three years. But this year they are back down below average, reporting revenue increases of 6.3 percent in the first half of 2005, compared with a 6.9 percent average rise for all firms. The listless transactional sector in the first half of the year hurt New York firms, due to their concentration on M&A and the financial sector. New York firms also spent more than firms elsewhere, boosting expenses by 8.1 percent, compared to a national average of 7.2 percent. Meanwhile, Northern California-based firms, which were hit hardest by the high-tech crash, continued to emerge from their slump, reporting revenue growth of 6.1 percent in the first six months of 2005, just 0.8 percent lower than the national average. This means they’re closing the gap from 2004, when Northern California’s first-half revenue growth of 7.7 percent underperformed the average by 2.6 percent. It’s even better when measured against 2003′s results, in which the region’s 5.4 percent annual revenue increase lagged behind the average by 3.7 percent. At the same time, Northern California-based firms spent more money than they did in 2005, although their 6.7 percent increase in expenses still came in below the national average. (In evaluating regional data, keep in mind that many of the survey participants have multiple offices, so their fortunes are not that closely tied to the economies of their headquarters cities.) Even though business looks good for the start of 2006, especially if deal flow stays strong, firms face a number of challenges going forward. They will have to contend with heightened pressure on associate compensation, particularly salaries, which have remained virtually flat since 2000. At the same time, we expect associate attrition levels to remain at the 20 percent level, in light of an expanded job market and the unpredictable mindset of Gen Y lawyers. Firms will have to work hard to keep and develop talent. We continue to urge firms to hold the line on salary increases while rewarding strong performance with bonuses, which gives firms more flexibility in managing financial ups and downs. Continued expansion, especially into China, and upgrades of professional support and infrastructure will also add to expenses. On the revenue side, the demand from clients to discount fees is mounting, and even the most profitable firms are starting to feel the pressure. To keep profits per partner up, we anticipate that firms will continue to move out unproductive partners, prune practice areas that don’t fit into their long-term strategies and deequitize partners on a case-by-case basis. There’s another factor that will dampen growth of the equity partnership too — the movement of the baby boomers into retirement age. The first of them will turn 60 years old in 2006. They may find it tough to head out the door, though: Despite the challenges that firms face, a piece of firm equity still makes for a very nice living. Danilo DiPietro is the client head of the Law Firm Group at the Citigroup Private Bank.

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