One of the obligations of commentators at this time of year is to give an end-of-year roundup and a new year prognostication. So let’s start with profitability, a subject dear to all our  hearts.

Citi Private Bank’s Law Firm Group serves some 600 law firms and 58,000 lawyers in the United States and the United Kingdom, and surveys them quarterly about their financial situation. The most recent survey results– for the third quarter of last year— are skewed toward AmLaw 100 firms – “44 Am Law 1–50 firms, 36 Am Law 51–100 firms, 49 Second Hundred firms, and 54 additional firms"– but nonetheless give a pretty interesting picture about the law business and its profitability in 2011 with indications for what 2012 holds.

Citi’s conclusions:  As a result of work put on hold during the third quarter (and therefore unbillable) and intimations of a continuing decline in demand in the fourth quarter, Citi projects that PPEP for 2011 will fall to low-to mid-single-digit growth–less than 2010’s 7.5%, and that 2012 will get off to a rocky start.

For the details: Citi found that law firm collections for the quarter were strong, but expenses continued to rise at a faster rate than earnings. Perhaps more disturbing is the report that corporate demand for legal services continued to decline for the third consecutive quarter, with WIP also declining. 

"Cumulative growth in demand for the first nine months was 1.5 percent, down from 1.8 percent during the first six months. This indicates that growth in demand slowed to only 0.9 percent for the third quarter…The slowdown has hit Am Law 50 firms… particularly hard."

Because there is simply less demand, income partners and of counsel are working fewer hours, while equity partners and associates continue to carry the ball. At the same time, leverage is declining generally, particularly the ratio of associates, who carry a higher profit margin, so the pyramid system only survives in theory. 

Citi went on to note that rate increases remained steady at 3.7% and realizations were strong.  But it also cautioned that:

"Expenses, which had already risen by 4.7 percent during the first half of 2011, continued to gain momentum during the third quarter, as they have now increased 5 percent across the industry for the first nine months of this year. This was driven by a continued increase in operating expenses—and in compensation expenses, since we saw a slight uptick in head count during the third quarter, likely due to the entry of first-year associates."

Obviously, with rates increasing by 3.7% and expenses increasing by 5%, most firms are slowly losing ground on both the profitability and productivity fronts.

"Looking at the 100 most profitable firms from 2001–2010 in our database, we saw a discernable decline in the percentage of associates represented in the leverage composition and a significant growth in the income partner, counsel, and of counsel categories. The result is a much more expensive leverage model, which would be fine if these more expensive lawyers were as productive as equity partners and associates, but they are not. In looking at average annual lawyer productivity from 2001 to 2010, income partners and counsel worked about 150 hours less than equity partners and associates."

"This modest increase in associate head count, combined with the slowdown in demand in the third quarter, translated into a decline in productivity gains—from 1.6 percent growth for the first six months of 2011 to 0.9 percent growth for the first nine months."

Collections were so strong in the third quarter that revenue growth outpaced expense growth, the reverse of the mid-year situation, so profit margin pressure was eased for the moment.  However,"the push for collections…along with the slowdown in demand, resulted in a significant slowing in inventory growth… " with WIP at " 3.6 percent for the first nine months (versus a cumulative growth rate of 6.3 percent for the first six months). The last time we saw the third-quarter inventory growth rate slowing from the first-half rate was in 2008." And the obvious implication for 2012 first quarter revenues is not pretty.

The result of these trends, Citi notes, is flat to negative equity partner growth in virtually all market segments and a preference for bringing in laterals over making internal promotions. (More on the state of lateral hiring in a future entry.) 

Hildebrandt’s quarterly "Peer Monitor" index for the third quarter of 2011 dropped 6 points to 56 (anything below 65 is deemed a negative operating environment)– breaking a string of three consecutive upward quarters. 

"While rates strengthened slightly, demand growth weakened. Most significantly, the rise in expenses continues to accelerate. In the third quarter, increases in expenses ran well ahead of slowing revenue growth, sharply curtailing profitability.  Growth in demand for legal services was positive, but slowed to 0.8 percent, its weakest reading so far this year. Rates firmed slightly, up 3.5 percent compared with the same period a year ago. But the worrisome trend in expenses that PMI has been tracking continues to worsen. Both headcount and overhead expenses rose to their highest levels of the year. In short, the market continues to grow – albeit at a lethargic pace. But expenses will need to be brought under control if demand does not pick up. Achieving topline growth and balanced expense controls will be the key themes for firms for the balance of 2011 and into 2012."

"Following widespread cost reductions in 2009 and 2010 (reflecting primarily significant reductions in headcount), expense growth turned positive early this year. As 2011 has worn on, costs have steadily accelerated to the point where they are now easily outpacing both demand and rate growth, thus impacting profitability. Until recently, firms had generally been doing a good job of balancing their headcount against slowly growing demand. But firms have stepped up their hiring in recent months in a modest return to traditional seasonal hiring patterns. While firms have been hiring, however, demand has slowed as the year has progressed, widening the gap between law firm capacity and available work. Whether this trend continues will depend on the performance of the broader economy and whether we see continued recovery in litigation and transactional work."

While in this survey, stated rates were up a comparable 3.5%, "realized rates have resumed the long‐term downward trend that has been in place since 2008, and reached another all‐time low in the third quarter. A similar story is unfolding in collections. Following a slight rise earlier this year, net collected realizations fell to a new all‐time low of 85.4 percent."

Some of these themes were evident in the results of The American Lawyer’s ninth annual survey of law firm leaders, as summarized below:

"Only 20% of respondents expect to see revenue growth in their corporate practices next year, compared to more than one-third of respondents last year. And clients are taking longer to pay their bills, according to 43% of the respondents. Billing rates are continuing to rise, with 93% of firms expecting to increase rates by 5% or less.

Cautiously optimistic, firms are holding steady on the size of their first-year associate classes, with 58% keeping their class size the same as in 2011. More than one-third of respondents expect to reduce their equity partnership ranks and 49% of firms have made efforts to align partner compensation with a willingness to cooperate in new initiatives such as project management.

Leaders are not as optimistic about profits per partner as they were last year. The majority (58%) of survey respondents expects PPP to grow 5% or less, which is higher than the 41% who responded last year. A healthy 26%, however, expect profits to increase by more than 5%, although this is down considerably from last year’s 38%."

For even more confirmation on the bleak 2012 growth outlook, here is Goldman Sachs’ Chief Economist predicting that 2012 will see average global GDP growth of 3% and US GDP growth of 2.5% or less, with early 2012 growth in the US particularly sluggish–slower than the last half of 2011.

An AmLaw Daily Business Review article published in mid-2011 to which Muir contributed (and which you may have to upgrade your membership in order to read), discussed the big differences in profit margin among the various AmLaw 100 firms. A five-year analysis (spanning the boom year of 2007 as well as the bust of 2009) "shows a striking chasm between the highest- and lowest-margin performers,"  ranging from 63% for Wachtell and 62% for Quinn Emanuel to 19% and 22% for Edwards Angell and Squire Sanders, respectively.

What did that analysis find distinguished high profit margins from low?

• Under-leveraging, of both associates and non-equity partners–those firms with higher than average profit margins in any given year (including the booms) had lower than average associate leverage, with an inverse correlation in leverage the higher the profitability went. Similarly, lower numbers of non-equity partners translated into higher profit margins, with a high of 46% compared to a low of 27%.
• Low rates of lateral hires–those with the most restraint in lateral hiring were in the top quartile of profit margins (with fewer than 4% lateral hires), while those in the bottom quartile laterally hired an average of 18% of their equity partners, with the three firms with the largest percentage of lateral partners (K&L Gates, SNR Denton and Duane Morris)reporting profit margins of only 26-27%. 
• A global presence while limiting non-strategic offices–those firms with large numbers of offices tended to have lower margins (34%) than those with only a few (46%), unless those offices were mostly outside of the US, in which case margins went up (to 41%).

So in terms of profitability, we have a bleak growth prognosis ahead while the old saws about how to improve profitability are proving wrong. 

Last year at this time, our entry on Where Will Profits Come From in 2011? concluded by saying what remains true today:

"The writing on the wall is pretty clear  Profits are unlikely to come from general demand in the market.  And there is only so much of your expenses and partners that  you can cut and still survive as a thriving firm."

If your firm is one of those that are trying to sail through these tough times using outdated business development and people management approaches, the waters ahead look pretty treacherous. Now is the time to embrace that scary word–innovation–and begin understanding how to achieve a new law practice that fits the new economy.