Many of the country’s biggest law firms got a bit of good news in the first half of 2011. Building on the positive signs we started to see during the first quarter of the year, demand and billing rate increases were even stronger at the midyear point, while revenue (cash collec­tions) held steady throughout the first six months.

While this is a promising outcome, we have seen expenses grow so quickly that they are now increasing at a faster rate than revenue—resulting in a squeeze on profit margins. Even before the current market uncertainty, firms told us that they were planning for slow growth. It is hard to forecast what the impact of today’s conditions will be on law firms, but we believe it could disrupt law firm work pipelines and deal flow, at least in the short term.

For the first half of 2011, revenue was up 3.7 percent across the industry. The increase was driven by strong inventory levels coming into 2011, increased rates, a 1.8 percent growth in demand, and likely improvement in realization. These results are based on a sample of 178 firms—80 Am Law 100 firms, 54 Second Hundred firms, and 44 smaller firms.

Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and over 35,000 individual lawyers. Each quarter, the Law Firm Group 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. These reports, together with extensive discussions with law firm management conducted on an ongoing basis, provide a comprehensive overview of financial trends in the industry and insight into where it is headed.

Rate increases and realization stood out as positive signs during the first half of this year. In 2009 and 2010, we saw rate increases that were less than half of those in 2001–07. In the first six months of this year, we’ve seen that trend begin to reverse. We recently asked managing partners of predominantly Am Law 50 firms to comment on how realization at the midyear point compared with last year; their comments indicate that realization has at least stabilized, if not improved. These two results suggest that we could be seeing an easing of the pricing pressure we’ve seen over the last two years.

But countering the positive impact of the uptick in revenue, rates, and demand is the growth in expenses we started to see during the first quarter. Expense growth gained even greater momentum during the second quarter. So much so that, at a 4.7 percent increase, we saw expenses grow more than revenue. Firms have been spending their money on long-overdue infrastructure projects, or in some cases, spring bonuses.

Looking beyond the near term, how will firms maintain the contribution per lawyer and profits per equity partner results they saw in 2010? Although the first half of this year showed signs of improvement, what impact will the current market uncertainty have on firms for the rest of 2011?

As Citi Private Bank’s chief investment officer, Richard Cookson, has been saying for over a year, the United States appears to be in for a protracted period of slow or no growth given the systemic issues the country is facing: sovereign debt concerns in the euro zone and the potential for ripple effects throughout the banking sector; the deficit issue in the United States and the lack of political bipartisanship to reach a credible solution; and the stubbornly high level of unemployment in the U.S.

We also asked the managing partners of predominantly Am Law 50 firms if they’re seeing a slowdown in work as a result of the stock market’s dive. The overwhelming majority of those who responded confirmed that they had already seen a mild slowdown. There’s a good chance M&A, private equity, and IPO work will at least dip as companies and investors seek some clarity before doing deals.

Head count is also a big issue for many firms right now. Despite the uptick in demand we saw in the first-half results, firms are cautious about growth prospects, and this wariness is reflected in the decisions they are making around head count. In the near term, overall head count growth is expected to be modest.

Fueled by the view that growth will not come organically, laterals are also becoming more of an imperative for firms, as we’ve seen in the number of headline-grabbing lateral moves this year. The increasingly wide dispersion in performance among firms is also a key factor in the active lateral market. We recently analyzed the performance of firms in the top tier and middle tier of profitability during 2007–10 and noted a material widening within the performance of these two groups.

We believe this increasing dispersion will only serve to further encourage rainmakers at underperforming firms to more actively look for opportunities elsewhere, while top-performing firms will seek to leverage their market advantage to buy talent for their weaker practice areas. So we are watching this trend very carefully.

Our 2011 forecast from the fourth quarter of 2010 indicated that 2011 will show some growth in profits per equity partner, just not as much as last year. While we do need to hedge our bets a little in light of the seismic disruption we’ve seen in the markets, we’re sticking to that forecast.

Dan DiPietro and Gretta Rusanow are chairman and senior client adviser, respectively, at Citi Private Bank’s Law Firm Group. E-mail: dan.dipietro@citi.com; gretta.rusanow@citi.com.