When Will Disruption Hit the Legal Industry?

The early years of the timelines are not surprising: a very strong linkage between the economy (U.S. GDP) and revenue per lawyer (RPL). However, the two uncouple after 2007-09; and while the economy has recovered, RPL remains below its 2007 level. As RPL is a proxy for price realization, these data show: 1) that the market's price trajectory has changed dramatically; and 2) price erosion has occurred because pricing is both below where it was in 2007 and well below where one would expect it to be at this point in the business cycle.

In analyzing cyclical businesses, it's important to look not at short or arbitrary time periods (e.g., five or 10 years), but to look at comparable points in the cycle. Accordingly, the following compares market data across two cycles: 1) between the law world peaks of 2000 and 2007; and 2) between the peaks of 2007 and 2016 (if not actually a peak, 2016 is certainly close to a peak). The analyses adjust for inflation using the consumer price index.

Table 1, below, looks at the fortunes of firms within the Am Law 200 over the course of these two cycles.

The firms are grouped by profitability at the start of the cycle — PPP 1-50 refers to the 50 firms with the highest profit per equity partner (PPP) at the start of the cycle; PPP 51-100 are the 50 firms with the next highest PPP, etc.

The data show that a similar number of firms (29 and 30) discontinued operations in each cycle due to bankruptcy, dissolution, merger into stronger entities, or falling below the Am Law 200 revenue cut off [Table 1(a)]. However, there is a sharp contrast in the number of firms that experienced RPL declines. Seventy-four firms experienced such declines in the second cycle compared with only six in the first cycle, [Table 1(b)]. This shows that the price erosion that we see for law firms in aggregate since 2007 (Figure 1) varies markedly across firms and that, as evidenced by the slightly higher number of firms in the PPP 1-50 and PPP 51-100 cohorts that have experienced RPL declines, it affects higher-profit firms slightly more than lower-profit firms. Said differently: the erosion of price realization that economics tells us to expect is in fact occurring, is concentrated in a subset of firms, and is hitting firms of all profit levels.

So why aren't partners feeling the pressure more? A piece of the answer is that law firms have been able to mitigate the impact of price erosion on profitability. As Tables 1(b) and 1(c) show: in the first cycle, roughly the same number of firms experienced price erosion (RPL) and profitability (PPP) declines; in the second cycle fewer firms have suffered a decline in profitability than have suffered price erosion. There seem to have been two major levers in mitigating the effect of price erosion on profitability: cost reduction and nonequity partner changes.

On cost, as Table 2, below, shows, while firms of all profitability levels increased cost-per-lawyer over the first cycle, they slowed this growth dramatically through the second cycle.

Indeed the 100 most profitable firms (the PPP 1-50 and PPP 51-100 cohorts) actually reduced average cost-per-lawyer. This probably reflects that it is easier for the more profitable firms to lower costs because they are typically starting from a higher cost position than their lower-profitability counterparts and thus have more to trim.

The dynamics with nonequity partners are subtler. As shown in Table 3(a), below, firms grew their nonequity cohorts dramatically over the first cycle (plus 13 percentage points in aggregate) and significantly, but less strongly (plus 7 percentage points), over the second cycle. Given the more intense profit pressure in the second cycle, one might have expected a greater second-cycle increase in nonequity partners. It may be that there's a natural limit on the percent of partners in the nonequity ranks — a repeat of the first-cycle percentage point increase in the second cycle would have led to almost equal numbers of nonequity and equity partners across the Am Law 200. A second nonequity partner dynamic is more-obviously consistent with intensified profit pressure: nonequity partner compensation grew more slowly in the second cycle than in the first, [Table 3(b)]. Indeed, for the 100 most profitable firms, nonequity partner compensation declined. A reduction in nonequity partner compensation is essentially a transfer from the nonequity partners into the firm profit pool and thence to equity partners.

Looking Forward

We are in the eighth year of an economic expansion. The average expansion since 1945 lasted 4.9 years, so the next downturn cannot be far away. When it hits, the effects on law firms will be more severe than last time. The reasons for this are twofold: 1) clients are more adept at taking work away from high-priced law firms and at pushing for price concessions; and 2) law firms are less well-positioned to offset the profit impact of revenue losses through cost reductions and nonequity partner changes as they've been pulling on these levers for almost a decade.

Table 4, below, lays out a thought experiment: what would happen if, when the next downturn hits, the industry suffers the same decline in revenue per lawyer as last time but is unable to offset it to the same degree through cost reduction and growth in equity partner leverage?

The left side of the table shows Big Law's financial drivers at the peak prior to the last downturn (2007) and then 5 years later — RPL was still 9% below the peak but, because cost per lawyer fell 11%, profit per lawyer was down only 7%. At the same time equity partner leverage rose 7% (driven predominantly by growth of the nonequity partner ranks) so that PPP was down only 2%. The right side shows a model of the next downturn: RPL falls the same as in the last downturn, but the cost reduction and leverage increase are lower (shown at a 2% decrease and increase, respectively). The model suggests a decline in PPP of almost 20%.

Obviously, the thought experiment is not a forecast. But it is instructive. It shows that the average profitability hit from the next downturn will be severe. As in the past, it will play out differently by firm — those with the more-focused and stronger positions will be hit less; those with broader positions and expansion efforts that haven't attained profitability will be hit harder. In a run-on-the-bank type of dynamic, this will lead to the implosion of the harder-hit firms in varying forms — dissolution, bankruptcy, forced mergers, etc. Then, alas, law firm partners will have an all-too keen sense that disruption is happening.

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Hugh A. Simons is an ALM Intelligence fellow. He is formerly a senior partner and executive committee member at The Boston Consulting Group and chief operating officer at Ropes & Gray. He is currently conducting research for a book on elite law firm strategy. He can be reached at [email protected]. Nicholas Bruch is a senior analyst at ALM Legal Intelligence. His experience includes advising law firms and law departments in developing and developed markets on issues related to strategy, business development, market intelligence, and operations. He can be reached at [email protected] or on Twitter @NicholasBruch.