Crisis illustration (peshkov)
Last year was a better one than 2015 for the Am Law 50, and especially for the most profitable firms. The same can’t be said for the rest of the industry. At 4.1 percent average growth in profits per equity partner (PPEP), 2016 was a decent year, but it fell short of 2015, with marginal demand growth and the midyear associate salary increases being key factors. Rate increases and faster collections were the primary drivers of revenue growth, while operating expense management helped blunt the impact of those associate salary increases. Looking ahead, 2016′s year-end inventory growth trailed 2015′s, setting up a softer start to 2017′s collections.
These results are based on a sample of 193 firms (77 Am Law 100 firms, 53 Second Hundred firms and 63 niche/boutique firms). Thirty-seven 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 the Law Firm Leaders Confidence Index. 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 growth of 3.8 percent fell slightly short of the 3.9 percent growth seen in 2015. Lawyer rate growth and a strong collections effort drove revenue growth in a weak demand environment. Demand was up just 0.1 percent, slowing from the 0.3 percent demand growth we reported for the first three quarters. This perhaps reflects a “wait and see” approach in the lead-up to the U.S. election and again in the lead up to the inauguration of President Donald Trump and his new administration.
Unlike the lengthened collection cycle seen in 2015, we saw a one-day shortening of the average collection cycle, to 107 days. Lawyer rate growth of 3.3 percent was stronger than the 3.1 percent growth we saw in 2015, though firms had to give some of that back, as seen in the 0.7 percent drop in realization.
Lawyer head count grew 1.7 percent. Most of that lawyer growth came from addition of salaried lawyers, as equity partner head count grew just 0.2 percent. This is consistent with the post-recession trend of actively managing equity partner head count.
While total demand grew marginally, lawyer demand growth was a bit stronger, at 0.3 percent. As this is much slower than the 1.7 percent growth in lawyer head count, the net effect was a 1.4 percent drop in average lawyer productivity. This drop in lawyer productivity is something we watch carefully, as excess capacity has been a key driver of the pricing pressure experienced by the industry for several years. The 0.7 percent drop in realization suggests pricing pressure was again evident in 2016.
Expense growth of 3.4 percent was consistent with 2015, and might surprise many, in light of the midyear associate salary increases. The key here was careful management of operating expenses. Compared to the 3 percent growth in operating expenses seen in 2015, the industry managed to control growth in 2016, reporting just a 1.9 percent increase. On the other hand, compensation expenses grew 5.4 percent, much higher than the 3.8 percent increase reported in 2015. While lawyer head count growth contributed to this, we also believe the increase in associate salaries was a key driver. The full effect of these increases is yet to be reflected in the results, as we’ve heard anecdotally that while many firms implemented these increases in mid-2016, others delayed implementing them to the fourth quarter of 2016 or the start of 2017.
As we enter a full year of higher salaries and more lawyers, no doubt firms will find it a challenge to manage expense growth. Of greater concern is the pressure that the associate salary hike is already having on many firms who matched salary increases for competitive, rather than performance, reasons. In our conversations with firm leaders, many express bafflement as to why so many firms adopted the increases when their productivity and profitability results couldn’t support them.
Profit margins widened as revenue growth outpaced expense increases. Net income grew 4.3 percent, but was more modest than the 4.7 percent growth seen in 2015. With only slight growth in the number of equity partners, net income growth was the primary driver of the 4.1 percent increase in PPEP. This is a more modest outcome than the 4.5 percent growth in PPEP we reported for 2015.
With a modest demand environment and a strong collections push during the fourth quarter, year-end inventory was up 2.9 percent, lower than the 4.6 percent growth reported at the end of 2015. This would suggest a softer start to 2017.
Behind the industry averages, we continued to see performance dispersion. Fifty-one percent of firms reported declines in demand, while 38 percent reported declines in PPEP. We also noted volatility in demand and PPEP performance from one year to the next, as measured by alternating years of growth and decline. Based on a common sample of 144 firms who reported to us in 2015 and 2016, we noted that 42 percent of firms experienced reverse trends in demand performance, while 44 percent of firms saw reverse trends in PPEP performance from one year to the next. As we wrote in the 2017 Citi Hildebrandt Client Advisory, volatility and dispersion are key characteristics of today’s law firm market, and will likely drive further consolidation in 2017.
As a further indicator of industry dispersion, we saw that the 15 most profitable firms who report to us outperformed the industry, with PPEP up 6.6 percent and net income up 6.9 percent. As most of these firms are in the Am Law 50, we noted that they drove the strong performance of that segment, by increasing both demand and rates, and collecting faster than in 2015. The Am Law 50 outperformed other segments in profit growth, and was the only segment to beat its 2015 performance. Am Law 51-100 and Second Hundred firms saw expense growth outpace revenue growth, as both segments saw modest rate increases and a slowing of collections, and in the case of the Am Law 51-100 firms, a 1.2 percent drop in demand. Going into 2017, niche firms were the only segment to see stronger year-end inventory growth compared to 2015, and only just (up 3.7 percent, compared to 3.6 percent).
When we examine the results by firms’ geographic reach, Global and Regional firms outperformed other segments on profit growth. For the Global firms, this was largely due to their collections effort, as demand was flat and rates increased a tepid 2.7 percent, partly reflecting their exposure to the euro and sterling. Regional firms were the only segment to see demand growth, and this, together with rate increases, drove their strong profit performance. With the strongest inventory growth of all segments, they are also positioned for a solid start to 2017.
While we are cautiously optimistic that 2017 will be another year of modest growth, in our conversations with law firm leaders, we note a higher than usual level of uncertainty, caused by the confluence of current macro events. As firm leaders remind us, we are in the early days of the Trump administration. The timing and scope of Brexit remain unclear. There are several national elections in key economies in 2017, in an environment of populism and anti-globalization. On the other hand, the strong performance of equity markets and continuing low bond yields are positive signs for transactional activity. So is President Donald Trump’s rhetoric about infrastructure spending, lowering taxes, regulation, health care and energy. In this context, our outlook for 2017 is modest industry growth, with continued dispersion and volatility, likely driving further consolidation.
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