Expenses are rising faster than revenue at the nation’s largest law firms, and those in charge of running those firms are running out of ways to manage the imbalance, according to a recent survey conducted by Wells Fargo’s Legal Specialty Group.

The survey—one of three that Wells Fargo conducts on the state of the legal industry each year by polling law firm clients—gathered input from 115 firms on a variety of performance-related categories covering the period from January through June. Of the responding firms, more than half came from The Am Law 100, according to Wells, with the rest falling into the Second Hundred.

According to Legal Specialty Group national managing director Jeff Grossman, who discussed the survey results with The Am Law Daily Monday, reining in costs continues to be a major concern across the industry. “It’s an environment where we’re still expense-focused, and I think it’ll stay that way for awhile,” he says. “I think law firms are more efficient today than they were two, three years ago, but they’re still challenged by the economic environment.”

The survey found that, collectively, revenue rose 3 percent among the responding firms in the first half of 2012, compared to the same six-month period last year. Profits, on the other hand, fell 0.7 percent, in large part because of rising expenses. In many cases, Grossman says, firms moved to strengthen their balance sheets last year by deferring expenses into 2012. That may have helped the 2011 figures, he notes, but wound up dampening profits in the first half of this year. Head count was also up across the board, which drove up firms’ payroll costs. And so far, Grossman says he has not heard of many firms planning to cut attorneys and staff in the second half of the year.
“Profit is a question mark,” Grossman says when asked how he expects firms to close out 2012. “All indicators suggest it’ll be down, but it depends on how firms manage expenses.” Collections, he says, will also play a key role.

How firms handle expenses and collections will be especially important because there are scant signs that demand for legal work will pick up between now and the end of the year, Grossman says. The presidential campaign figures into that calculus, he adds, because deals are often put on hold during election years. Based on their workload during the first half of the year, lawyers at the surveyed firms are on track to bill 1,678 hours per attorney—a figure that would mark a 1 percent decrease compared to 2011. (The ideal hours-per-lawyer average, Grossman says, is 1,800, though firms rarely hit that mark across the board.)

Even with the amount of work coming in at fairly stagnant levels, firms have been able to generate some additional money by raising their rates—something that seems to happen each year without fail. Grossman says rates were up about 3.7 percent on average in the first half of the year, though the figure effectively drops to 2.9 percent when discounts are factored in. The average hourly rate being billed by attorneys across all levels at the surveyed firms was $560.

The ongoing push-and-pull between clients and law firms over fees is unlikely to go away, Grossman says: “If they don’t raise rates, they will fall behind because clients will still ask for discounts.” Alternative fee arrangements—another way clients seek to avoid paying higher hourly rates—were used for 13 percent of billable hours among survey respondents.

Continuing another trend that Grossman says he has noticed over the years, the difference between the highest and the lowest performers within the sector keeps growing. For instance, while revenue per lawyer was up 1.2 percent overall during the survey period, it rose as much as 33 percent among the highest-performing firms and dropped by as much as 33 percent among firms in the lowest tier. In an even starker divergence, profits per partner were up as much as 100 percent for some firms and down as low as 75 percent among the poorest performers.

The survey also looked at what law firms are doing to bolster their balance sheets, finding, for instance, that the amount of capital gathered from partners was up 7 percent during the first six months of the year. The use of lines of credit provided by banks rose 14 percent during the first half of the year, though Grossman says he anticipates such borrowing to taper off in the second half. The survey also found that one in three responding firms were carrying an underfunded pension liability of some kind, with a half-dozen firms reporting between $10 million and $50 million in unfunded pension liabilities. (The only way to address that problem, Grossman says, is for firms to freeze pension plans and begin capping their obligations to retirees.)

Earlier this year, Wells Fargo looked at how much law firm partnerships have changed over the past decade. Grossman says his group found that most firms had seen one-third of their partners turn over, and that firms with lower turnover actually were less productive.

As part of the latest survey, Wells Fargo also asked about a topic that has become of great interest in the wake of Dewey & LeBoeuf’s demise: how many lateral hires command compensation guarantees.

Grossman says that all told, firms reported giving 4 percent of their lateral hires guaranteed compensation for one or more years, representing less than 3.5 percent of firm profits. One surveyed firm, he says, reported giving guarantees to 8 percent of all partners, which consumes 15 percent of the firm’s profits.

Wells Fargo’s findings fall roughly in line with those contained in another recently released survey, this one conducted by Citi Private Bank’s Law Firm Group of its law firm clients. Responses from 79 law firm leaders, 49 of them within The Am Law 200, to the Citi survey showed them slightly less confident overall during the second quarter of this year than they were during same period in 2011. Respondents to the Citi survey seemed to have better luck with profits than the Wells group. Though 29 percent reported that their profits had either decreased or gone unchanged during the first six months of 2012, 40 percent reported growth of 5 percent or less, and 33 percent reported profit growth of 5 percent or more.