Size mattered in the first-quarter 2017 industry results, with stronger top-line results and greater expense pressure for larger firms. Industry demand growth was tepid, though billing rate increases were stronger than usual and collections were faster, driving moderate revenue growth. However, expense growth outpaced revenue gains, driven by lawyer compensation increases. And while faster collections aided revenue growth, they also drove inventory growth to its lowest level since the first quarter of 2013, setting up a challenging second quarter. Behind the industry averages, we saw pronounced differences between the performance of firms based on size. Demand and revenue results were strong for large firms, in contrast to a challenging start to 2017 for Second Hundred firms. On the other hand, strong revenue growth wasn’t enough to counter the expense pressure caused by lawyer compensation increases, felt most acutely by large firms.
These results are based on a sample of 180 firms (76 Am Law 100 firms, 52 Second Hundred firms and 52 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 4.9 percent during the first quarter of 2017. While total demand was up a modest 0.4 percent, lawyer demand, the portion that commands the higher rates, was up a healthy 1.9 percent. Billing rate increases, the primary driver of revenue growth since 2010, were up 4 percent, stronger than the 3 to 3.5 percent range we have seen throughout the post-recession years. A strong collections effort also aided revenue growth, as the collection cycle shortened by 1.6 percent.
However, expenses increased 5.6 percent, outpacing revenue growth. Lawyer compensation expense growth, at 9.1 percent (versus 3.1 percent growth in operating expense), drove much of this increase as, for the first time, we can see the full effect of the associate compensation increases many firms have implemented since mid-2016.
Contributing to the strong compensation expense growth was a 1.8 percent increase in total lawyer head count. However, this did not extend to the equity partnership, where firms showed a decline in head count of 0.4 percent. This contrast in head count growth rates drove leverage higher by 3 percent.
The good news is that, at 1.9 percent lawyer demand growth, slightly higher than total lawyer head count growth, the industry was able to maintain lawyer productivity levels while adding lawyers.
Behind these averages, we continue to see high levels of dispersion and volatility. Fifty-two percent of firms saw demand decline during the first quarter of 2017. 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 141 firms that reported first-quarter results in 2015, 2016 and 2017. Approximately 55 percent of these firms either saw demand increase in 2016 and decrease in 2017, or vice versa. This is quite a bit more volatility than we saw last year at this point, when 47 percent of firms saw a volatile result.
Analyzing the industry results by revenue size, we noted that Am Law 1-50 firms outperformed the other segments in top-line growth. They saw the greatest growth in revenue (6.5 percent) and inventory (4.4 percent), driven by the highest growth in demand (2.4 percent) and billing rates (4.2 percent). However, they were also the segment hit hardest by the associate compensation increase, with the highest growth in lawyer compensation expense (10.4 percent), driving total expense growth of 6.6 percent. Am Law 51-100 firms saw revenue grow 5.3 percent, driven by the second-highest rate increase at 3.1 percent and the largest shortening of the collection cycle. That said, this segment saw a 1.2 percent decline in total demand, and ended the first quarter with just 1.7 percent inventory growth, setting these firms up for a challenging start to the second quarter.
Most notable was the very challenging first quarter for Am Law Second 100 firms. They saw the largest decline in demand (4.1 percent) and the lowest revenue growth (2.4 percent) among the Am Law 200 segments. This segment also experienced more pronounced levels of dispersion and volatility than all other segments. Seventy-one percent of Second Hundred firms saw demand decline (compared to 38 percent of Am Law 1-50 firms), while 65 percent experienced volatility. Heading into the second quarter of 2017, Second Hundred firms also have the lowest growth in inventory (0.3 percent). Niche/boutique firms were the only segment outside of the Am Law 1-50 firms to see demand grow. However, they saw revenue decline, driven in large part by a material lengthening of the collection cycle and the lowest pace of rate growth (1.6 percent). On the positive, they enter the second quarter with the second highest growth in inventory among the segments at 2.3 percent.
Looking at firms by geographic reach, international firms outperformed other segments in revenue growth, at 7.2 percent. However, they also saw the greatest increase in expenses (7 percent), driven by the largest increase in lawyer compensation expense at 11.6 percent. This was due in part to the largest growth in lawyer head count (2.6 percent). International firms also saw the largest growth in inventory at 5.4 percent. Global firms saw the second-highest revenue growth at 6.3 percent, and saw the lowest increase in expenses (4.3 percent), driven in large part by strong operating expense controls. Revenue growth at global firms was driven by the largest increase in demand at 2.2 percent and lawyer demand at 3.4 percent. National firms saw the lowest growth in both revenue (2.7 percent) and inventory (2.5 percent), as demand grew just 0.4 percent. Regional firms were the only segment to see demand decline. Despite this, they saw revenue growth of 5.1 percent, driven largely by the strongest rate increase of the segments at 4.3 percent, and go into the second quarter with a 2.7 percent increase in inventory.
Throughout our meetings with law firm leaders during the first quarter, we heard a mix of caution and what could best be described as cautious optimism about 2017. While the first-quarter average industry results are decent, this mix of sentiments is echoed in the pronounced levels of dispersion and volatility, particularly for Am Law Second Hundred firms. On the other hand, while larger firms enjoyed a stronger start to this year, they also carry the lion’s share of the expense pressure created by associate salary increases. Looking ahead, we expect continued pronounced dispersion and volatility behind modest industry growth in 2017. The challenges will be different for firms, depending on size. Larger firms will need to maintain strong top-line growth to counter the expense pressure. Smaller firms will need to improve top-line growth. It wouldn’t surprise us to see more consolidation as a result.