Law firms are not guaranteed another profitable year despite strong demand and rate increases

Many law firms enjoyed tremendous financial success in 2020 despite the pandemic. Although demand for law firm services at its nadir was 5.9% lower than the same period in 2019, profits per equity partner in midsize firms finished the year up approximately 6%, according to Thomson Reuters data. How did firms pull that off? Two efforts were crucial: stabilizing revenue through substantial rate increases, and significant savings in overhead expenses. A year later, with disruptions receding and economic optimism taking their place, expectations to maintain high profit margins persist. Now, though, the sharp rebound of overhead and direct expenses represents a serious threat. Firms are responding by prioritizing performance improvement strategies for existing clients and operations, as opposed to investing in new business. Specifically, firms are seeking to control costs using technology solutions—an endeavor that comes with a separate set of challenges but also some benefits that executives are seeing in a new light.

New dynamics, high expectations

After 18 months of managing profit through uncertain times, the days of low revenues are coming to an end. Demand for legal services in the third quarter of 2021 was 4.4% greater than the same period last year, following second-quarter year-over-year demand growth of 7.3%, according to Thomson Reuters. Additionally, RSM’s Middle Market Index reached an all-time high of 145.5 in the third quarter, showing that middle market business conditions point to continued robust economic growth, rising revenues and net earnings. We do expect this optimism to level out slightly in the fourth quarter, as frustrations over prolonged labor market supply challenges and inflationary pressures are proving to be persistent challenges. But optimism will remain relatively high as firms continue to adapt their internal operations to capture the strong demand. That said, there’s no guarantee that strong demand and rate increases will result in another year of record profits for law firms. A return to normal also means a return of costs. Direct expenses in the third quarter increased 7.2% from the same period last year, a jump Thomson Reuters attributes to increased associate compensation. Meanwhile, year-over-year overhead costs grew in the third quarter (1.1%) for the first time this year. And costs are expected to continue to rise through the remainder of the year. The increase in expenses is largely driven by how firms are reacting to higher associate salaries and a hot labor market—58% of all middle-market companies already have increased compensation and 70% intend to increase it further, according to the third-quarter RSM US Middle Market Business Index survey. Additionally, overhead expenses, such as travel and business development costs, are being reintroduced as workplaces continue to open. But the bar of high profits has been set. If firms could maintain profitability during the crux of a pandemic, why can’t they do so this year under more favorable conditions? That is the expectation, anyway, and to protect profit margins, we see a shift in law firm executives’ strategic priorities.

Prioritizing improvements over expansion

Although demand and optimism are increasing, a recent Thomson Reuters survey indicated law firm executives intend to prioritize higher margins on existing work over investing in aggressive expansion tactics in the near future. In the two charts immediately below, you can see the notable focus on various performance improvement strategies within existing client operations. Managing expenses will also be a main focus, according to the survey. Many costs—business development and travel, for example— decreased because of the pandemic environment, not because of firm policy or strategic planning. As those expenses return naturally, executives realize they need to be controlled in order to maintain 2020 margins. So where are law firms targeting cost control? Two areas stand out: updating and repurposing existing real estate, and the operational efficiencies and cost savings achieved through technology enablement. The investments in technology are potentially transformational as more executives begin to appreciate how it can help their firms beyond cutting costs. In Part 2 of this blog post, we examine how firms are embracing those additional benefits and what this means for the sector.