Some glimmers of sunshine for law firms, say Citi experts

As representatives of the law firm group at Citi Private Bank, we've met with more than 150 of our clients since 1 June. During these benchmarking reviews, partner retreats, firm leadership sessions, industry forums and individual meetings, the cliche that we've heard most frequently is, "may you live in interesting times." It is said grimly and through clenched teeth.

Let us introduce a kinder, gentler replacement - a saying from a Zen master: "Don't hope for life without problems. An easy life results in a judgmental and lazy mind." From that perspective, we couldn't ask for a better time to be alive.

This is a glimpse of our nine-month flash results - a snapshot of industry performance for the first three quarters of the year - and a look at a few of the coping mechanisms that firms are using.

Midway through 2008, we noted that firms were experiencing the worst margin compression we've seen since we began collecting interim data in 2000. We also said that the most profitable firms were feeling the most pain and that global firms seemed to be feeling the least.

Now we see some subtle but meaningful shifts. And we can report a few glimmers of sunshine. The nine-month numbers for the roughly 150 firms that reported to us indicate the following:

A slight increase in revenue and slight decline in the growth of expenses, resulting in moderating margin compression. Revenue for the first nine months of 2008 was up 5.5%, compared to 4.8% in the first half, and nine-month margins were down 3.8%, compared to 5.3% in June. At this rate, revenue growth for 2008 will fall far short of the average annual revenue growth of nearly 11% that firms posted between 2000 and 2007.

Demand - defined as gross hour - was up 0.1% through September, after declining 0.3% in the first half, meaning there was an increase of about 1% in the third quarter. Again, this is far short of the average annual 2000-07 growth rate of 3.9%. The improvement in the third quarter suggests that countercyclical practices such as bankruptcy may have begun to kick in.

Headcount growth remains at about 5.5%, so productivity - or average hours per lawyer - dropped by 5.1% through September. That is a slight improvement over the 5.5% drop in the first half of the year, but still a sign that too many lawyers are chasing too little business. During the 2000-07 period, productivity was relatively flat, despite annual lawyer growth in the 6% range.

As we look at the results on a firm-by-firm basis, we note the following:

Global firms (those with more than 25% of their lawyers outside the US) outperformed the industry through June on all metrics - onsiderably higher revenue growth, less severe margin compression and stronger demand. But the story changed at the nine-month point. While global firms still outperformed the industry in the first nine months, they showed a slowdown in revenue growth (10.4% for the nine months versus 12.2% for the half) as well as demand (0.1% for the nine months versus 0.6% for the half). And because their headcount growth continues to outpace the industry - these firms had an increase in lawyers through September of almost 8% - their productivity declined by 7.3% in the first nine months of 2008, only a slight improvement over the six-month decline of 7.6%. This reinforces what we've been hearing anecdotally about this slowdown truly going global, and it raises the possibility that a global footprint may hurt, not help, a firm, at least in the short term.

International firms (those with 10%-25% of their lawyers outside the US) continue to underperform, but they improved their numbers somewhat during the third quarter. Their margin compression was 5%, compared to 6.5% for the half, and their decline in demand was 2%, compared to 2.5% for the half. The drop in productivity was relatively consistent in both periods, around 8%. This supports the view that these firms, whose overseas footprint tends to be mostly in the UK and Western Europe, have had a double hit, as the US economic slowdown spread overseas at the beginning of this year.

New York-headquartered firms - we have 32 in our sample - also continue to bear more than their share of the pain. Their growth through the first nine months of 2008 has been weaker than the industry as a whole. For them, revenue growth actually declined in the third quarter, falling from 3.9% at mid-year to 2.6% at the close of the third quarter. These firms are among those experiencing the greatest margin compression, and their demand was down 3% at the nine-month point, only a slight improvement over the 3.8% decline they posted through June. Their nine-month lawyer headcount growth (6%) was higher than the industry-wide average (5.5%), and not surprisingly, productivity declined by 8.5% through September, only a modest improvement over a 9.3% decline through June.

Stepping back from the numbers, here are some of the coping mechanisms firms are using right now:

Emphasise collections. Get to your clients early and often. All of our data and anecdotal evidence indicate a lengthening of the cash conversion cycle. In layman's terms, law firms are serving as banks for their clients. If collection efforts are neglected, the hill most law firms climb in December will become Mount Everest.

Institute a systematic expense review. If you haven't already done it, you're late to the game, but it will still help ease the pain in 2009.

Pay attention to your laterals. This is the first year since 2000 when cohesion will be sorely tested. Laterals, by definition, have less glue attached to them. Hold them close and love them!

Talk to your top clients. You want to understand the ways in which the world is changing - and it will change in profound ways - so you can determine the implications for the work you'll be doing.

Assess your leverage model. This requires long-range and far-reaching analysis. It starts with developing a view about the quantity and nature of the work that will be available to law firms in the next three to five years and then a clear-eyed assessment of whether today's leverage model will fit with the work of the future.

Add laterals strategically. There is a lot of pain in the marketplace, and partners are much more open to moving. Firms with very focused strategies will be able to fill geographic or practice area gaps. But - and it's a big but - it's buyer beware, as many partners are in the market because they've read the tea leaves (or had the tea leaves read to them!).

Manage expectations for next year. Tell your partners that 2009 will most likely look a lot like 2008: soft demand and further consolidation. Tell them there's no reason to panic but there's more pain coming.

We opened with a Zen saying, so let us close with another: "From the withered tree, a flower blooms." The industry will survive this mess and be the better for it.

Dan DiPietro is client head of the law firm group of the Citi Private Bank. Cindy Tambourine is the group's senior client adviser.

This article first appeared on The Am Law Daily blog on americanlawyer.com.