Demand growth for law services continues to rise.
Key takeaways
Law firms may see an increase in transactional demand this year.
Challenges in collections are an ongoing issue.
Law firms maintain forward momentum with rising profitability
Bolstered by law service rate growth that has begun to outpace inflation, profitability metrics for law firms continue to improve despite rising challenges in collections. Demand growth for law services was slow but steady in the third quarter of 2023. Transaction demand declined further, but projections imply that the worst is in the rearview mirror for mergers and acquisitions (M&A) activity.
Demand for law services
Midsize firms led the way with a 3.7% increase in demand growth compared to a 0.3% increase for Am Law 100 firms, according to the Thomson Reuters Law Firm Financial Index. Demand growth remained strongest in countercyclical areas like bankruptcy (6% growth year over year). But high interest rates continued to dampen M&A activity in the market, dragging down law service demand in this area by negative 5.2% year over year.
Steady growth
The Federal Reserve’s strategy of raising interest rates to help control persistent inflation proved successful in 2023. Inflation continued to decrease, coming in at 3.5% for the third quarter, following four consecutive quarters of decline.
Although demand growth for law services has varied greatly over the past few years, law firms have maintained their decades-old strategy of raising law service rates an average of 4.5% year over year. This strategy puts law firms in a strong position to grow profit margins now that inflation has dipped below law service rate growth after two years of the reverse.
Economic factors
In December, RSM economists adjusted their forecast downward for the likelihood of a recession in the next 12 months, to 25%. Additionally, we anticipate the reversal of rate increases, beginning with rate cuts in mid-2024. We project four 25-base-point decreases in the second half of 2024, with a total cut of 250 points in the next 24 months.
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RSM analysts forecast that the second half of 2024 will see a considerable increase in the number of initial public offerings, and transactions in general, which will prop up demand for law services in key areas such as M&A and real estate.
Profitability metrics
Profitability metrics improved as law service rates increased by 6.3% year over year, their highest levels since before the pandemic. Additionally, the rate at which expenses increased continued to drop year over year compared to the previous quarter. Law service rate growth increased by 6.1% year over year in the third quarter, the first time it surpassed direct expense growth since the fourth quarter of 2021.
Although expense growth has decreased overall for law firms, there are still bifurcated strategies between Am Law 100 and midsize firms in key areas such as hiring. Am Law 100 firms continue to be much more cautious about hiring, with a 1.3% decrease in head-count for associates in 2023 compared to a 8.3% increase for midsize firms. This divergence in strategies was evident in total expense growth, which came in at 4.8% growth year over year in the third quarter for Am 100 firms compared to 7% for midsize firms. We will watch end-of-year profitability metrics to see how these strategies play out.
Firm size was not the only factor when it came to hiring strategies. Different sectors had different approaches.
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Technology-focused operations were hit hard in 2023, with layoffs and delayed first-year associate start dates. According to Bloomberg Law, this was mainly because of stagnant demand in M&A, which drove overcapacity in firms.
Issues with collections
The collections cycle lengthened by 5% year over year, continuing a two-year trend of law firm clients taking longer to pay bills, according to Citigroup. This trend was seen across industries, with clients feeling the cash flow squeeze of economically cautious customers and high interest rates. Although strategies can be implemented to reduce the time to collect operationally, law firms should expect delayed collections to plague their balance sheets until economic confidence and growth return.
Looking forward
Law firms should look at their collections processes and technology to see where efficiencies can be created to reverse the trend of longer collections. This means starting at the invoicing process step. Additionally, law firms should prepare for an increase in transactional demand in the second half of 2024. They should ensure that they are maintaining or strengthening their strategic partnerships in the M&A space to meet anticipated demand.
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