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A ‘return to growth’ is a mirage for law firms

28 October, 2014

. Law. Strategy

A just-published survey on larger law firms in the UK quietly celebrates a ‘return to growth’. PwC’s 2014 Law Firms’ Survey also finds ‘a degree of stability and confidence is returning to the legal sector’.

This survey is comprehensive and admirably reported with some undoubted good news and eye-catching infographics, but the narrative doesn’t tell the full story. So, courtesy of this PwC lens, let’s take a look at whether ‘return to growth’ is a sign of recovery for law firms. Calling these findings a ‘return to growth’ is a mirage for law firms. I analyse why.PwC analysed 2014 financial performance of the largest 100 UK firms broken by size into the top 10, 11-25, 26-50 and 51-100.

Here are some key facts from the PwC report with my comments:

1. The proportion of firms enjoying an increase in fees has risen year-on-year from 63% to 80%. Good news, but merger activity contributed substantially to this outcome.

2. 70% of firms grew faster than inflation in 2014 compared with 43% in 2013. Good, but why is top-line growth be noteworthy at all?

3. Except for firms in the 26-50 band, all others increased their net profit margins. Good news, no question about it. But there’s a big difference between margins for the top 10, 40%, and other bands, 24% to 28%.

4. Much of the margin improvement has come from increased utilisation and reduced fee-earner numbers. Fewer people are working longer. And I suspect leverage has decreased in keeping with trends in the USA and Australia.

5. Fee income per chargeable hour dropped across the board year-on-year, ranging from 8.1% for the top 10 through 2.8%, 9.3% and 0.4% for the other bands. Price-down pressure continues – no doubt driven by clients and hyper-competition.

6. Improving profitability has been a focus for many firms with 58% recording increases compared to 45% in the previous period. Good news, but how much of this is the result of de-equitisation?

7. The number of firms making capital calls in all bands outside the Top 10 has increased ‘notably’ and the average call has increased for all bands. Warning bells should be ringing.  

8. Finally, to quote PwC: ‘while the results of the 2014 survey reflect an improvement in revenues and profits for many firms, all financial KPIs are still short of 2008 inflation-adjusted levels – in particular profit per full equity partner where bandings are between 21% and 29% behind 2008’. Was 2008 a particularly good year? Or was it simply the last year of the ‘golden era’?

A ‘return to growth’ is a mirage for law firms

Those with a horizon of a few years will find justifiable comfort in these and many of the other findings in the PwC report.

But I argue that a ‘return to growth’ is not a sign of recovery for law (or any other professional services) firms. Viewed in a strategic time perspective, these findings actually confirm what my partner, Warren Riddell, and I have been writing about for several years:

September 2012: PPEP levels are doomed without re-invention

October 2013: BigLaw at sea. Red Ocean or Blue Ocean?

February 2014: The Ides of Maturity for professional services firms

May 2014: Life cycle maturity and the professions

October 2014: The Big Bang in BigLaw – or how irreversible forces are changing law firms

Whichever way you want to interpret – and hopefully challenge – these analyses and opinions, the fundamental demand-supply dynamics in the legal profession have changed from a sellers’ to a buyers’ market. And that’s irreversible.

There is and can be no ‘recovery’ in a structural change sense. Yes, economic cycles are over-laid on the underlying structural change. And yes, recovery in an economic cycle sense is welcome. No doubt about that being good news.

But consider for a moment the business model of law firms which we have nicknamed BigLaw, and which we have described in detail in several posts, e.g. here and in our book NewLaw New Rules. The BigLaw business model is characterised by:

+ A partnership-based structure with little or no real business balance sheet strength

+ A human capital pyramid that is treated as a fixed cost

+ The productivity of lawyers being measured by hours recovered from clients

+ Tight restriction of equity to maximise profit per point of equity

+ The major price structure is (still) based on the billable hour

+ A mind-set of top-line growth is good

+ Equity partners’ rewards (largely) linked to revenues introduced and managed.

Re-read the eight points taken from the PwC report

In the light of the BigLaw business model which is operated by 99% firms, the eight points taken from the PwC report assume a very different perspective. Buoyed by a lift in the wider economy, these firms are taking steps to maximise their profitability – and it’s working. But for how long? This is the really important question.

Like larger law firms everywhere, the top 100 UK firms are squeezing more billable hours from staff (how high can utilisation go?), trimming costs (how low can overheads go?), reducing the number of equity points on issue (what’s the irreducible minimum?), and bolstering working capital with calls on owners (when will enough Mirage_dreamstimebe enough for some partners)?

And then on top of it all, when will the free agency risk come into play? My post ‘Why the economics of free agency should worry partners‘ – and the enlightening commentary by Ed Reeser – explain the dangers inherent in partners  jumping from one firm to another to seek greener pastures.

The “lateral” topic is not covered by PwC, but warrants simultaneous and equal consideration with the reported trends in practice economics. Why? The combination of the uncomfortable and inexorable pressures of trying to keep the BigLaw business viable and the ever-present danger posed by laterals is a tough and toxic mixture.

Too many firms focus on the short-term looking for signs of hope. That hope is too often found in revenue growth that is interpreted as ‘things are improving’ and ‘we’ll be OK, just look at the increasing fees’.

This is why a ‘return to growth’ is not a sign of recovery. It’s like an mirage in the desert.

Author

This post was written by George Beaton, a director of Beaton Capital and Beaton Research + Consulting and associate professor at The University of Melbourne.

3 Responses to A ‘return to growth’ is a mirage for law firms

David Goener says: 31 October, 2014 at 4:27 pm

George, your critique of the PWC report is very interesting and shows that the UK market is not unlike the US market as reported in the AMLAW 100 Report earlier this year.

While the headline numbers in the US made reassuring reading with an average 5% increase revenue for calendar 2013, the key financial metrics of profit per partner (PPP) and revenue per lawyer (RPL) were flat. Further the averages were misleading with outlying performances on the high side from a handful of firms skewing the numbers.

While revenue growth is positive, profitability and cash collected pay the bills.

Further details about the US market may be found in my post from April this year – http://www.beatoncapital.com/2014/04/state-american-biglaw-firms-relevant-australia/

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