We have our first comprehensive report on how 2008 is shaping up financially, courtesy of The American Lawyer, and Dan DiPietro of Citi’s Private Bank, and it paints a picture of what are soon going to be, if they aren’t already, vastly diminished expectations.
Let’s set the scene.
Since 2001, we’ve enjoyed overall consecutive year over year growth rates at almost double digit levels in practically every metric that counts. Here are the CAGR (compound annual growth rate) figures for the 2001 to 2007 time span:
- Revenue: 10.6%
- YTD 2008: 4.8%
- Gross billable hour demand: 3.9%
- YTD 2008: -0.3%
- PEP: 9.3%
- YTD 2008: -9.1%
- Growth in the ranks of equity partners: 2.9%
- YTD 2008: 1.7%
- Associate compensation (roughly 23% of total firm revenues): 10.1%
- YTD 2008: 15.2%
Now all of these trends have turned negative:
- Revenue growth has reversed, with demand the weakest since 2001
- Since firms have continued to add lawyers, there’s "profit margin compression"–lower revenues hit higher expenses
And, fascinatingly:
The slowdown is hitting the most profitable firms the hardest. In the first half of 2008, demand dropped off even more dramatically and expenses increased at a more rapid pace at the top firms, resulting in even greater margin compression and a steeper drop in productivity than experienced by their less profitable rivals. The practice areas that normally provide a lift in a downturn — restructuring, bankruptcy and litigation — have not helped cushion the drop-off in transactional work.
It’s not just a failure of the classic countercyclical practice areas to kick in; there appears to be a structural component involved as well.
When firms are broken out by profitability, our data produced an interesting finding. The firms that soared in 2002 through 2007 were harder hit in the first half of 2008 than their less profitable peers. From our sample of 165 firms, we broke out 63 top-tier firms (defined as those with profits per equity partner above $650,000 in the year 2000). Over the past six years, this group has consistently produced higher growth in revenues and PPEP than other firms.
That changed dramatically in the first half of 2008. Growth in PPEP for 51 of the 63 top-tier firms that reported their results to us plummeted from an 11.7 percent increase in 2007 to an 11.8 percent drop in the first six months of 2008. In contrast, their less profitable rivals experienced a 5.3 percent drop in PPEP in the first half of 2008. After reaching a seven-year peak of 7.4 percent growth in 2007, demand at top-tier firms actually dropped 1.6 percent in the first half of 2008. Again, this decline compares unfavorably with the 1.1 percent rise in gross billable hours at the other firms in our sample.
Top-tier firms experienced even greater profit margin compression than their peers, with revenue growth of 4.3 percent and an increase in expenses of 10.9 percent. In contrast, the other firms we surveyed had revenue growth of 5.5 percent and a rise in expenses of 9.1 percent. Demand at top-tier firms declined in both the first and second quarters of 2008, in contrast to their less profitable competitors, for whom demand dipped in the first three months but increased in the second three months.
The posited explanation is that since firms with the highest profitability tend to concentrate on serving the financial services industry’s demand for transactional work, they are suffering disproportionately from the freeze gripping that sector. This rings convincingly true to me. And the data support it: Hours per lawyer have dropped 8% at these top-tier firms compared to a decline of 2.9% elsewhere.
One last observation from the report and then some commentary.
What Citi defines as "international" firms, with between 10 and 25% of their lawyers abroad, "experienced greater profit margin compression than any other group of firms." By contrast, "global" firms, with more than 25% of their lawyers abroad, have experienced the least profit margin compression.
If you assume that firms just beginning, or in the early stages, of international expansion are focused on the UK and the EU, this makes some sense: Those geographies are experiencing a similar, though not as sharp, a slowdown as we here in the US. So their geographic diversity hasn’t helped much. By contrast, if you think Citi’s definition of "global" firm identifies firms farther down the globalization path, they’re likely to have substantial presences in Asia and the MidEast–areas anything but suffering from the Western economies’ downturn.
More importantly, this speaks to the power of a diversified portfolio of practices–both by specialty and by geography.
So: What’s to be done?
Since you can’t create a truly compelling international platform by yourself overnight, you have one aggressive and one passive option. The aggressive one is to carefully, thoughtfully, and thoroughly explore a potential merger with a firm that, together with yours, would provide that international platform.
Globalization is here to stay, and the notion of a powerhouse firm based primarily in one country–no matter how large the domestic economy–will increasingly become a mark of irrelevance.
The more passive, or perhaps I should say more cautious, response is simply to do what you can to cut costs.
There’s just one problem with cutting costs: Your biggest costs are (a) people and (b) office space.
You can’t cut corners on either one. And, as many firms learned to their lasting chagrin after the dot-com bust, if you cut associate ranks drastically to improve short-term results, you have no mid-level bench strength when the good times return. Neither your clients nor people in your recruiting pipeline–nor partners who have to turn down work or over-stress their colleagues–forget this soon.
Which brings me to the real point.
Firms that are "suffering" (down 10% in profits?–let’s get a grip, people) are probably in that situation because they made bets–hopefully calculated–to concentrate on practice areas that were hot. That’s all well and good, if they were consciously chosen bets placed with an understanding of the odds of their coming up snake-eyes.
Managing a sophisticated law firm is not remotely a quarter by quarter exercise, and it’s also not a year by year one. It requires explicit, considered, hard thought through choices about what your firm is, what it’s capable of, and what it can credibly and realistically aspire to given your client base, your recruiting pipeline, and a clear-eyed view of your partners’ and associates’ appetite for change.
And then it requires a consistent communications effort, forceful, undeviating, adapted to different audiences at different times but indistinguishable in thrust. You need to be shockingly clear about the vision, able to crisply articulate it, relentless in communicating, and prepared to reinforce it all with carrots and sticks.
Come to think of it, maybe it’s easier just to cut costs.
