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The year is off to a good start, driven largely by improved demand, supporting our projection earlier this year that 2014 will be a better year than 2013. But this positive beginning comes with challenges, and some caveats.
Demand growth was partially magnified by a difficult demand environment in first-quarter 2013, creating a relatively low hurdle for law firms to clear and driving more favorable revenue performance that outpaced expense growth. The primary challenge facing law firms is that demand improved as the year progressed in 2013, which could potentially temper the robust growth seen so far this year.
It’s also important to note the differences in performance across segments of the market. The Am Law 1-50 firms drove much of these results, outperforming all segments in revenue and demand growth. Through the lens of geographic reach, global and international firms outperformed U.S.-centric firms with regards to revenue, demand and lawyer rate growth. So while the industry results look promising, what they mean for individual law firms depend on their size and geographic reach.
These results are based on a sample of 177 firms (76 Am Law 100 firms, 48 Second Hundred firms, and 53 additional firms). Twenty-nine 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). 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.
Through the first three months of the year, revenue was up 4.3 percent, the most favorable first-quarter revenue result we have seen since 2008. The primary factors in this result were a 1 percent increase in demand and a 4.4 percent increase in billable rates. Rate growth in first-quarter 2014 was the strongest it has been in the first three months of the year since 2008. Despite a difficult first quarter in 2013, demand improved as the year progressed, creating positive momentum heading into 2014, but also raising the bar for firms to surpass as 2014 progresses.
Expenses increased modestly at 1.6 percent, split almost evenly between attorney compensation and operating expenses (up 1.7 percent and 1.6 percent, respectively). While firms continue to focus on expense management, timing also seems to have had an impact. An informal survey of leaders from 51 law firms (30 Am Law 1-50 firms; 11 Am Law 51-100 firms; six Second Hundred firms; and four other firms) indicates that year-end prepayments were up compared to the previous year, further softening the first-quarter 2014 expense increase.
Total lawyer head count increased slightly at 0.7 percent and was outpaced by total lawyer billable hours growth at 1.8 percent, resulting in a 1.1 percent increase in productivity. This easing of the excess capacity we have experienced in recent years might translate into some stabilization of realization. Firms continue to tightly control equity partner head count numbers, reporting flat growth in first-quarter 2014.
Timing for collections remained relatively unchanged in the first quarter, though total inventory increased 3.7 percent, primarily driven by an increase in unbilled time. Increased inventory, coupled with improved demand and a stable collection cycle, suggests positive collections momentum for the second quarter.
A rising tide of positive economic indicators and increased demand for legal services, however, is not lifting all boats. Although the overall results indicate positive momentum for the legal services industry as a whole, a closer look at the results shows that Am Law 1-50 firms drove much of the growth (much as they did in 2013), and they continue to distance themselves from the rest of the pack. They experienced the only increase in demand, led all segments in revenue growth, and saw the lowest increase in expenses. Although these are very positive results for the Am Law 1-50, it is important to keep in mind that revenue growth for Am Law 1-50 firms was weakest among all segments in first-quarter 2013, providing a boost to the revenue results seen in first-quarter 2014. Am Law 1-50 firms also outpaced all segments in total inventory growth in first-quarter 2014, suggesting a strong start to the second quarter. On the other hand, firms outside of the Am Law 200 had a rough start to the year. These firms saw the largest decline in demand, the lone drop in revenue, the greatest growth in expenses, as well as the smallest increase in inventory heading into the second quarter.
Looking at the industry results by geographic reach, firms with a greater international presence outperformed other segments, continuing the trend we saw in 2013. Global firms (mostly a subset of the Am Law 1-50 group), in particular, outpaced all segments in revenue, demand and lawyer rate growth in first-quarter 2014. U.S.-centric firms, on the other hand, saw more modest revenue and demand results. A bright spot is that these firms experienced the most material total inventory growth among the segments, suggesting a better second quarter.
Although there may be higher hurdles to climb throughout the rest of this year, the positive demand momentum and inventory buildup we saw in the first quarter suggests a strong second quarter, and we believe that 2014 remains on track to ultimately outperform 2013.
Andrew Godwin is lead analyst of Citi Private Bank’s Law Firm Group. Senior client advisers John Wilmouth and Gretta Rusanow contributed to this article.