In the fourth quarter, the Law Firm Financial Index (LFFI) dropped to a new all-time low score, highlighting the challenges that large law firms continue to face
Resuming its six-quarter slide, the Thomson Reuters Law Firm Financial Index (LFFI) recorded its worst score in the Index’s history, only seven quarters removed from its highest score of all time. While significant challenges and obstacles have hampered firms in 2022, there are signs that firms may fare better in 2023.
Key takeaways in Q4:
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- Demand contracted at a historic rate as firms were measured against the peak demand of Q4 2021. Data suggests that certain firms within the Am Law 100 may be recovering.
- Issues with demand combined with continued hiring brought productivity to an all-time low during a time when associate compensation is as costly as ever.
- Expenses have improved, with welcomed signs of slowing growth rates.
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The demand dilemma
Firms’ struggles to log hours came mainly from two sources: declining demand from clients, and tall baselines to overcome. Whereas transactional demand (a combination of corporate general, mergers & acquisitions, tax, and real estate practices) was strong relative to pre-pandemic levels at the start of 2022, this demand tapered off steadily over the course of the year.
With non-transactional demand fighting to recover to its pre-pandemic level, law firms that were already having difficulty measuring up to last Q4 now had a tougher row to hoe. That was made even more difficult because the final quarter of 2021 was also one of the busiest for firms on record, with a glut of transactional demand lifting the large law firm industry into record profitability. Not surprisingly, having to measure from firms’ current valley against this peak put the LFFI on route to its new all-time low score.
Further, continued hiring throughout 2022 brought in a fresh class of associates at a time when many law firms were already having difficulties keeping their current lawyers busy. This situation of fewer hours being spread around more lawyers resulted in historically low productivity, both in terms of contraction against last year and hours per lawyer per month.
Can there be a turnaround?
Despite all this mostly dismal news, there was evidence that the legal industry — and similarly, the Index — may have hit bottom and could see a turnaround this year.
For example, while expenses continued to grow on-top of the growth firms experienced in 2021 (as both lawyer-based expenses and overhead outpacing worked rate growth in 2022), the average lawyer remains more profitable than they were before the pandemic. Still, the result of this current expense growth is that profit per lawyer effectively erased the gains of 2021, which strongly impacted the Index’s score.
Add into this that the transactional surge has ebbed, non-transactional demand is on the mend (led by some of its largest practices such as litigation and strength among Midsize law firms) and overall demand remains even with pre-pandemic levels, even after Q4’s contraction. The Am Law 100, which has been the segment facing the greatest demand struggles, is also showing signs of recovery within certain pockets.
Expense growth is also showing slowing in its growth across multiple categories, with more of the expense growth coming from the on-boarding of new talent rather than salary increases or inflation like in recent quarters.
Firms are also gearing up for another increase in their rates to boost 2023 revenues. Last year was the first since 2008 in which firms’ pace of worked rate increases fell behind inflation, hampering their bottom lines. While firms are facing issues with realization, potentially because of client pushback, significant rate increases would be a useful tool to stem the decline of profit per lawyer.
Ultimately, the situation surrounding 2023 is too unstable to know for certain if law firms are going to reverse their fortunes. A recovery from the top of the market, slowing expense growth, and another series of rate increases may be enough to pull the LFFI out of its tailspin and send it back into normal territory.
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