Mid-size firms struggle to keep pace

Lawyers celebrating after The Lawyer 100 revealed that firms broke through the £5bn fee income barrier over the last 12 months should pause for thought. The underlying trend for fees and profits shows that increases in these areas have significantly declined.

Last week, a survey by The Lawyer and PricewaterhouseCoopers indicated that fees have only increased for 80 per cent of firms in the past year, which compares to 93 per cent in 1998 and 87 per cent in 1997. And profits have risen for 69 per cent of firms, compared with 81 per cent in 1998.

This is the first year that the percentage of firms increasing their profits has not risen since the UK pulled out of recession in 1996. But this time the economy remains buoyant while the curve of increasing fees and profits is levelling off.

A close look at the figures in the survey shows that size does matter.

Every firm with more than 100 partners continued to increase its fees billed per partner. All firms with 81-100 partners increased their fees but not to the same degree as those with more than 100. It may seem logical that increases in fees drop in steady proportions as the size of firms decrease, but that is not the case.

Firms with 51-80 partners see a decrease in fees for 20 per cent and figures then improve for firms in the 31-50 partner bracket. They see a wholesale increase in fees in similar proportions to firms with more than 100 partners.

Below this level, increases in fees decline in staggered proportions until they hit the band of firms with four or fewer partners, which has a general decrease of 28 per cent.

Profit increases mimic this trend. All firms with more than 100 partners continued to increase their profits. Firms in the 81-100 partner band all increased their profits, but significantly less than firms with more than 100 partners. And firms with 51-80 partners once again see fewer increases. From firms with 50 partners downwards there is a similar decline in the number of firms with profit increases to the pattern established for fee incomes.

What may be concluded from this is that the larger the firm is the more likely it is to be dominant in the marketplace, unless it is in the 51-80 partners band, which appears to hold a cluster of weaker firms.

If we look further than this it appears firms with more than 81 partners are strengthening to the detriment of their smaller counterparts, that is if we assume the amount of work available in the legal marketplace remains constant. Firms in the 51-80 partner band are dropping significantly behind the rest, and firms with fewer than 50 partners are losing ground.

Many lawyers attribute this to growing demand by clients for cheaper but higher quality service from firms, which is cutting the value of work and pushing it up to firms with more resources and experience. As Tony Williams, managing partner of Clifford Chance, says: “As we are seeing in many industries, a top tier of firms are emerging.

“The top tier get the more complex work. They have the depth of resources and they are likely to get the next piece of work because companies are not likely to give that work to firms that do not have a proven track record.”

Williams identifies globalisation as a key factor. He says: “There are many more transactions that are cross-border so they have become more complex. There are few vanilla deals these days. In almost every case there will be a regulatory issue. The whole game is getting more complex and you need a greater spread of resources.”

Ian Dinwiddie, director of finance at Allen & Overy, agrees that the internationalisation of business affects how clients choose firms.

Dinwiddie says: “I think the globalisation issue is the big thing. Clients are increasingly wanting to go to one firm or a couple of firms whereas a few years ago they would have gone to the firm in the area.”

The tiers below the larger firms seem to be coming towards the end of an era of unprecedented growth in fees and profits, and firms ranked directly underneath the top practices are sliding the quickest.

But analysts say Williams and Dinwiddie are overstating the flight of clients from firms in the 51-80 band to larger practices. They say the value of work for practices in these firms is dropping but the volume remains similar. Clients do not appear to be paying the same rates for the work as they did in previous years.

Alan Hodgart, European director of legal consultancy Hildebrandt, says these firms are getting lower value work because they are neither specialised nor have a depth of resources. He says: “The firms that are good at everything but not great at anything are busy but their profits are dropping. They are working the same hours but not earning the same money. This is something that is market driven.

“As a market evolves this is happening. We saw that with accountants in the 1980s. It forced them out of business or made them merge. Fifteen years ago accountants were like lawyers.

“There were gradations in sizes but now you have the Big Five and very small firms. I am not trying to frighten anyone but the next five to seven years are the most crucial for law firms.”

But Hodgart thinks that niche firms create a hidden statistic because they are attracting high value work. He says: “In big transactions work is going to the large firms or specialised practices, such as in IP and IT. The work is going to the experts.”

Richard Kemp, managing partner of niche IT practice Kemp & Co, which was founded less than two years ago, says: “I have made more profits here than anywhere else that I was a partner.” He was previously a partner at Garretts and Hammond Suddards.

Kemp adds: “If you can push profits up to 35-40 per cent you are doing well. We are between those figures.” PricewaterhouseCoopers analysts say profit margins in law firms before tax should be about 30 per cent of fees, but few firms accomplish this.

All firms with more than 100 partners had a profit to fee ratio above 25 per cent profit. Only 33 per cent of firms in the 81-100 partner range reported profits in excess of 25 per cent.

The 51-80 partner band saw 60 per cent of firms making more than 25 per cent. Below this bracket the amount of firms expands to 69 per cent and then contracts by fairly regular amounts. But the figures are more erratically spread than those for fees and profits. This is probably because profit-to-fee ratios are affected by the management of firms more than market forces, because the equation shows how much of a firm's fees is converted into profit rather than other expenses, such as staff and property costs.

Adrian Fox, director of legal recruitment consultants QD Legal, says: “Management has always been a problem for firms. But the larger firms seem to be managed better and they have a terrific infrastructure. That is a cost but it also helps the firm achieve greater profitability.”

Steve Cantle, chairman of Kennedys, says: “Lawyers have given great advice but in the past we have not been watching fundamental matters like the overheads, budget, and cash flow.”

Hodgart says: “The larger firms started looking at management in the 1980s. The partners there who did not take notice are gone. In smaller firms there is not as clear a sense of direction. A firm with 20 partners should not have those partners pulling it in 20 different directions.”

It seems from an analysis of the figures that clients' purse strings are tightening. But larger firms and niche practices are attracting an increasing amount of higher quality work. This means their fees and profits are on a steady incline.

Small firms are still holding their own in the new competitive market place, but increasingly less so. And the practices with 51-80 partners are seeing a dramatic slowdown in profits and fees.

They are continuing to work hard, but their clients are paying less. At least the figures show that they seem to be using management effectively to maximise profits.