The top-line strength of 2018 continued to build in our nine-month results for the law firm industry. Revenue growth accelerated and continued to be fueled by inventory buildup that is being replenished almost as quickly as it’s collected. Further, growth in 2018 has been more balanced than any year in recent memory as demand has added lift to billing rate increases—the perennial driver of revenue growth in the extended post-recession period.

While we remain confident that revenue results will remain strong through the end of the year, we see some challenge to profit growth for 2018. Expense growth, which was already relatively high at the midpoint of the year, moved very close to revenue growth at nine months, threatening to place pressure on law firm margins by year-end. In fact, almost half of all participants have experienced margin compression thus far in 2018, despite stellar revenue results. While this will most certainly be a year of unprecedented industry growth since the recession—especially if firms focus heavily on collections—it may also be a year in which firms recalibrate their budgets to ensure that they grow profitably.

These results are based on a sample of 190 firms (79 Am Law 100 firms, 51 Second Hundred firms and 60 niche/boutique firms). Thirty-four 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” (at least 25 percent of lawyers based outside the United States). Firms with less than 10 percent of lawyers based outside the U.S. are classified as either “national” (less than 50 percent of total lawyers based in headquarter office) or “regional” (greater than 50 percent of lawyers based in headquarter office).

Citi Private Bank’s Law Firm Group provides financial services to more than 600 U.S. and U.K. law firms and more than 35,000 individual lawyers. Through our quarterly Citi Flash Survey, the Law Firm Group’s advisory services team confidentially surveys firms in the Am Law 100 and the Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey and produce the Law Firm Leaders Confidence Index semiannually. These reports, together with extensive discussions with law firm leaders, provide a comprehensive overview of current financial trends in the industry as well as forward-looking insight.

Revenues grew 6.3 percent, an acceleration from the 5.5 percent growth at the midyear point. Propelling this growth was a demand increase of 2.5 percent and lawyer billing rate growth of 4.3 percent. Rate growth moderated slightly from the first-half results but remains the highest nine-month growth figure we’ve published since 2014.

On the other hand, demand growth has continued to increase in each quarter of 2018 and, at the nine-month point, was the highest since 2007. Collection cycles continued to slow; this is mostly due to large inventory levels that have accumulated as demand has been higher than usual. Law firms also tell us that they’ve experienced a slowing in payment by clients, particularly where e-business is involved. Firms have begun to collect on this inventory, and growth levels are down from 8 percent in the first half to 7.1 percent, but clearly inventory will continue to provide a tailwind for revenue growth through the end of the year. In our recent conversations with clients, we know that they are driving the message home with partners.

Lawyer head count grew 1.6 percent, driven entirely by increases to salaried lawyers, as equity partner head count was down 0.3 percent. Firms continue to actively manage net equity partner additions to effectively zero and continue to see the resulting increases in lawyer leverage. However, the difference in 2018, unlike the long-standing post-recession trend, is that lawyer productivity improved as well. A higher level of lawyer leverage is a far more profitable proposition when there are hours to support it.

Expense growth came in at 5.9 percent, just below revenue growth. We’ve already heard from firms that there have been pressures on expense growth—among them, technology upgrades, investments in professional staff and cybersecurity spending. However, adding to those pressures in the nine-month results is our first look at the effects of associate compensation increases put through beginning in July. While operating expenses were up 4.7 percent, materially higher than the 1.6 percent at this point last year, lawyer compensation expense growth contributed more to total expense growth at 7.5 percent, up from 5.2 percent at the midyear point.

Behind the industry averages, we continued to see performance dispersion, albeit with a much more positive tilt than we’ve seen in recent years, as just 38 percent of firms saw demand decline, compared with the 62 percent of firms that saw demand growth. This is in contrast to the roughly 50/50 split we’ve become accustomed to seeing in recent years. While the dispersion results are more favorable, we continue to see high levels of volatility, despite the strength of the 2018 results. To measure volatility in demand performance, we looked at the 148 firms that reported nine-month results in 2016, 2017 and 2018. Approximately 44 percent of these firms either saw demand increase in the first nine months of 2017 and decrease in the first nine months of 2018 or vice versa. Furthermore, 23 percent of firms saw demand decline in both periods. The prolonged period of performance dispersion and ongoing volatility that we’ve witnessed in the industry will likely lead to continued consolidation.

When we look across the law firm industry segmented by revenue size, it’s clear that the largest firms are enjoying the strongest year in aggregate. Am Law 1-50 firms saw the greatest growth in both lawyer rates (4.5 percent) and demand (3.3 percent). They also saw the second-greatest growth in revenue (7.3 percent), despite being the only segment to see the collection cycle lengthen. As a result, they enter the last quarter of the year with by far the strongest buildup of inventory (9.1 percent). A strong fourth-quarter collections effort could really boost revenue results for the largest firms in the industry.

Where Am Law 1-50 firms may be challenged in 2018 is in profit growth. Through the first nine months, expense growth for these firms is at 7.5 percent, up from 6 percent at the midyear point, and outpacing revenue growth. By year-end, a disproportionate number of Am Law 1-50 firms will have moved higher on associate compensation and will be under expense pressure from it.

Size is certainly being rewarded in this market, but we believe brand strength is an equally important characteristic. The Am Law 1-50 segment has a high concentration of strong brands, but so does our “other” segment of firms. Many of these firms are boutiques, operating on a much smaller scale than the Am Law 1-50, with impressive brand strength and a focused product offering tailored to a certain practice area, industry or region. We think this puts them in a position of relative strength in the market, and the financial results bear that out.

Through the first nine months, “other” firms saw the greatest growth in revenue (7.8 percent), and the second-greatest growth in demand (2.5 percent). They saw the greatest shortening of the collection cycle but still post the second-greatest accumulation of inventory heading into year-end (5.6 percent). Am Law 51-100 firms saw a return to strong performance in the third quarter as revenue grew 4.9 percent, driven by demand growth of 2.4 percent and the second-greatest growth in lawyer billing rates at 3.9 percent. These firms have also experienced inventory growth of 4.6 percent.

In contrast to the relative strength shown by the largest and smallest firms in our sample, the Am Law Second Hundred firms continue to be challenged. They were also the only segment to see demand decline (-0.2 percent) in a year that has been characterized by outsized demand growth, relative to recent results. They also saw the lowest growth in revenue (2.3 percent), lawyer rates (2.8 percent) and inventory (1.1 percent).

Looking at firms by geographic reach, we find that firms with international exposure performed better than the national and regional segments. Global and international firms posted stronger revenue, demand and rate growth than national and regional firms. Further, global and international firms each have greater than 9 percent growth in inventory heading into the fourth quarter, as compared to 5.9 percent and 4.2 percent for national and regional firms, respectively.

Collections always play a significant role in fourth-quarter results but, with inventory growth levels at decade highs, they will be particularly important in determining the strength of 2018. More than likely, this will be a year of strong top-line growth for the industry, but also characterized by expense pressure and continued dispersion among market segments. As firms end 2018 and look forward to 2019, it will be even more important to ensure that continued growth is profitable, particularly as this extended period of growth points to a looming downturn at some stage. Further, while our dispersion results show that some firms are enjoying even greater success than the average results of 2018 are showing, it also suggests that some firms are struggling mightily. We would expect this phenomenon to lead to further and perhaps accelerated consolidation ahead.

David Altuna is a client adviser in Citi Private Bank’s Law Firm Group, and Gretta Rusanow is head of advisory services.