The preliminary Citi 2011 report is out and it’s time for a bit of reading between the lines. In particular, we like to focus less on what’s said than on what is studiously elided.
Here’s the top line:
For law firms, 2011 was a tale of two years. The strong demand momentum coming into 2011, which continued through the first six months, caused many law firm leaders to believe that a degree of certainty had been attained. The second half of the year was a rude awakening as demand, particularly in transactional work, withered away and has yet to bloom again.
So, while revenue growth in 2011 exceeded the prior year, even greater expense growth squeezed margins and resulted in a PPEP (profits per equity partner) increase of just 3.3 percent vs. 7.4 percent in 2010. In 2010 the industry was rebounding from a weak 2009 which made higher year-over-year increases easier to attain—not so in 2011.
Revenue growth of 4.1 percent in 2011 was due to moderate rate increases, a modest shortening in the collection cycle and a slight increase in demand. With low year-end inventory growth, the industry might be in for a slow start to collections in 2012, and if tepid demand growth continues into the year, it will create a challenging revenue environment.
The “withering away” of transactional work has, I submit, one proximate cause, one which is likely to be with us as far as the eye can see: No credit. More and more banks, here and in the EU, appear to be “zombie banks,” which, as Japan demonstrated convincingly during the 1990’s, are primarily good for only one thing: Supporting zombie companies. The syllogism is direct and brutal: No credit, no deals, no deals, no need for deal lawyers. As a good friend who used to run the second largest office of an AmLaw 25 wrote to me,
Clients cannot do deals if there is no capital to fund them. With the collapse of the capital markets to provide capital and the valuation of assets substantially diminished from the great recession, entire industries that would be actively trading are basically shut down. No transactional velocity means no purchases, no sales, no mergers, no refinancings, no recapitalizations. But it also means less litigation, as winning the dispute is only half the battle. If there isn’t a pool of net asset value to seize after victory…..why bother?
The comment that revenue growth was 4.1% year over year also requires a heaping tablespoon of salt:
- Citi reports that the collection cycle shortened by 1.3%; backing this out of the revenue “growth” figure takes it to 2.8%. (Sure, shortened collection cycles are a hygienic thing to do, but you are borrowing from the future to do so, and you can’t play that game forever, at least not in the for-profit private sector.)
- Rate rises, of an unspecified amount, are also mentioned, but the meaningful number (which Citi doesn’t report in this preliminary “flash” release) is realized rates. If my rate is $600/hour but I routinely give you a 15% discount and only collect 85 cents on the dollar after that, is my rate $600 or $433? (600 * 85% * .85)
- Citi also attributes the revenue growth to “a slight increase in demand,” but distinguish between organic growth in demand and poaching revenue from rivals. To the extent that firms sampled in this early report grew by lateral acquisition, that is of course no real demand growth at all, merely a shifting from one firm’s income statement to another’s.
- We also don’t know and can’t tell how much of this goes on, but beware firms that capitalize the recruiting cost of new lateral hires and amortize it over some multi-year period; it should be expensed 100% in the year incurred or else you are overstating current period income and slagging a sunk cost onto future years.
- Finally, one way to increase rates has nothing to do with “rack rate” or list price sticker adjustments at all: Just put more and more senior people on matters where you used to use some juniors and midlevels. Voila.
What else can we divine?
Expenses were up 4.4%, “outpacing the rate of revenue growth” and primarily reflecting increases in compensation (as opposed to overhead). And here’s a clue: A leading driver of higher compensation was salary rises “as lawyers became more senior.” So the talent mix appears to be tilting upwards.
Could that be because more senior lawyers not only produce juicier numbers for the firm but because clients are finally getting traction in just saying no to juniors clambering all over their matters? Just a hunch.
Even if that’s what’s going on, we apparently still have more lawyers than we need:
We saw head count grow slightly, and [grow] slightly faster than demand, [so] we saw a marginal decline in productivity. Looking at absolute productivity numbers, at an average of 1,642 hours per lawyer, we’re still seeing results well below the historical levels of productivity.
Finally, Citi’s coda, which conceals more than it reveals:
All said, not a bad year and we suspect likely to be the new definition of a good year for the legal industry at least for the foreseeable future.
I strongly suspect this could be rephrased in pithy words of Anglo-Saxon derivation: “It ______. Get used to it.”
Now what?
Dr. Economist, reviewing what we just learned about this patient, has a ready diagnosis, one you can state with a high degree of confidence: This describes an industry facing fundamentally stagnant demand and (accordingly) stagnant prospects for real revenue growth.
Compare that—and it compares vividly—to the boom years of approximately 1980 through September 2008, where annual revenue growth of 6-8%/year, compounded, occurred virtually across the AmLaw 200 so long as everyone simply kept the autopilot engaged.
Economists, and students of industrial structure in particular, have plenty to say about industries characterized by some or all of the following:
- Being in a mature market sector.
- Offering products/services which their clients believe possess a high degree of fungibility from firm to firm. Or, stated slightly less harshly, clients find a high degree of substitutability among the offerings of competing firms.
- With excess capacity.
- Facing price pressures.
- Quietly and imperceptibly at first, but in an accelerating and more visible way, facing threats from disruptive business models and technologies.
I won’t spoil the fun; these topics will be left for another day.
One conclusion you may have already reached for yourself, however: The management style that worked for 30 years won’t work today. And whether you’re in management or in the loyal rank and file, suffice to say we may all soon be resorting to one-syllable words of Anglo-Saxon derivation.
