The early 2012 results are in: Law firm profits increased by 4.3 percent in 2012, in line with Citi Private Bank’s full-year 2012 forecast. We must admit, though, we doubted our powers of prognostication after reviewing the third quarter 2012 results. But the factors in the fourth quarter of 2012 that drove such a strong finish to the year (very strong collections, a spike in demand, and more moderate growth in expenses) may not be sustainable.

Revenue growth of 3.6 percent in 2012 was driven by a push for collections in the fourth quarter. Revenue growth accelerated from the 1.7 percent result for the first nine months of 2012 vs. the same period of 2011. Demand growth during the fourth quarter played some part, reversing the trend we had seen during the first three quarters (when demand growth slowed and then went into a slight decline).

However, a full year demand growth rate of only 0.2 percent could hardly to explain the full-year revenue result. Part of the answer lies in the focus firms placed on collections, particularly during the fourth quarter, as we saw the collection cycle shortened by 2.1 percent in 2012 (vs. a lengthening of 1.2 percent we had seen in the third-quarter results).

Sample of firms

These results are based on a sample of 179 firms (80 Am Law 100 firms, 49 Second Hundred firms, and 50 additional firms). Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and more than 35,000 individual lawyers

Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and 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.

Looking at 2012, it’s true that demand improved during the fourth quarter, but that was driven by an uptick for the Am Law 1-50 and smaller firms. With that said, when we look at the full year 2012 results, the Am Law 1-50 still finished 2012 flat to the prior year, and smaller firms still saw a decline vs. 2011.

Anecdotally, the fourth quarter uptick might have been a short-term trend, as clients focused on getting work completed before year-end for tax reasons. Firms tell us they fear demand levels may return to the trend we observed during the first nine months of 2012.

It’s also important to insert a cautionary note about survivorship bias and its impact on revenue, demand and equity partner growth. Survivorship bias comes into play when a firm dissolves during the period being measured. Because there was a significant bankruptcy that took place in 2012, [Editor's Note: Dewey & LeBoeuf], that firm’s revenue, demand, and equity partner data is removed from 2011, creating a lower data set for the base year. It’s clear the bulk of the failed firm’s revenue went to other firms who reaped the rewards in 2012.

While the year-over-year calculations noted above are an accurate portrayal of the results of our sample, it’s important to keep survivorship bias in mind when interpreting the results. If the failed firm’s figures were included in the 2011 data, revenue growth would be reduced by about 1 percent, demand would have been a negative 0.5 percent and equity partner head count would have been a negative 1 percent (all are approximate figures).

Rates also remain an area of modest growth. At 3.7 percent growth, they increased at slightly more than 2011, and more than in the prior two years, though still lagging historical averages.

Margin pressure relieved

Expense growth slowed throughout the year to an annual rate of 3.1 percent. Industry expenses grew at a slower pace than revenue, removing the margin pressure seen in 2011 and continuing into the first nine months of 2012.

Helping firms achieve this was the slowdown in head count growth and the lack of spring bonuses in 2012. It’s possible that firms may have caught up on expenses relating to infrastructure projects, which had been delayed immediately after the recession, and which had been a driver of expense increases since 2011.

Firms may have elected not to pre-pay 2013 expenses, given a combination of the pressure on revenue growth, and tax-related concerns.

Head count increased modestly at 0.7 percent for the year with a slowdown in the fourth quarter. Equity partner head count was up only 0.1 percent, driven mostly by increases at smaller firms, and suggesting that the trend of careful equity partner head count management continues.

With head count growth exceeding demand growth, we saw productivity decline 0.6 percent across the industry. We expect that this continuing productivity gap caused many firms to feel more severe pricing pressure.

Revenue could grow

Looking ahead, with an inventory growth rate of just 1.7 percent, and only slight growth in demand, we are concerned about the start of 2013. If demand improves as the year progresses—as seems possible given some positive economic signs—then revenue growth could likely overcome any slow start to the year.

If the catch-up in infrastructure-related expenses has indeed played out, firms continue the spate of recent announcements trimming nonlegal staff, and head count increases remain modest, then expense growth will likely slow. However, a lot will depend on the prepayment behavior of firms, and how they handle payment of associate bonuses.

Given these possibilities, profits per equity partner growth in 2013 will likely be again in the low single-digits—the new definition of a good year for the legal industry.

Dan DiPietro and Gretta Rusanow are chairman and senior client adviser, respectively, at Citi Private Bank’s Law Firm Group. This article first appeared in The Am Law Daily, a Daily Report affiliate.