By Thomson Reuters
Editor’s note: The following information is based on the U.S. market, but we present it here as an FYI for Canadian law firms.
The year ahead is likely to be fraught with numerous challenges and uncertainty for law firms, according to the 2023 Report on the State of the Legal Market, issued today by the Center on Ethics and the Legal Profession at Georgetown Law and the Thomson Reuters Institute.
Although 2022 yielded reasonably good financial results for law firms, 2023 will likely involve multiple headwinds, such as slowing demand, less client spend optimism, higher expenses, falling productivity, weakening realization, and inflation. In addition, client work may be shifting, threatening to reshuffle the hierarchy of the law firm market.
Profits-per-equity partner (PPEP) soared to record levels in 2021. But PPEP fell 4.2% for the 12 months ending November 2022. When financial books close for 2022, it will likely be the first full-year drop for PPEP since 2009. The report states partners “may feel significantly less well-off than in 2021” when combined with effects of inflation.
“After finding ways to endure and even thrive through the effects of the pandemic, law firms now face a confluence of factors that look to make 2023 a challenging year,” said James W. Jones, a senior fellow at the Center on Ethics and the Legal Profession at Georgetown Law and the report’s lead author. “Firms are being confronted with issues ranging from slowing demand to record-low productivity, all of which could have significant impacts on their economic and institutional health in 2023 and beyond.”
Falling Demand, Client Spend Optimism
Law firms saw a substantial slowing in demand for their services throughout 2022. Demand fell by an average of 0.1% in 2022 through the end of November, and will likely finish the year in negative territory, compared with the robust 3.7% rebound in growth for all of 2021. The report attributes this collapse in demand primarily to a sharp contraction in transactional work, such as M&A, brought about by growing economic uncertainty. This has particularly impacted larger firms, such as the Am Law 100, where demand has fallen “precipitously.”
Looking ahead, although legal department optimism for 2023 remains positive, it has been trending downward over the last several months.
Market Shifts Towards Midsize
Midsize firms stood alone among the market segments in seeing demand growth in 2022. The report describes this apparent willingness by clients to move work in search of high-quality but more cost-effective counsel as “striking.” While larger firms saw stark deterioration in all practices, midsize firms were increasingly competitive, especially in litigation, labor & employment, and intellectual property.
Falling demand and higher lawyer headcount combined to significantly reduce productivity. While average hours worked per lawyer has been steadily declining for more than 20 years, it fell sharply in 2022, reaching the lowest level ever recorded by Thomson Reuters Financial Insights, an average of 119 billable hours per month.
The report calculates this means the average lawyer billed $98,000 less in total fees than a comparable lawyer in 2007, based on average rates for 2022.
Competition for talent and other rising expenses continue to be a drag on profitability. Following record increases in lawyer compensation in 2021 and 2022, revenue growth per full-time equivalent (FTE) is not keeping pace. Both direct and overhead expenses are rising at double-digit rates, the highest since 2009, as a result of factors including higher talent compensation, return-to-office expenses, business-development costs, and inflation. The report cautions that “in an environment where revenue generation is slowing, such an expansion in expenses is alarming should it continue.”
Rates Hindered By Inflation, Falling Realization
While firms managed strong 4.8% growth in worked rates for 2022 through the end of November, it was largely overtaken by inflation. By comparison, the Federal Reserve’s personal consumption expenditures price index was up 5.0% through the same period. The report warns that while firms may be able to tolerate this divergence for a while, the situation is not sustainable long-term.
At the same time, after rising steadily for the previous two years, collection realization has begun to level out or decline across all segments of the market. The report suggests this could be due to firms losing their focus on billing discipline or clients pushing back on invoices and payment cycles, or both.
Firms Need to Examine All Aspects
“Market conditions are becoming increasingly complicated and dynamic, especially as the global economic outlook remains highly uncertain, creating concerns about the financial backdrop for the legal market,” said Paul Fischer, president, Legal Professionals, Thomson Reuters. “Law firms need to closely examine all aspects of their business – including talent management, practice management, workflows, operations, and finances – and employ the necessary solutions and technology in order to successfully navigate the year ahead.”
The 2023 Report on the State of the Legal Market is issued jointly each year by the Center on Ethics and the Legal Profession at Georgetown Law and the Thomson Reuters Institute. The report – relying on data from Thomson Reuters – reviews the performance of U.S. law firms and breaks down the factors that drive the need for firms to take a longer-range, more strategic view of their market positions.
Download the 2023 Report on the State of the Legal Market here.
The Center on Ethics and the Legal Profession at Georgetown Law is devoted to promoting interdisciplinary research on the profession informed by an awareness of the dynamics of modern practice; providing students with a sophisticated understanding of the opportunities and challenges of a modern legal career; and furnishing members of the bar, particularly those in organizational decision-making positions, broad perspectives on trends and developments in practice.
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