Stifling expenses and a slowdown in transactional work during the first quarter could sink profit growth for the rest of the year, according to a new analysis of legal industry performance.
The Law Firm Financial Index (previously the Peer Monitor Index) published Monday found even robust demand growth during the first part of 2022 wasn’t enough to counteract a decline in M&A, a cooling in corporate work and nearly double-digit overhead and direct expense increases from last year.
The report stated “many market fundamentals remain strong,” including a three-year high in Q1 demand growth (2.7%), plus positive rates and productivity. But the quarterly composite score of law firm profitability declined for the third straight time, to 46—its lowest point since 2009.
Direct expenses were “the most notable” influence on that score, the report stated, increasing 13.1% after large bonuses and multiple associate pay scale increases went into effect. Overhead also increased 9.9% overall, on the back of staggering increases in recruiting (121.3%), business and marketing development (75%), office expenses (31.1%) and support staff benefits (13.4%), among others.
Along with inflation, which is currently outpacing the 5% billing rate growth in the industry, a 5.7% decline in M&A and a relatively cool 2.2% increase in corporate work, firm profitability is on “shaky” footing, said Bill Josten, strategic content manager for Thomson Reuters, which produced the financial index report.
“I’m usually loathe to talk about things like profits per equity partner, because it’s so prospective at this point,” Josten said in an interview. “But with all these things combined, if those trends persist throughout the year, that could have a very noticeable impact on the growth potential of profits per equity partner.”
The report noted that in addition to the 2.2% growth in corporate, real estate (7.9%) and labor and employment (1.0%) transactions also increased relative to Q1 last year, and litigation grew 2.2% compared with that period at the start of 2021.
The analysts have previously questioned whether the perpetual compensation increases during Big Law’s war for talent are sustainable, and they reiterated in Monday’s report that it’s “anyone’s guess” how long the cycle will last. Regardless, they wrote, the recent increases “will likely be felt for several quarters to come,” the report stated.
Josten noted that some of the overhead expenses dropped so precipitously during the pandemic that any type of recovery would show a large growth factor, and that on a dollars per lawyer basis, those expenses still hadn’t recovered to where they were leading into 2020.
They may not get all the way there, he added. But he noted they’ve still got room to grow even further. “I think that’s almost inevitable, that we’ll see increases in overhead expenses,” he said.
Josten said analysts will continue to key in on those costs, as well as the costs of talent and the trajectory of transactional work throughout 2022. The report concluded by noting there were multiple “anomalous” results calculated in this quarter, such as the triple-digit growth figure for recruiting expenses, that would have been excluded as outliers in previous versions of the report.
“Indeed, 2022 is setting some odd precedents, and indications are that we likely have not seen the last of these complex shifts,” the report stated. “If these trends continue unabated, law firm profitability growth could mirror the index’s downward plunge.”