Nine-month quarterly flash survey results from Citi Private Bank show further evidence of the continued challenges facing the legal industry. Momentum has slowed since the strong start to 2016—when we saw growth in demand of 1.8 percent and growth in revenue of 5.8 percent—resulting in just 0.3 percent growth in demand and 3.7 percent growth in revenue at the nine-month point. These numbers are similar to the modest results we’ve come to expect throughout most of the post-recession years.
Notably, during the third quarter we started to see the impact of associate salary increases on expenses and margins. More important, behind the industry averages we saw the beginning of stratification across the various industry segments, caused by the pressure firms faced to raise associate salaries: First, there is evidence of varied levels of adoption of the new compensation levels, and second, for firms that did move compensation higher, there will be varied effects to profitability.
These results are based on a sample of 188 firms (79 Am Law 100 firms, 52 Second Hundred firms and 57 niche/boutique firms). Thirty-two 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 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.
Revenue grew 3.7 percent at the nine-month point. Billing rate increases of 3.2 percent remain the primary driver of revenue growth as demand (i.e., all timekeeper hours) rose a modest 0.3 percent and the collection cycle shortened by just 0.6 percent.
Expense growth accelerated from 3.1 percent at the six-month point to 3.4 percent for the first nine months. Increased associate compensation helped drive lawyer compensation expense up 4.1 percent, compared to 3 percent at the six-month point.
Further, compensation growth outstripped growth in operating expenses (2.9 percent), a reversal from our midyear report. This all occurred despite lawyer head count growth decelerating to 1.6 percent, from 1.8 percent in the six-month period, and seems to be a clear manifestation of the rise in associate compensation, though it will be some time before we see the full impact of the increases in pay.
While many firms announced associate salary increases, often across multiple offices, others took months to react, and even more continue to take a wait-and-see approach. For the firms that did raise salaries, the impact on profitability will vary, depending on the firm’s profits per equity partner and the size of the market in which it operates.
Firms added total lawyers at a 1.6 percent pace, driving lawyer leverage higher, but also placing downward pressure on lawyer productivity, which fell 1.2 percent, as lawyer demand increased just 0.4 percent. However, firms increased the size of the equity partnership just 0.4 percent, showing they continue to be cautious in the face of slow demand growth.
Looking toward year-end revenue results, inventory growth (3.1 percent) moderated at both the six-month and nine-month points and is well below the 4.6 percent growth the industry saw at this point last year. Barring a flurry of new activity during the fourth quarter, this could signal a slower close to 2016 than we saw in 2015.
Behind these averages, we continue to see high levels of dispersion and volatility. Forty-six percent of firms saw demand decline during the first nine months of 2016. We also saw volatility in demand performance, defined as alternating periods of demand growth and decline.
To measure volatility in demand performance, we looked at the 136 firms that reported nine-month results in 2014, 2015 and 2016. Approximately 46 percent of these firms either saw demand increase in 2015 and decrease in 2016, or vice versa. The dispersion and volatility results underscore the challenges firms face in a slow-growth, hypercompetitive market where one firm’s growth is likely to come at the expense of another.
Grouping the firms based on Am Law 200 rankings, Am Law 1-50 firms saw both the greatest revenue growth (5.4 percent) and expense growth (4.3 percent). This was the only segment to see revenue growth outpace expense growth. Rate growth and a shortened collection cycle were primary drivers, as was the 0.8 percent growth in lawyer demand. Further good news for this segment is that, even with strong collections, they accumulated inventory at a pace that exceeded the rest of the industry, positioning them for a strong end to 2016.
Am Law 51-100 firms saw the second-strongest growth in revenue (2.2 percent)—but well off the pace of the Am Law 1-50 firms—driven entirely by rate growth (3.3 percent) as demand declined and the collection cycle lengthened. Second Hundred firms saw just 0.1 percent growth in revenue. Second Hundred firms and the niche/boutique firms saw the greatest growth in total demand, but in both cases revenue growth was challenged by longer collection cycles, and in the case of Second Hundred firms, rate increases that also lagged the other segments.
Looking at the firms by geographic reach, global firms saw the strongest revenue growth (5.2 percent). This was driven primarily by collections, as they saw the lowest rate growth among the segments (1.6 percent), due in part to foreign exchange fluctuations. Looking ahead, global firms also saw the lowest growth in inventory, which may challenge fourth-quarter results.
Other than global firms, national firms were the only segment to see revenue growth exceed expense growth. Expense growth was greatest at international firms. Rate growth was greatest at international firms and regional firms. Those two segments also saw the greatest growth in inventory heading into the fourth quarter.
From a revenue size standpoint, associate salary increases seemed to have the largest effect on Am Law 1-50 firms, and from a geographic reach perspective, global firms, and international firms. Among their respective segments, these had the greatest growth in lawyer compensation expense. They also each saw compensation expense growth accelerate from the six-month point.
Further evidence of stratification was seen, by revenue size, in niche/boutique firms and by geographic reach, in regional firms, as these were the only segments where operating expense growth outpaced compensation expense growth.
With one quarter to go in 2016 we continue to stand by our forecast of low-single-digit profit growth, published in the 2016 Citi Hildebrandt Client Advisory. This forecast, which may have looked conservative at best in May, when we published first-quarter results, is coming more into focus with each passing quarter. The fourth quarter of 2015 was quite strong. To match that strength in 2016, the industry will have to pick up momentum in the face of a number of challenges, including increased associate compensation; continued uncertainty around the implications of the Brexit vote; and the uncertainty created by last week’s surprising U.S. election results. If the industry does not find incremental momentum, 2016 results could fall short of 2015′s.
David Altuna is a client adviser within Citi Private Bank’s law firm group and Gretta Rusanow is head of advisory services. Senior client adviser John Wilmouth contributed to the article.
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