Last year finished out strong for the law firm industry, outpacing 2016 on revenue and profit growth. Stronger revenue growth came from comparatively higher billing rate increases and improved demand, especially during the fourth quarter. And while expense growth matched revenue growth, keeping margins steady, net income growth was a solid 4.5 percent. With a slight drop in equity partner headcount, that translated into growth of profits per equity partner of 4.8 percent. More good news could be found in strong year-end inventory levels, suggesting positive momentum for the first-quarter of 2018. That said, we continued to see dispersion in performance, with the Am Law 50 firms far outperforming the rest of the Am Law 200.
These results are based on a sample of 189 firms (81 Am Law 100 firms, 53 Second Hundred firms and 55 niche/boutique firms). Thirty-three 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). Firms with less than 10 percent of lawyers based outside the United States are classified as either “national” (less than 50 percent of total lawyers based in headquarter office), or “regional” (greater than 50 percent of lawyers based in headquarter office). 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 growth of 4.5 percent was greater than the 3.8 percent growth seen the previous year. Lawyer billing rate increases, improved accrual realization and improved demand (total timekeeper hours), drove revenue growth, which was tempered only by a slowdown in collections.
Lawyer billing rates were up 3.7 percent compared to only 3.3 percent the previous year, and were further bolstered by a 0.3 percent improvement in accrual realization versus what had been a 0.7 percent decline in 2016. This improvement in realization suggests that firms were less susceptible to pricing pressure this past year, or perhaps more persuasive in stating their value proposition to clients.
A pickup in demand in the fourth quarter also helped to redeem what had been a sluggish year. Demand ended the year up 0.7 percent after being down 0.2 percent through nine months, and compares quite favorably to last year’s 0.1 percent growth. It’s worth reiterating our comment this time last year when we indicated a slowdown in fourth-quarter 2016 demand growth might reflect a “wait and see” approach in the lead-up to the U.S. election and again in the lead-up to the start of the new administration. To some extent, therefore, this year’s strong finish benefited from comparison to the comparatively weak finish last year.
The only drag on 2017 revenue was a slight lengthening of the collection cycle, which was due in part to the buildup in inventory arising from the pickup in demand. We have heard anecdotally that some firms, having reached or exceeded their revenue growth goals, pushed less for collections toward year end, preferring to leave more for a strong start to 2018.
Lawyer head count grew 1.9 percent, slightly more than the previous year. That growth came from the addition of salaried lawyers, as equity partner head count declined by 0.3 percent. This continued the trends over the past 10 years of actively managing equity partner head count, as well as the steady increase in leverage.
As solid as the 0.7 percent total demand increase was, lawyer demand growth was stronger, at 1.7 percent. This increase, however, lagged the 1.9 percent growth in total lawyer headcount, resulting in a modest 0.2 percent decline in productivity, which is much better than the 1.4 percent decline of a year ago. This relatively small drop in lawyer productivity last year could be another reason for the improvement in accrual realization, as lawyers might have negotiated more confidently in light of a perceived stabilizing of productivity.
Expense growth was up 4.5 percent compared to only 3.4 percent in 2016. As expected, expense growth was driven primarily by an increase in lawyer compensation expenses—6.5 percent compared to 5.4 percent the previous year—reflecting not only the increase in salaried lawyer head count, but also the impact of the associate salary increases that the industry started to adopt in mid-year 2016.
As we look ahead to 2018, absent another round of industry-wide salary increases, compensation expense growth will mostly reflect the increase in head count and any shift toward a more senior demographic. While firms saw compensation expense pressures, they managed to control operating expense growth. Although the 3.1 percent increase is up from the 1.9 percent reported in 2016, last year’s result is in line with what we saw in 2014 and 2015, as firms continue to be challenged by expense pressures like infrastructure investments, marketing and business development costs, and additional insurance premiums (particularly related to cybersecurity).
Profit margins remained flat, as revenue and expenses grew at the same rate, but given that the growth rate for each was higher than in 2016, net income also grew more—4.5 percent compared to 4.3 percent. With the modest decrease in equity partner headcount as compared to 2016’s increase, 2017’s PPEP growth was also comparatively stronger, at 4.8 percent versus 4.1 percent.
On the strength of the increases in demand and billing rates, as well as a slowdown in collections, year-end inventory was up 6.1 percent, much higher than the 2.9 percent increase reported at the end of 2016. This would suggest a strong start to 2018.
Behind the industry averages, we continued to see performance dispersion. The good news was that a greater proportion of firms reported growth in demand and PPEP than in 2016. A majority of firms (56 percent) experienced an increase in demand in 2017, compared to slightly less than half (49 percent) in 2016. This translated into more firms enjoying an increase in PPEP (68 percent versus 62 percent). On the other hand, volatility in performance from one year to the next actually increased. Measured by alternating years of growth and decline and based on a common sample of 143 firms who reported to us in 2016 and 2017, we noted that 45 percent of firms experienced reverse trends in demand performance, while 51 percent of firms saw reverse trends in PPEP performance from one year to the next (compared to 42 and 44 percent, respectively, in 2015 and 2016). We believe that these high levels of dispersion and volatility will likely continue to drive further consolidation in 2018.
Dispersion in performance was also evident between industry segments, based on revenue size. Am Law 1-50 firms outperformed the other segments in revenue, net income and PPEP growth for the second consecutive year. They tied niche/boutique firms for the largest demand growth (1.7 percent), and had the strongest growth in year-end inventory (8 percent), putting themselves in the best position for collections at the start of 2018. And this growth was enjoyed by the largest proportion of firms of any of the segments—with 68 percent reporting growth in demand (up from 53 percent in 2016) and 87 percent in PPEP (up from 83 percent in 2016).
The experience was very different for Am Law 51-100 and Second Hundred firms, which both experienced comparatively weaker billing rate increases along with declines in demand. Indeed, half of the Am Law 51-100 firms reported declining demand, while 60 percent of Am Law Second Hundred firms experienced a decline.
To help offset soft revenue, Am Law Second Hundred firms continued to manage their expenses more closely than any of the other segments and also continued to reduce the number of equity partners. They were rewarded with an improvement in their profit margins, and net income and PPEP growth second only to Am Law 1-50 firms. On the other hand, Am Law 51-100 firms saw greater growth in expenses than in revenue, compressing their margins and resulting in modest net income and PPEP growth. Despite the solid demand growth, niche/boutique firms also experienced profit margin compression, very modest growth in net income, and the only decline in PPEP among the segments after increasing equity partner head count.
When we examine the results by geographic reach, global and international firms outperformed national and regional firms in revenue and profitability growth. Global firms saw the greatest revenue growth, followed by international firms, and both were the only segments to enjoy margin improvement, driven by a combination of solid rate increases, improved accrual realization and improved demand. Global firms had the stronger net income and contribution per lawyer growth, while international firms had superior PPEP growth following a reduction in equity partner head count. Both segments also had large buildups of inventory at year-end, especially accounts receivable, preparing the way for strong first-quarter 2018 collections. National and regional firms, on the other hand, both saw revenue growth fall short of expense growth, compressing margins.
The strong demand growth seen in the fourth quarter, together with solid year-end inventory and Citi’s positive outlook for markets across the globe, suggest a positive start to 2018. That said, this is a market that favored the largest firms in 2017. While we expect 2018 to be another year of mid-single-digit revenue and PPEP growth for the industry, what remains to be seen in this dispersed and volatile market is whether the largest firms will continue to pull away from other market segments. What’s clear is that, size aside, this is a market that will continue to favor firms who build strong brands, nurture client relationships and adapt their talent models to keep up with an evolving legal services market.
John Wilmouth is a Senior Client Advisor in Citi Private Bank’s Law Firm Group, and Gretta Rusanow is Head of Advisory Services. Citi Private Bank is a business of Citigroup Inc., which provides its clients access to products and services through bank and non-bank affiliates of Citigroup. Not all products and services are provided by all affiliates or are available at all locations. The views expressed herein are for informational purposes only and are those of the authors and do not necessarily reflect the views of Citigroup Inc. All opinions are subject to change without notice.