Reports hint a downturn for law firms is coming

Three recent reports suggest that AmLaw 200 firms' results may be in for trouble:

Report #1:  Billable hours softened in Q2

“The large law firm market took a steep turn downwards in the second quarter as demand and productivity slumped, while headcount and expenses moved higher,” according to ThomsonReuters Peer Monitor's Q2 2016 report.

Softer demand. Demand softened in the second quarter, with average billable hours (aka “demand”) for the surveyed firms dropping 0.9% compared to the year-ago figure. The report describes this as the biggest quarterly demand drop in almost three years.

The hardest hit practice segments were tax (-3.4%), real estate (-2.3%), litigation (-1.8%) and bankruptcy (-1.8%). Corporate (+0.1%) and patent prosecution (+0.2%) were essentially flat.

The quarterly Peer Monitor survey covers 151 U.S.-based firms, including 53 AmLaw 100 firms, 42 AmLaw Second Hundred firms and 56 midsized firms, which are firms with 200-plus attorneys that are not part of the AmLaw 200.

The report notes that the drop in demand affected only AmLaw 100 and AmLaw Second Hundred firms, not the midsized firms included in the survey, which were up 1.0%. The AmLaw Second Hundred firms were hardest hit, with a 1.8% demand drop.

Lower productivity. Productivity (average hours per lawyer) also declined 2.8%, due not only to slackening demand but also rising headcount.

Higher rates worked. Rates worked were up 2.9% in the second quarter, though, as compared to the year-ago quarter. The report does not address whether this improvement in rates was sufficient to offset the drops in average billable hours and productivity. The average collection realization rate was basically flat at 82.4%, vs. 82.2% in the first quarter.

Higher expenses. Expenses have also continued to increase in 2016, after reaching a low for recent years in the fourth quarter of 2015. Direct expense growth was 3.2% and overhead expense growth 4.0% in the second quarter, as compared with the year-ago period.

The report concludes that profits for the full year could still show growth over the prior year, but that the need to overcome first half results will make this difficult to achieve.

Report #2:  Most law firms are still stuck in the past, according to general counsels

The majority of large law firms are stuck in the past, according to a recent survey of General Counsels by BTI Consulting.

While the percentage of corporate counsel reporting that their law firms have changed for the better has reached 43.5%, up from 24.5% in 2010, a majority of counsel continue to report that their law firms are stuck and can't seem to change.

BTI says its analysis is based on more than 300 independent, individual interviews with CLOs and General Counsels at Fortune 1000 companies and large organizations conducted between March 2015 and September 2015.

The following are given as examples of change categorized as favorable by the respondents: alternative fee arrangements, better client service, improved value through staffing changes, streamlined case management, expanding advice to include business issues, embracing e-discovery technology, and acquiring more industry knowledge.

The report states that comments by general counsels fall into three categories:

• Firms that talk about change but don't achieve it.
• Firms that raise rates but don't otherwise change.
• Firms that resist requests to save money, to settle litigation early or to otherwise streamline their operations, and instead tell general counsels that budget overruns are unpredictable and inevitable.

The report concludes by advising firms to conduct client interviews to learn what clients like and don't like about their firms' approach to change. It notes that firms that don't change will find general counsels transferring business to the firms that do.

Report #3:  Top transactional firms may face a drop-off in work

Top transactional law firms may face a drop-off in M&A and other premium work, according to a recent report by ALM Intelligence, the research arm of the American Lawyer. The report analyzes the results of 23 AmLaw 100 firms[1] that emphasize high value corporate deal work, such as M&A, complex bankruptcies, IPOs and derivatives. It asserts that these 23 firms, which are largely based in New York City, “saw weak revenue growth in 2015, barely grew in headcount terms, and largely underperformed the Am Law 200 in profitability growth.”

Considering results to date in 2016, the report observes that top transactions firms have seen significant declines in M&A work – down as much as 60%, based on public M&A deal flow data. The report extrapolates that this M&A decline will correlate with similar declines in other high value transactional work.

The report concludes with two possibilities:

• The “best case” is that the 2015 decline and predicted 2016 decline represent a “hiccup” in deal flow, from which the top transactional firms will recover when deal activity returns.
• The other, “more likely,” scenario is that these top firms are starting to experience the same structural pressures that have hit the mid-market firms in recent years, such as rate pressure from clients. The report asserts that the top firms that “adjust their operating models and prove their value add” will continue to succeed, whereas the others will continue to experience financial pressure, perhaps merging or even dissolving.

The report concludes that getting ahead of changing market conditions, such as by improving efficiency, would be advisable.

It's not about the timing, but rather the inevitability

In addition to the three recent reports summarized above, there have been many other reports in the past few years that cast even favorable law firm results in a negative light. Do all these reports merely represent a glass half full view of the world? Are things really still OK?

What could happen?

Whether or not these reports accurately call an economic downturn, at some point it will happen. Others can focus on predictions. Let's instead consider what could happen when the downturn does occur.

First, overall demand for the services of AmLaw 200 firms will fall. Some practice areas, such as bankruptcy and certain types of litigation, will benefit. History tells us, though, that those improvements will not be enough to offset the decrease in profitable transactional and other work. As a result of reduced demand, firm lawyers will work fewer billable hours.

Second, realization rates will decline as firms are forced to accept even lower fees just to keep their pipelines filled – in other words, to keep their lawyers working enough to pay the firm's expenses.

Third, most firms will not be bold enough to implement a quick and controlled proportional downsizing by dismissing both partners and associates to eliminate overcapacity. Some will be too timid; others will hold off in hope that the downturn will be short-lived. Therefore, profits per partner will decline as a result of lawyers billing fewer hours and matters experiencing lower realization rates.

Firms are generally already controlling expenses. The modest expense cuts still available will not be enough to significantly offset the demand and realization rate declines. The more dramatic step of dismissing some associates will produce some expense offset, but will not fully offset the profit decline because the reduced profit pool caused by lower demand and lower rates must still be shared across the same number of partners.

Firms with higher associate leverage and a greater proportion of non-equity partners (also a form of leverage) will experience the biggest profit declines when revenues decline. The financial and social risks of having too many non-equity partners is discussed in my prior blog, “Do you have a bloated middle?” Beyond these issues, firms with significant debt or major levels of partner guarantees – hopefully few in number after the lesson of Dewey & LeBoeuf – will have the most difficult time.

Fourth, firms with the greatest declines in profits per partner will experience a flight to quality, as not only their lateral partners depart but also their homegrown partners leave for positions at firms perceived to be financially stronger – or firms at least willing to pay them more. The stronger partners will be more mobile and many will be likely to leave first, exaggerating the difficulties. Once partners start leaving, it is too late to fix the problem.

Fifth, the weakest firms will succumb to this death spiral and fail – either outright or through a merger with a larger firm. How many firms end up disappearing in this manner and how quickly that occurs will be a function of the length and severity of the economic downturn.

When the dust settles …

The net result will be that the strong firms get stronger, relative to the others, and the surviving weak firms get weaker.

Obviously firms are different and the foregoing scenario speaks in generalities. Still, the question remains: Which group will your firm be in and what can you do now to achieve your best outcome?

What firms should do to survive and even thrive

There are several steps a firm should take now to survive the next downturn, and perhaps even be one of the firms that emerges stronger than the others.

Develop a strategic plan

A firm needs a strategic plan – the picture of what it wants to look like in five or ten years. The plan needs to be actionable and achievable. It needs to differentiate the firm from other firms. A plan to “provide the highest service to our clients, be kind to our employees and responsible to our community” is vague and not actionable. A plan that includes “having among the top three IP litigation practices in the United States” is concrete and actionable, but probably not achievable. A plan to "grow revenues 50% in our commercial lending practice, and grow profits per partner 80%, over the next five years through adding lawyers in New York, Chicago and Silicon Valley, shedding less profitable work, and utilizing fixed fees for a majority of our work" satisfies the requirements of being actionable, achievable and measurable.

Before formulating a strategic plan, the firm needs to learn about itself:

• The firm needs to conduct (or have conducted for it) a substantial number of client interviews. What are its strengths and weaknesses? Who is the competition for various types of work and on what basis does the client decide to hire for those types of work?
• The firm needs to analyze its finances. What is the relative profitability of each practice group (both in absolute terms and per equity partner)? Considerations for allocating expenses are discussed in my prior blog, “Is matter profitability smoke and mirrors?”
• The firm needs to understand how its partners think about the firm, again through individual interviews. What do they see as its strengths and weaknesses? Where do they see the firm in five or ten years? This goes not only to the question of what the firm should do, but also what the partners are willing to accept.

There is much more that goes into formulating a strategic plan.

When completed, the plan should describe specific outcomes, with objective yardsticks where possible. It should be specific enough that it will be possible readily to determine at any point whether good progress has been made and to know when the plan has been achieved.

Execute the strategic plan with discipline

Developing a good strategic plan takes time and hard work. Executing the plan is even more difficult.

The actions required will likely be dramatic – otherwise the strategic plan probably isn't worth much. Actions could include eliminating certain practice areas, growing others, closing or opening offices, bringing in laterals or changing the way matters are priced. The compensation plan may also need to change (see next section). In pursuing these major actions amidst the daily whirlwind of running a firm, it will be easy for firm leadership to get bogged down and lose focus.

The execution plan should include a list of specific actions, time frames and responsible individuals. To maintain accountability, a periodic status check with all responsible parties should occur.

The firm's culture and how well the firm's lawyers work together should also be considered. The more collaborative the culture, the easier some changes will be. But other changes may be more difficult in a highly collaborative firm, such as eliminating certain practice areas or closing offices.

A periodic analysis should be scheduled to assess where the firm is vs. where it needs to be in the action plan. The entire partnership should be kept informed. Change is stressful. So is uncertainty. Both can cause valuable people to leave. Open communication helps.

Consider the metrics the firm should be using to evaluate success. Revenues (billings) take into account only one side of the income statement. Profitability is a better measure because it also takes into account leverage and expenses. Profitability can be measured not only at a firm-wide level, but also by practice group, by matter and by lawyer. Measurement at all these levels is a good idea. The use of profitability as a metric is further discussed in my prior post, “Realization rate vs. profitability – what's the better metric at the matter level?”

A separate question is who should be allowed to see what information, especially regarding profitability. The firm needs to balance the potential divisive effect of some information against the benefits of using the information to motivate partners to improve profitability.

Consider the firm's compensation plan

Whenever a firm engages in a change initiative, it needs to consider whether its compensation plan aligns with the desired behavior of its partners. Changing compensation plans is difficult, slow and potentially divisive. Yet a firm cannot expect its partners to change the way they work if the economic incentives discourage the desired behavior.

For example, the compensation for practice leaders should take into account their responsibilities as leaders and not penalize them for doing somewhat less client work. The challenges facing practice group leaders whose compensation is not aligned with their leadership role is discussed in my prior blog, “The plight of the practice group leader.” The benefits of aligning their compensation are discussed in my prior post, “The costs and benefits of investing in practice group leaders.”

The firm may not need to alter its compensation plan to achieve the changes it desires. While it is ideal when compensation incentives align with desired behavior, behavioral change may still be possible where compensation incentives are at least neutral vis-à-vis the change. Where compensation incentives discourage the behavior, however, change should not be expected.

A firm needs to be realistic about the extent of change that's possible. If the compensation plan would discourage the desired behavior outlined in the strategic plan but cannot be changed, then a different course of action should be established in the plan.

Overhaul the way lawyers work

Whatever changes are demanded by the strategic plan, the firm will be better off if its lawyers can produce the same work in fewer hours or using lower-priced lawyers. These kinds of efficiency improvements will reduce write-downs and write-offs and can improve leverage, all of which improve profits. Some steps to achieve these improvements are described in my prior blogs, “Top strategies for practice group collaboration and efficiency” and “Learning the magic – how to get lawyers to follow through on collaboration and efficiency commitments.”

Diverting billable hours to invest in re-engineering the way the firm's lawyers work can pay back handsomely in future years. Furthermore, if there's excess capacity, then the benefits of this re-engineering can be realized for no incremental cost.

If partners need to improve their business development skills, which is commonly the case, the firm should address that as well. Outside coaching on an individual basis should be seriously considered, at least for partners. Partners should also be asked to prepare individual business plans and should be held accountable, including through compensation incentives.

Process improvements should also be made. These may include eliminating from scope the work not valued by the client, preventing unnecessary work from being performed, and obtaining client agreement to a fee increase before scope is expanded to include additional work. Scoping and monitoring the progress of work are discussed in my prior two-part blog, “Legal Project Management for practitioners – The non-scary version – Part 1” and “– Part 2.”

Conclusion

Some recent reports suggest large law firms may face a downturn in 2016. Whether or not it happens this year, a downturn will occur at some point. Regardless of what they believe will happen in the near-term, firms should be working now to position themselves to survive and hopefully thrive when the downturn occurs.

These actions include developing a specific and actionable strategic plan, executing it with discipline and becoming more efficient.

----------------------------------

[1]        The firms are (in declining order of profits per partner): Wachtell, Paul Weiss, Sullivan & Cromwell, Kirkland & Ellis, Cravath, Simpson Thacher, Cahill Gordon, Davis Polk, Gibson Dunn, Skadden, Cleary, Latham & Watkins, Milbank, Debevoise, Willkie Farr, Weil, Schulte Roth, Fried Frank, Cadwalader, Sidley Austin, Ropes & Gray, Shearman & Sterling and Morrison & Foerster.

[Photo credits: © Can Stock Photo Inc. / dacasdo, OutStyle & AnatolyM]