Law Firms Gain, But With Big Caveat

Law firms are back ' sort of.

Revenues and profits were up by nearly 10% in 2004, a clear sign that firms have shaken off the tech bust slump.

But even as the biggest legal shops are reaping the harvest of a buoyant economy, they face some difficult choices ahead to maintain revenues ' and to grow profits.

Those are the findings of a confidential Citigroup Private Bank study of firm finances obtained by Legal Times, the Washington, DC-based weekly legal newspaper sibling of LFP&BR. Though it doesn't name specific firms, the annual Citigroup study is based on the financial performance of 143 law firms across the country and is considered by law firm managers as one of the most important barometers of the state of the legal business.

The 2004 study gave firms high marks for improving overall profitability and holding the line on expenses. The challenge lies in how firms achieved revenue growth: hiking rates and squeezing additional billable hours out of their attorneys.

Rate increases accounted for two-thirds of the revenue gains made in 2004. But firms face mounting pressure from clients to rein in costs. Hiking fees by 6% may not be so easy in the years ahead.

And there are only so many hours an attorney can bill. Firms have kept a lid on head count, but if they want to keep revenues climbing, they may need to hire more lawyers or dump less-lucrative clients and practices, the study says.

The study “is a warning sign that this increase in revenues and profitability might not be sustainable,” says Steve Nelson, an Arlington, VA-based consultant with the legal recruiting firm McCormick Group. “There are only so many big clients who are going to pay these rates to go around.”

Rate Pressure

Although companies have pushed law firms to pare down on rates for more than a decade ' ever since DuPont began scaling back on outside legal costs ' law firms have continued to issue 6%-8% rate hikes.

But clients' willingness to accept rate hikes at more than double the pace of inflation “may be finally coming to an end,” the study's accompanying analysis warns. Indeed, last year's rates increased at a slower pace than in 2003, the study shows.

Fortune 100 companies like General Electric Co. are leading the push against unfettered rate increases. In 2003, the Connecticut-based company began winnowing law firms through an online auction for legal work in its financial services sector. Last year, GE extended the program to the entire company.

Efforts like these are forcing law firms to rethink their rate structures, the study says. According to the study, firms are increasingly entering into contracts that limit rate hikes or mandate a fixed fee. They are offering so-called bulk discounts for companies that beef up the size of work they offer law firms. And some firms are weeding out clients that are not as profitable or that conflict with the firm's growth strategy.

No doubt, rates will continue to climb. And when it comes to bet-the-company legal work, general counsel are more than willing to pay whatever the price, says Susan Hackett, senior vice president and GC of the Association of Corporate Counsel.

But for more-run-of-the-mill work like licensing, trademarks and insurance defense practices, where specialization and prestige have less effect on the outcome, cost-cutting pressures will exact the highest toll, the study's analysis says.

Scott MacKay, an associate general counsel with Lockheed Martin Corp., explains it this way: He's willing to pay $750 an hour for Seth Waxman – the former solicitor general who is now a Wilmer Cutler Pickering Hale and Dorr partner and Supreme Court advocate – to argue an important case. But he says he's unwilling to pay that price if the firm is doing “an internal investigation for 6 months.”

Still, Ward Bower, a consultant with Altman Weil Inc., says clients are not running away from high billing law firms in any significant number.

And even some law firms acknowledge that rate hikes can only do so much to boost the bottom line. Covington & Burling managing partner Stuart Stock says that much of his firm's 8% revenue growth in 2004 stemmed from more work and more billable hours. “Rate increases are not going to be the way that over the long term you change your economic results,” Stock says.

Looking Inward

If firms are unable to continue the pace of rate increases, they will have to find a way to perform more efficiently.

Law firms made inroads on this score last year, increasing average attorney hours by 1.8% to 1757 hours, the study shows. Meanwhile, they were doing it with fewer lawyers. Hiring was at its lowest point in a decade ' with head count increasing just 1.5% in 2004.

The phenomenon was particularly pronounced among DC-based firms where head count remained unchanged from 2003, according to information gleaned from the 14 Washington, DC-based firms in the study and broken out from the national numbers in a regional sampling of data. The reason: The DC offices of out-of-town firms are increasingly snagging lawyers in the Washington market, law firm consultants say.

Still, the Citigroup study argues that firms can squeeze more billable hours out of their lawyers and, perhaps, reach the 1900-plus hours billed on average during the height of the tech boom in 1999 and 2000.

Consultants aren't so sure. They say it's unclear whether firms will be able to regain the momentum of the tech boom when profits were soaring and lawyers seemed able to bill limitless hours. They point to younger attorneys who tend to opt for lower pay in exchange for a more manageable workload. This accounts for some of the 3.5% drop in associate ranks at law firms last year.

“It used to be 20 years ago that when a person who graduated from law school went to a firm, [his/her] goal was to make partner,” Nelson says. “Now the goal is to put a few years in and get a good in-house job.”

But firms have found ways other than through billable hours to eke out higher profits. End-of-the-year debt was down 17.2%. (“There is a little bit of a post-Brobeck sensitivity,” says the study's author, Danilo DiPietro, client head of Citigroup Private Bank's Law Firm Group, when contacted about the study.) Technology upgrades and outsourcing have also cut down on some overhead costs. And guarding the entry to the equity partnership has boosted profits for the top brass.

Firms are also starting to tweak their compensation systems to entice and retain top rainmakers. Some have increased their partner bonus pools to reward high-billing partners.

Others, like Arnold & Porter and Arent Fox ' which have historically limited the pay differences between top- and bottom-earning partners ' have recently raised the maximum amount the biggest rainmakers can earn for the first time in years, according to partners at both firms.

Small Firm Catch-Up

The study also shows that smaller firms are attempting to play catch-up on rates and profits with their larger rivals.

Rates grew by 6.7% among firms ranked in the second half of the Am Law 200 ' the annual ranking of the highest-grossing U.S. law firms compiled by The American Lawyer magazine. That exceeds the average increase among the top 100 firms. Similarly, profits per partner rose 16% among the second-tier firms ' a significantly higher rate than the top 100.

Whether the second hundred firms will continue to outstrip their larger peers is uncertain, DiPietro says.

Much of the second-tier firms' growth has come from their strength in litigation ' one of the biggest sources of last year's work, DiPietro says.

In 2005, corporate mergers and acquisitions are likely to generate more work, and, says DiPietro, “the [second] 200 firms don't tend to be M&A go-to firms.”

Whatever happens, DiPietro sees a healthy year ahead. The challenges of balancing rates and productivity won't depress profits right away. Or as the Citigroup analysis puts it: “2005 is shaping up as a busy and successful year for most law firms, although there are some clouds on the horizon.”

Law firms are back ' sort of.

Revenues and profits were up by nearly 10% in 2004, a clear sign that firms have shaken off the tech bust slump.

But even as the biggest legal shops are reaping the harvest of a buoyant economy, they face some difficult choices ahead to maintain revenues ' and to grow profits.

Those are the findings of a confidential Citigroup Private Bank study of firm finances obtained by Legal Times, the Washington, DC-based weekly legal newspaper sibling of LFP&BR. Though it doesn't name specific firms, the annual Citigroup study is based on the financial performance of 143 law firms across the country and is considered by law firm managers as one of the most important barometers of the state of the legal business.

The 2004 study gave firms high marks for improving overall profitability and holding the line on expenses. The challenge lies in how firms achieved revenue growth: hiking rates and squeezing additional billable hours out of their attorneys.

Rate increases accounted for two-thirds of the revenue gains made in 2004. But firms face mounting pressure from clients to rein in costs. Hiking fees by 6% may not be so easy in the years ahead.

And there are only so many hours an attorney can bill. Firms have kept a lid on head count, but if they want to keep revenues climbing, they may need to hire more lawyers or dump less-lucrative clients and practices, the study says.

The study “is a warning sign that this increase in revenues and profitability might not be sustainable,” says Steve Nelson, an Arlington, VA-based consultant with the legal recruiting firm McCormick Group. “There are only so many big clients who are going to pay these rates to go around.”

Rate Pressure

Although companies have pushed law firms to pare down on rates for more than a decade ' ever since DuPont began scaling back on outside legal costs ' law firms have continued to issue 6%-8% rate hikes.

But clients' willingness to accept rate hikes at more than double the pace of inflation “may be finally coming to an end,” the study's accompanying analysis warns. Indeed, last year's rates increased at a slower pace than in 2003, the study shows.

Fortune 100 companies like General Electric Co. are leading the push against unfettered rate increases. In 2003, the Connecticut-based company began winnowing law firms through an online auction for legal work in its financial services sector. Last year, GE extended the program to the entire company.

Efforts like these are forcing law firms to rethink their rate structures, the study says. According to the study, firms are increasingly entering into contracts that limit rate hikes or mandate a fixed fee. They are offering so-called bulk discounts for companies that beef up the size of work they offer law firms. And some firms are weeding out clients that are not as profitable or that conflict with the firm's growth strategy.

No doubt, rates will continue to climb. And when it comes to bet-the-company legal work, general counsel are more than willing to pay whatever the price, says Susan Hackett, senior vice president and GC of the Association of Corporate Counsel.

But for more-run-of-the-mill work like licensing, trademarks and insurance defense practices, where specialization and prestige have less effect on the outcome, cost-cutting pressures will exact the highest toll, the study's analysis says.

Scott MacKay, an associate general counsel with Lockheed Martin Corp., explains it this way: He's willing to pay $750 an hour for Seth Waxman – the former solicitor general who is now a Wilmer Cutler Pickering Hale and Dorr partner and Supreme Court advocate – to argue an important case. But he says he's unwilling to pay that price if the firm is doing “an internal investigation for 6 months.”

Still, Ward Bower, a consultant with Altman Weil Inc., says clients are not running away from high billing law firms in any significant number.

And even some law firms acknowledge that rate hikes can only do so much to boost the bottom line. Covington & Burling managing partner Stuart Stock says that much of his firm's 8% revenue growth in 2004 stemmed from more work and more billable hours. “Rate increases are not going to be the way that over the long term you change your economic results,” Stock says.

Looking Inward

If firms are unable to continue the pace of rate increases, they will have to find a way to perform more efficiently.

Law firms made inroads on this score last year, increasing average attorney hours by 1.8% to 1757 hours, the study shows. Meanwhile, they were doing it with fewer lawyers. Hiring was at its lowest point in a decade ' with head count increasing just 1.5% in 2004.

The phenomenon was particularly pronounced among DC-based firms where head count remained unchanged from 2003, according to information gleaned from the 14 Washington, DC-based firms in the study and broken out from the national numbers in a regional sampling of data. The reason: The DC offices of out-of-town firms are increasingly snagging lawyers in the Washington market, law firm consultants say.

Still, the Citigroup study argues that firms can squeeze more billable hours out of their lawyers and, perhaps, reach the 1900-plus hours billed on average during the height of the tech boom in 1999 and 2000.

Consultants aren't so sure. They say it's unclear whether firms will be able to regain the momentum of the tech boom when profits were soaring and lawyers seemed able to bill limitless hours. They point to younger attorneys who tend to opt for lower pay in exchange for a more manageable workload. This accounts for some of the 3.5% drop in associate ranks at law firms last year.

“It used to be 20 years ago that when a person who graduated from law school went to a firm, [his/her] goal was to make partner,” Nelson says. “Now the goal is to put a few years in and get a good in-house job.”

But firms have found ways other than through billable hours to eke out higher profits. End-of-the-year debt was down 17.2%. (“There is a little bit of a post-Brobeck sensitivity,” says the study's author, Danilo DiPietro, client head of Citigroup Private Bank's Law Firm Group, when contacted about the study.) Technology upgrades and outsourcing have also cut down on some overhead costs. And guarding the entry to the equity partnership has boosted profits for the top brass.

Firms are also starting to tweak their compensation systems to entice and retain top rainmakers. Some have increased their partner bonus pools to reward high-billing partners.

Others, like Arnold & Porter and Arent Fox ' which have historically limited the pay differences between top- and bottom-earning partners ' have recently raised the maximum amount the biggest rainmakers can earn for the first time in years, according to partners at both firms.

Small Firm Catch-Up

The study also shows that smaller firms are attempting to play catch-up on rates and profits with their larger rivals.

Rates grew by 6.7% among firms ranked in the second half of the Am Law 200 ' the annual ranking of the highest-grossing U.S. law firms compiled by The American Lawyer magazine. That exceeds the average increase among the top 100 firms. Similarly, profits per partner rose 16% among the second-tier firms ' a significantly higher rate than the top 100.

Whether the second hundred firms will continue to outstrip their larger peers is uncertain, DiPietro says.

Much of the second-tier firms' growth has come from their strength in litigation ' one of the biggest sources of last year's work, DiPietro says.

In 2005, corporate mergers and acquisitions are likely to generate more work, and, says DiPietro, “the [second] 200 firms don't tend to be M&A go-to firms.”

Whatever happens, DiPietro sees a healthy year ahead. The challenges of balancing rates and productivity won't depress profits right away. Or as the Citigroup analysis puts it: “2005 is shaping up as a busy and successful year for most law firms, although there are some clouds on the horizon.”