Firm Financials, Talent War Cooling?, and Scaling Up
Thomson Reuters’ Law Firm Financial Index (“LFFI”, formerly the Peer Monitor Index) measures drivers of law firm profitability for over 160 firms on a quarterly basis and assigns a composite score representing the change in those drivers compared to the same quarter the previous year; growth in factors driving revenue contribute to a higher score; growth in expenses contribute to a lower score.
The LFFI composite score for Q1 2022 represents the lowest quarterly score since 2009 (Law Firm Profits May ‘Plunge’ This Year Amid M&A Slowdown and Expense Growth, Andrew Maloney, 5/9/22, The American Lawyer). However, the underlying fundamentals are not nearly as negative as the score and associated reporting suggest. First, the LFFI measured demand growth against Q1 2021, which set an incredibly high baseline. Second, although M&A demand was down (-5.7%), several other practices experienced demand growth, leading to overall demand growth of 2.7% over Q1 2021: Real Estate (7.9%), Litigation (2.2%), Corporate (2.2%), Labor & Employment (1.0%), and IP (.02%). Third, rates increased 5% compared to Q1 2021. Fourth, although overhead expenses increased significantly compared to Q1 2021, they still have not reached pre-pandemic levels on a per attorney basis (Law Firm Financial Index Q1 2022 Executive Report (“LFFI Q1”), 5/2/22, Thomson Reuters).
One underlying metric that may ultimately weigh down profits is the substantial increase in direct expenses (compensation & benefits to non-equity attorneys). These expenses were up 13.1% compared to Q1 2021, in a quarter that included successive adjustments to the “Cravath” pay-sale and massive year-end bonus payouts. Associate compensation grew 12.1% among the 160 firms measured in the LFFI; AmLaw 100 firms saw the most growth at 17.3%, followed by firms in the Second Hundred at 12.3% and Midsize firms at 7.4% (LFFI Q1). These compensation increases will likely be the biggest threat to profit growth in the short- and long-term.
Talent War Cooling?
Nationally, 4,713 associates moved in Q1 2022, down 5% from last year’s mark of 4,964, but still far exceeding the 5 year average of 2,459 moves by 92% (Associate Lateral Moves in the First Quarter Remain Strong, Patrick Smith, 4/22/22, American Lawyer, citing Decipher Legal Intelligence). Despite the strong quarter, there are signs that the war for talent is cooling some: 1) job postings offering 100% remote work are declining; 2) firms are reportedly reducing hours of summer associates whom they had kept on as law clerks post-summer to ease associate workload in the Fall and Winter; 3) there is less hiring from non-traditional sources like Canadian and Australian associates. 4) Signing bonuses are beginning to deflate a little (Signing Bonuses and Associate Hiring Cool Down, as Law Firms Prioritize ‘Quality over Quantity”, Jessie Yount, 4/20/22, The Recorder).
Still, the associate lateral market remains active and competition for talent continues. Current 4th year associates represent the smallest law school enrolling class since 1973, which limits supply of coveted mid-levels. And partners are increasingly viewing associate resources as a major consideration in evaluating a potential move.
Scaling Up
Law firm leaders in three recent mergers of midsize law firms cited as the impetus for merging “the demand to build deeper and broader expertise, for attracting top talent and clients and competing against larger firms” (Competition and Talent Pressures Spark Run of Midsize Law Firm Mergers, Andrew Maloney, American Lawyer, 5/4/22). Merger consultancy Fairfax Associates found 62% of the announced mergers from Q1 involved at least one firm with 5 - 20 lawyers. Fairfax consultant Lisa Smith expects these trends to continue as firms seek to scale up to keep pace with BigLaw’s offerings and to become “a credible choice for the board” and “a safe choice for the client, particularly if they are moving work from a larger firm.”
Scaling up can also help to protect against poaching by larger firms. Consultant Peter Zeughauser notes that net income of larger firms allows them to pick off select groups from relatively smaller firms, even when those smaller firms have had a series of highly profitable years in a row (‘The Nature of the Beast’: Lateral Group Moves Gain More MomentumAndrew Maloney, 4/21/22, The American Lawyer). Indeed, there have been several large practice group acquisitions so far this year of 43, 27, 24, 16, and 11 attorneys respectively, and all but one of these groups moved to a relatively larger firm.
