Will a rise in counter-cyclical practice work and a slowdown in expense growth fuel a recovery in law firms' financial fortunes?
Thomson Reuters Institute’s Law Firm Financial Index (LFFI) experienced a long-awaited rise in the first quarter of this year, ending a year-and-a-half decline. The rise was due to historic rate increases, slower expense growth, and the emergence of counter-cyclical practice areas.
However, the recovery is divergent in nature, with Am Law 100 firms and Midsize firms facing different sets of challenges and exhibiting varying strengths. In addition to improved performance across all major practice areas in Q1 2023, we are seeing the rise of macroeconomic counter-cyclical practices, led by litigation, labor & employment, and bankruptcy, while transactional practices continue to struggle.
Key takeaways in Q1:
The LFFI score improved from last quarter, but remains at historically low levels
Expense growth slowed for firms at the top of the market, but remains a struggle for most other firms
Demand for counter-cyclical practice areas and rate growth increased significantly, resulting in overall financial improvement
The divergent paths
These practices have driven Midsize firms to post the fastest demand growth for three consecutive quarters, as well as seeing better relative performance in transactional practice areas. These firms, however, still struggle with high expense growth, due to their historic hiring.
Am Law 100 firms’ challenges, on the other hand, include the largest demand decline of all tracked segments, primarily driven by a significant shortfall among the Top 50 law firms. However, these firms have found new strength in their ability to slow expenses, which relieves pressure on the LFFI score overall. Layoffs in Q1 appeared at first to be more widespread among Am Law 100 firms, but they remained relatively shallow and factored into direct expenses’ slowing pace.
This bifurcated recovery highlights the current state of the legal industry, with every strength coming with a weakness. Am Law 100 firms’ market-leading worked rate growth has offset some of its demand shortfalls; but in response, these firms’ collection realization against worked rates has declined more than in other segments. Meanwhile, Midsize firms’ headcount and expense expansion surpassed their strong demand and revenue growth, resulting in shrinking productivity and profitability.
Although law firms have not fully recovered from poor operating environment that led to Q4 2022’s all-time low LFFI, all metrics have improved to a certain extent. However, the rise of counter-cyclical practices provides additional caution for economic stability throughout the rest of 2023. The challenges faced by firms of all types could still feel overwhelming, but each segment’s differing trend in hiring and expenses may provide insight into what law firm leaders believe their prospects will be in the near-term and perhaps for the long-term future.