Forum Magazine: The Lure of Failing Strategies

Topics: Business Development & Marketing Blog Posts, Client Relations, Data Analytics, Efficiency, Forum Magazine, Law Firms, Midsize Law Firms Blog Posts, Thomson Reuters

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In the recently released 2018 Report on the State of the Legal Market, produced by the Thomson Reuters Legal Executive Institute and the Georgetown Law Center for the Study of the Legal profession, principal authors James W. Jones and Milton C. Regan wrote of the lure of failing strategies.

During the 1930s, the French government constructed a massive line of fortifications along its borders known as the “Maginot Line.” While designed to protect France and ensure French victory, in reality the German army simply went around or flew over the Line.

Recent scholarship argues that the true failure came from the failure of the French to understand that the nature of warfare had fundamentally changed. They assumed that the next war would be like the last one. They failed to understand that the German Wehrmacht was operating with a dramatically different playbook.

It is not uncommon for organizations of all kinds — including law firms — to suffer from such strategic blind spots and remain committed to once successful strategies even as evidence mounts of their failure.

This a particularly apt description of many law firms in today’s rapidly changing market.  Ignoring strong indicators that their old approaches are no longer working, they choose to double down rather than risk change. Like the French military in the 1930s, they are ready to fight the last war but, unfortunately, not to meet the challenges barreling toward them.

Current State of the Legal Market — By the Numbers

Broadly speaking, it appears that law firm financial performance in 2017 represents “more of the same” from recent years with sluggish growth in demand for services, continuing decline in productivity, relatively modest increases in rates, continuing downward pressure on realization and some upward pressure on direct expenses.

Demand Growth — Demand growth for law firm services, as tracked by Thomson Reuters Peer Monitor®,[1] was essentially flat in 2017. This continues a seven-year pattern and stands in stark contrast to the 4% to 6% annual growth in demand experienced in the legal market prior to 2008. Demand growth was slightly positive for Am Law 100 firms, remained flat for Midsize firms and declined noticeably for Am Law Second 100 firms.

In terms of specific practices, demand growth was slightly positive in corporate practices, tax and IP litigation, but was negative in all other fields, most particularly general litigation, which represents some 30 percent of all practice activity. Most firms have seen demand for their litigation services decline for several years, but during 2017 the pace of decline accelerated.

Productivity — During 2017, the number of lawyers in US firms grew modestly by 1.3%.  Coupled with flat demand growth, however, even this small increase in head count resulted in a continuing decline of productivity across the market.[2]

Currently, billable worked hours per month are some 13 total hours below the level from 2007.  That represents a total of 156 billable hours per year.  At an average hourly worked rate for all lawyers of $475, this indicates a cost to firms of about $74,100 per lawyer per year.

Rates and Realization — During 2017, law firms raised their standard rates by a fairly modest 3.1%.  More importantly, their worked (or agreed) rates grew by an average of 3%. Am Law 100 firms increased their rates by a significantly greater percent than their Am Law Second 100 or Midsize firm counterparts.

As in previous years, rate increases were met with push-back from many clients.  Consequently collection realization against standard rates continued to decline. However, realization measured against worked rates seems to have largely leveled off since 2013.

Expenses — A modest overall growth in direct expenses was attributable primarily to the jump in associate compensation, especially among Am Law 100 firms. By contrast, indirect expenses shrank modestly.[3] Overall, since 2012, firms have done a good job managing their expenses, in sharp contrast to practices prior to the Great Recession.

Leverage — Leverage[4] across the market remained essentially unchanged from the beginning of the decade.

Billing and Collection Cycles — Changes in the billing and collection cycles of law firms remained essentially flat, indicating that most firms continued to manage their accounts receivable fairly well.

Profit Margins — Law firm profit margins[5] on average across the market were essentially flat during 2017. With rare exceptions, the trend for profit margins has been slightly downward since 2007.

So, What Can Be Done?

A very interesting study released by Thomson Reuters Legal Executive Institute in November 2017, and based on Peer Monitor data, analyzed the performance of firms across the market during 2014, 2015 and 2016 based on their compound annual growth in revenue per lawyer and total profit (net income before distributions to equity partners), and their average change in profit margin.[6] Those firms that fell into the top quartile were designated as “dynamic firms,” and those that fell into the bottom quartile as “static firms.”

Interestingly, factors like size; leverage; firm location; or a firm’s regional, national or global footprint did not seem to make a difference.[7] Also, dynamic firms increased their rates at the same pace as the average for the entire market and only slightly more aggressively than static firms, so rate growth made little difference.[8]

So, what did matter? Dynamic firms had a substantially higher realization than their static counterparts. Additionally, while both populations saw a comparable percentage of their revenue from alternative fee arrangements (AFAs) at around 25%, 75% of the dynamic firms reported they proactively pursued AFAs with their clients, while 70% of the static firms said they offered AFAs only in response to client requests.[9]

One difference between the two groups may be counter-intuitive. Dynamic firms increased their overhead expenses in almost every category in 2016, while static firms cut their expenses in many areas. Two areas stood out: (i) marketing and business development expenses; which dynamic firms increased by 4.6% compared to a 1.8% increase by static firms; and (ii) investments in technology, which dynamic firms grew by 3.2% while static firms added only 1.2%, all on a per-lawyer basis.[10]

Dynamic firms reported that increased expenses in business development were designed to facilitate more client interactions and direct client meetings, business development coaching for lawyers and brand development. Dynamic firms said their technology investments were focused on improving workflow efficiency, as well as enhancing their ability to assess profitability and better analyze data.[11]

The market for law firm services is being transformed. Firms that respond proactively to these changes have every prospect of doing well. But firms that choose to ignore them may find themselves trapped in outmoded strategies and operating models that, like the Maginot Line, will fall well short of their intended results.


Notes

[1] Thomson Reuters Peer Monitor data (“Peer Monitor data”) are based on reported results from 168 US-based law firms, including 56 Am Law 100 firms, 47 Am Law Second 100 firms and 65 additional Midsize firms.

[2] “Productivity” is defined as the number of billable hours worked by lawyers divided by the total number of lawyers.

[3] “Direct expenses” refer to those expenses related to fee earners (primarily the compensation and benefits costs of lawyers and other timekeepers).  “Indirect expenses” refer to all other expenses of the firm (including occupancy costs, administrative and staff compensation and benefits, technology costs, recruiting expenses, business development costs and the like).

[4] For these purposes, “leverage” is defined as the ratio of all lawyers other than equity partners in a given firm to the equity partners in the same firm.

[5] In the present context, “profit margin” means a firm’s net income (total revenue less all expenses but before distributions to equity partners) divided by the firm’s total revenue.

[6] Thomson Reuters Legal Executive Institute, “2017 Dynamic Law Firms Study,” Nov. 2017 (“Dynamic Law Firms Study”). Access the Study at http://legalexecutiveinstitute.com/2017-dynamic-law-firms-study/.

[7] Id. at 2.

[8] Id.

[9] Id. at 7-8.

[10] Id. at 9-10.

[11] Id. at 10.