For the first time in six years, law firm expenses in the US and the UK are growing faster than revenues, according to a recent article in The American Lawyer.  For the first six months of 2007, gross revenue grew at a strong 13.1%, well above the compound annual growth rate of 10.5% of the prior three years, while productivity (average hours per lawyer) was flat.  Rate increases were in line with the six-year average increase of 7% and, continuing an upward trend, there was an increase in leverage– total lawyers rose by 7.4%, significantly above the increase in equity partners.

But there were also big increases on the expense side, with the expense growth rate of 13.7% much greater than the average 9.2% of the last three years and outstripping the increase in revenues (13.1%) for the first time in six years. 

The reasons are pretty obvious.  A 17% rise in compensation costs accounted for the bulk of the increase in expenses.  This last year has seen not only big jumps in associate compensation and bonuses but also the announcement of special additional bonuses yet to come.  Equity partner growth in the first half of 2007 was also up 1.5 percent, over .5% from the prior year, although still not up to the average six-year rate of 2.6%.  Operating costs (occupancy and overhead) also grew close to 12%, in many cases driven by additional new hires.  And poor currency conversions rates relating to foreign office expenses have driven those costs up dramatically.

So what does the crystal ball tell about the future?  With the drop off in transactional work caused by the credit crunch and no up-tick in bankruptcy and litigation, productivity in the second half of 2007 is likely to slow, and those higher salaries and bonuses on top of bonuses will fully hit the books.  Revenue for the entire year is likely to be cushioned by the strong inventory accumulated during the first half of 2007, resulting in still decent increases in profits per equity partner of 6-8%.

But 2008 may be another matter altogether.  If transactions don’t come back and other practices don’t take up the slack, reduced revenues and even layoffs may be in the offing. 

It’s a new year coming.  Let’s hope the party hats stay on.