How well did law firm leaders’ projections about industry performance during the first half of 2017 reflect what actually happened? The first-half 2017 issue of the Citi Private Bank Law Firm Leaders Confidence Index, published in January, showed a slight increase in overall confidence levels in the industry. This increase was in large part driven by law firm leaders’ confidence in the outlook for their own firms. Comparing this first-half Law Firm Leaders Confidence report to the Citi Law Watch Quarterly Flash report for the first half, released in August, we found some accurate or near accurate predictions and some notable differences, particularly as to how well law firm leaders expected their firms to perform.
Citi Private Bank’s Law Firm Leaders Confidence Index (LFLCI) is a semi-annual, forward-looking measure of confidence levels within the legal industry. The first-half 2017 LFLCI values are based on a sample of 153 firms (66 Am Law 100 firms, 39 Second Hundred firms and 48 niche/boutique firms), with responses collected in October 2016. One response was accepted from each firm and was submitted by the firm’s managing partner, executive director, chief operating officer, chief financial officer or equivalent member of the management team. The result is a composite index that shows the relative level of overall confidence based on a series of component indices. For each index, 0 indicates very low confidence, 100 indicates neutrality, and 200 indicates extreme confidence. We then compared the first-half LFLCI projections with the actual first-half 2017 results, based on 165 firms (69 Am Law 100 firms, 48 Second Hundred firms and 48 niche/boutique firms) from the Citi Quarterly Flash survey conducted for the first half of 2017. Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and more than 35,000 individual lawyers. In addition to the LFLCI and the Quarterly Flash survey, we conduct a more detailed annual survey. 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.
Overall confidence in the industry for first half of 2017 was 114, 2 points above the prior report. Contributing to the increase was a 4-point improvement in the global economy index to 97. It remained the only index in the report below neutral but the improvement contrasted with a one-point decline in the outlook for the U.S. economy index, to 110. No doubt the U.S. election was at the forefront of most people’s minds at the time the data was collected in October 2016, and perhaps contributed to the uncertain outlook for the U.S. economy. Of course, given the timing, the added uncertainty that came with the result of the election is not yet priced into the index.
A major contributor to the increase in overall confidence was law firm leaders’ increasingly strong confidence in the outlook for their own firms. They continued to be particularly bullish with regard to demand, as that index had the second-highest value in the report at 130, up 3 points from the prior report. However, there was a notable difference in the predictions of law firm leaders and actual results. In our last article comparing projected versus actual results for the second half of 2016, we wrote about the “positive bias” evident in law firm leaders’ projections for their own firms. Up just 0.4 percent during the first half, 48 percent of firms saw demand decline, while only 10 percent of respondents projected a decline.
Confidence in revenue growth rose 3 points to 116, but we also saw differences between projected and actual performance. While the industry reported revenue growth of 4.9 percent, 35 percent of firms saw revenue decline—much higher than the 7 percent of firms that projected a decline in the first-half LFLCI.
Anticipated improvements in realization continue to drive at least some of the expectations of stronger revenue growth. The realization index was 107 and improved 5 points. However, only 21 percent of firms expected realization to decline, while 55 percent saw a decline. On the other hand, for the 45 percent of firms that saw realization improve in the first half of 2017, this suggests that they may be better able to react to pricing pressure in ways that minimize the negative impact on profitability and may even be accretive to profits. In our Peer Reviews, we have seen our clients adopt more flexible and lower cost leverage models to respond to client demands for more efficient delivery of legal services. Further, in our Citi 2017 Law Firm Leaders Survey, respondents described having a better experience with pricing, driven in part by better project and pricing management.
A projection that closely reflected actual market performance was the net income index—one of only two indices to decline, as it dropped 1 point to 108. This concern mirrors the margin pressure that we saw in the actual first-half results, as expenses were up 5.1 percent, outpacing the revenue growth of 4.9 percent. This was driven in large part by the associate compensation increases put through by many firms starting at the midpoint of 2016. In fact, lawyer compensation expense increased 7.5 percent and made up 62 percent of the total expense growth.
Interestingly, in spite of the increased cost of associates, law firm leaders were bullish about expected levels of associate headcount growth. At 137, and up 6 points from the prior report, respondents expected to add associate headcount at a 1-3 percent pace. This projected growth closely matched actual growth with firms reporting an increase in associate headcount of 2.9 percent in the first-half results. Law firm leaders were also fairly accurate in their projections for equity partner headcount growth, albeit a bit more optimistic compared to what actually happened. At an index value of 119, they projected less than 1 percent growth in the average equity partnership, consistent with what we’ve seen in recent years. However, even this modest growth projection was optimistic relative to the 0.2 percent decline in equity partner headcount that the industry saw in the first half of 2017. This relationship of associate hiring and essentially no net growth in equity partners also infers a projection of increased lawyer leverage, which we did see up 2.8 percent in the first-half 2017 Quarterly Flash. Unfortunately, while increased leverage has historically been a profit driver for the industry, it doesn’t perform as such unless there are enough hours to support it. And with average demand growth coming in much more modestly than the total lawyer headcount growth of 1.9 percent, lawyer productivity was down 0.3 percent during the first half of 2017.
Law firm leaders seemed to predict pressures on their margins and hiring trends with reasonable accuracy. Further, sentiments regarding improved realization, while not entirely accurate, do correspond with what we hear anecdotally from firms about their focus on doing work differently and more profitably. The greatest divergence between expectation and reality appeared in top-line growth. While this speaks to law firm leaders’ continued positive bias when forecasting top-line growth at their own firms, it also speaks to the widening dispersion and heightened volatility we see behind the industry averages, suggesting (1) how law firm leaders believe that their firms will be the ones to grow, likely at the expense of others, and (2) just how challenging it’s become to predict growth in a volatile legal market.