Tuesday 15 January 2019
The first Management Team Together meeting of 2019, hosted by Watson Farley & Williams LLP, on ‘Resilience through change’, examined the findings of PwC’s annual Law Firms’ Survey, which covers current trends and the future outlook for law firms. Presenters were Kate Wolstenholme, PWC’s UK leader of industry for business services, and Tony Hodgson who handles PwC’s legal consulting work.
The survey covers UK headquartered firms and US firms with London offices and includes some 70% of the top 100 law firms. Firms submit their data anonymously and the analysis groups them into four bands: Top 10; 11-25; 26-50 and 51-100.
Wolstenholme used interactive charts to outline UK and international operating and financial performance before moving onto working capital. Hodgson covered the people element, human capital, the impact of technology and future trends.
2018 was a good year for law firm growth and profitability: 89% of firms reported growth and 39% enjoyed double digit growth. Firms are more successful at converting growth to profit than in previous years, particularly in the mid-range. While the top 10 firms experienced smaller percentage growth and saw profit margins fall for the fourth consecutive year, profit margins for the top 51-100 firms overtook the top 26-50 firms.
The profitability gap between mid-market and larger firms is closing, as mid-market firms are catching up. This is due to the specialist nature of smaller firms, technology adoption improving efficiency, and multiple mergers elevating new firms into higher bands. Firms with profit margins below 20% are more amenable to mergers, which open up new opportunities in terms of business opportunity and the ability to invest in scale-up technology.
Fee and income arrangements are still mostly based on time and materials although more top firms are employing pricing experts to help them price more creatively and competitively. Wolstenholme explained that the survey does not ask firms for their rates; rather it looks at fee incomes and gross profit per chargeable hour. The data shows that firms are holding their line on pricing, with slight fee increases. Fees per equity partner are trending upwards across the bands.
Unsurprisingly, people are the biggest cost. While non-fee earner costs are decreasing, perhaps due to automation and process re-engineering replacing manual tasks, IT costs are creeping up, and firms are spending more on IT systems and cyber protection. Furthermore, US firms are putting upward pressure on salaries, so it is important for firms operating internationally to get their headcount and chargeable targets right. The averages for each of the four bands show a broad range of operating and financial performance between UK firms. The ratio between headcount and chargeable hours shows that firms are improving their margins by are doing more with existing resources and being braver on pricing rather than chipping away at costs.
Hodgson looked at the people data, which showed a decline in fee earners in the top 50 firms, particularly in the more junior ranks, while the 51-100 are increasing their numbers. Mid-market and smaller firms show expansion, although staff turnover remains high across all bands, meaning that recruitment is an ongoing challenge.
In the UK income per fee earner, and per chargeable hour increased year on year, and profits per equity partner continued their upward trend. In the largest firms, this is offset by equity partner numbers decreasing, whereas mid-tier firms are expanding, increasing revenue, fee earner numbers and chargeable hours. Merger activity is also contributing to the success of firms in the lower bands, elevating more specialist firms into the top 100.
As firms improve their profit margins by maintaining/increasing chargeable hours without becoming ‘over-lawyered’ the pressure this puts on lawyers’ time means firms are grappling with related challenges around generational expectations, work-life balance, agile working and diversity.
The international dimension
As firms merge and grow, international markets have become more significant to revenue, and managing partners have to factor in variations in profitability across different territories. However, international operations are a huge contribution to top-line growth, particularly in the top two bands – the top band saw 80% growth from international operations. The highest growth was in western Europe, and the most challenging were emerging markets in the middle east and China. The significantly higher PEP rates in US firms goes some way to explaining why UK firms continue to seek US mergers, notwithstanding the cultural impact.
The figures were less promising when it came to working capital, although firms are using data to incentivise better working capital management. The underlying trend is that lock-up days are still creeping upwards, with a high average WIP days and debtor days.
A question was raised about e-billing, which apparently is causing problems due to the multitude of platforms being used. However, the survey shows that 70% of billing does not use an e-billing platform.
External funding reduced for all bands except 11-25. There was more interest in alternative funding, including IPO, but this was limited by concerns around profit distribution and other partnership issues.
Business support priorities
Technology is the stand-out business support priority across all bands. Keeping up with the pace of technology change involves procurement, investment and ongoing expenditure. Hodgson underlined the importance of understanding the business case for new technology and deriving value from technology investments. Key focus areas include standardising processes and data analytics. Rather than reducing costs, technology projects tend to involve introducing and leveraging new operating models.
This is creating new trends in recruitment as firms are employing specialists in pricing, digital and emerging technology, business transformation and innovation as well as legal project management. While the top firms are focused on pricing, the lower bands are concentrating on improving their data analytics capabilities.
A busy slide showed firms’ technology projects – planned, underway and recently delivered. Current and recent activity mainly involves business transformation initiatives: upgrading core systems and improving mobile and remote access, as well as modernising time capture capability. AI and robotics, including smart contracts are emerging, but legal is lagging behind other sectors as these projects are generally limited to research and pilot projects. Surprisingly little attention is devoted to technology for resource management and planning, which is supporting project management in other industries.
Future analysis: four key challenges
Looking to the future, the survey findings identified four key challenges: Brexit, shortage of talent, cyber threats and technology.
Brexit: These divided into operational challenges about freedom of movement and potential office relocation, regulatory challenges and continued uncertainty – the need to adapt to the outcome of Brexit negotiations and identify the potential opportunities.
Shortage of talent: With almost full employment, there was a focus on hiring and retaining new talent, developing an attractive working culture and offering career progression, and effective employee communication. There is increased focus on diversity and inclusion, particularly gender diversity in the partnership, but this is not reflected in the survey findings.
Cyber threats: 82% of all firms surveyed expressed concern about cyber security. This reflects a focus on digital transformation. Respondents were concerned about their firm’s ability to respond to and recover from a cyber event and whether they are adequately prepared in terms of response and business continuity planning, including training the board, partners and employees.
Technology: Again, responses were split between operational issues and the challenging speed of technology change. There was concern that the basics were in place and there were plans to improve/upgrade them and a reiteration of the concern over security. There was also focus on the challenges of emerging technology: both identifying ‘best fit’ products to invest in and funding continuing technology investments.
Finally, notwithstanding these concerns and challenges: all firms surveyed anticipated fee income to continue to increase, so clearly there is continued optimism in the sector.