Business and professional services industry outlook
INSIGHT ARTICLE |
Key takeaways from the fall 2020 business and professional services industry outlook
- A drop in legal billings could lead to unintended operating tactics in the fourth quarter.
- The ongoing shift to remote work has broad, long-lasting ramifications for law firms.
- The M&A environment for government contractors has come back to life.
- Uncertainty about the pandemic and election exacerbates the wait for 2021 budget appropriations.
- Human capital management is becoming crucial for BPS companies’ operations.
- The pandemic and weakened labor market present several problems for staffing services.
The law firm sector has faced many challenges since the onset of COVID-19. From bookings decreasing drastically to partner compensation cutbacks, to figuring out how to manage their summer internship programs, firm leaders have been on the edge of their seats since March, asking what’s next? However, as the U.S. economy continues to recover, the sector has begun to edge closer to pre-COVID-19 operations.
Bookings and billings
A recent survey by software company Clio showed that law firm bookings rallied over the summer to a level almost equal to bookings in January of this year.
But what does this mean for law firm leadership as they guide their firms into the ever-critical final quarter of the calendar year? In the same study, Clio identified that while bookings are on the rise, associated billings have begun to trend downward again entering the fourth quarter. This could simply be a matter of timing, as new bookings take time to come to close or be billed out by billing attorneys. But it is worth keeping an eye on as cash collections ramp up in the fourth quarter.
Law firm leaders historically look to cash collections during the fourth quarter to determine how successful a year was, and a drop in billings can lead to unintended operating tactics in December. Billing attorneys, under pressure to collect outstanding fees from their largest clients, might be urged to offer large discounts on fees in December if it guarantees they can collect. This, in turn, would mean a drop in top-line revenues for the firm, while allowing partner bonuses and distributions to be paid out in January.
This year continues to challenge how traditional law has been practiced, a test that promises to last through the end of the pandemic. While many of the Am Law 100 and 200 firms continue to operate in their virtual offices, leaders are beginning to ask themselves if this could be what a firm looks like moving forward. Many firms under lease for their current palatial offices are entering conversations with landlords to discuss future options for reducing square footage per attorney. Internal survey results from many firms have shown that many of their attorneys enjoy the virtual environment and the flexibility it offers them in their everyday lives outside of law. This may be a difficult concept to grasp for many experienced partners in these firms, but the need and desire to have a 300-square-foot office has been replaced by the desire of many attorneys at big firms to work remotely.
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This may be a difficult concept to grasp for many experienced law firm partners, but the need and desire to have a 300-square-foot office has been replaced by the desire of many attorneys at big firms to work remotely.
Hoarding by partners
The Thomson Reuters Peer Monitor Index measured the second-quarter downturn in demand for legal services at 5.9%, while the average bill rate increased 5.2%. This means that more experienced attorneys with higher billing rates are performing the work. Senior partners’ need to bill hours is eroding the leverage that many law firms had created by allowing their less experienced attorneys to build experience and skills from more challenging legal work. This will come back to bite them.
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Senior partners’ need to bill hours is eroding the leverage that many law firms had created by allowing their less experienced attorneys to build experience and skills from more challenging legal work. This will come back to bite them.
After how the Great Recession disrupted the legal profession, many experts noted that entire classes of attorneys lost valuable experience in their careers. This led to those classes looking for opportunities outside of big law firms, which resulted in a group of lost attorneys within. While the pandemic has not been as devastating to the legal profession as the Great Recession was, and while law firm leaders have learned from some of their swift decisions a decade ago, firms are still dealing with the potential of losing valuable leverage as less experienced attorneys bear the brunt of the pandemic.
While the federal government is a reliable customer to serve amid a raging pandemic, the government contracting community was not fully immune to COVID-19 disruptions during the summer. Contractors active in the intelligence community relied on federal reimbursement through the CARES Act, while those less affected reignited discussions around acquisitions and growth. The House of Representatives and Senate each passed their versions of the fiscal year 2021 National Defense Authorization Act (NDAA), but budget reconciliation and budget appropriations will come later in the year, heavily influenced by government officials elected in November. All eyes are on the election, as contractors consider policy and investment priorities under a Trump or Biden presidency.
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All eyes are on the election, as contractors consider policy and investment priorities under a Trump or Biden presidency.
Budget appropriations and the National Defense Authorization Act
The Senate on July 23 passed its version of the NDAA for fiscal 2021, which began Oct. 1. The bill provides a total of $740.5 billion for national defense programs, including $636.4 billion allocated to the Department of Defense (DoD) and $25.9 billion to Department of Energy (DoE) programs related to national security.
Total funding and allocations among agencies for fiscal 2021 are overwhelmingly consistent with those in fiscal 2020.
Per the Senate Armed Services Committee, the four priorities of the 2021 NDAA include supporting our troops, their families and the civilian workforce; charting a course for the National Defense Strategy now and into the future; building a modern, innovative and lethal force; and reshaping Pentagon management to maximize performance, accountability and lethality.
The House also passed its version of the bill (H.R. 6395) on July 21. The bill would become law after the House of Representatives and Senate prepare a unified bill in conference. The timeline for passing the 2021 NDAA is slipping, though, as the federal government continues to prioritize its COVID-19 response over passing budget appropriation bills. Congress’ calendar and priorities will result in the NDAA (and other budget appropriation bills) not being passed until after the November election or January inauguration. We entered fiscal 2021 under a continuing resolution that maintains spending at levels equal to the prior fiscal year. It is not uncommon for the government fiscal year to begin without fiscal year budget appropriations in place, as continuing resolutions have become commonplace.
CARES Act section 3610 relief
The primary concern of contractors during the pandemic is implementing section 3610 of the CARES Act, which is intended to provide reimbursement for contractors who cannot work in light of the pandemic but must be kept in a ready state to attend to national security needs. This is especially relevant in the intelligence community, where information security is of utmost importance and the workforce is cleared and highly skilled. The Professional Services Council, an industry leader and advocate for government contractors in Washington, submitted a letter to Congress on July 15 and again on Sept. 10, requesting the extension of section 3610 past Sept. 30. Both letters highlighted the negative consequences the absence of an extension would have on the industry, economy and national security. The government answered by extending section 3610 through Dec. 11, 2020, consistent with the rest of the fiscal 2021 continuing resolution package passed on Sept. 30 (H.R. 8337).
Paycheck Protection Program loan forgiveness
PPP loan forgiveness is especially complicated for federal contractors. Guidance and interpretations of loan forgiveness continue to evolve, but federal guidance to date suggests the U.S. government believes it is entitled to a credit to the extent the company participates in contract vehicles subject to Federal Acquisition Regulation part 31. Administering a credit requires a nuanced analysis that considers employee compensation, contract structure, labor distribution and other factors. This leaves contractors considering what PPP funds mean to their existing and future contracts.
Mergers and acquisitions market warming up
The M&A pipeline for nearly all industry sectors dried up in March and April in light of tightened debt markets during the height of COVID-19 uncertainty. The government contracting M&A pipeline is beginning to replenish as the trend of industry consolidation continues, as founders look for liquidity and as large public companies continue to seek growth, added capabilities and access to a diverse set of government end customers.
Top government services executives highlighted their commitment to acquisition activity as a key strategic driver of growth going forward. Strategic M&A was noted as a near-term strategic initiative in recent earnings calls for CACI, ManTech, Vectrus, PAE, Perspecta, Parsons, Booz Allen Hamilton and others.
Specifically, CACI President and CEO John Mengucci said: “In terms of capital deployment, M&A remains our top priority.” PAE President and CEO John Heller acknowledged a “dramatic shift” since July, as they have witnessed many opportunities come to market. ManTech President and CEO Kevin Phillips said his company is “actively reviewing M&A opportunities, as we have seen the market return.”
Meanwhile, the middle market government services ecosystem also experienced an active M&A environment this summer. A sampling of noteworthy late summer strategic deals include KBR’s purchase of Centauri LLC, Noblis’ purchase of Inductive Minds and T-Rex Solutions’ purchase of Zot.
Financial buyers such as Arlington Capital Partners, AE Industrial Partners, Carlyle Group, DC Capital Partners, IMB Partners and Sagewind Capital were also active.
Even more active than the government services M&A pipeline was the aerospace and defense marketplace. There was a flurry of transactions in the aerospace and defense products and manufacturing space (such as CACI’s purchase of Ascent Vision Technologies in August). Both strategic and financial buyers remain positioned and ready for an increase in assets on the market as the economic recovery continues.
The eventual economic reckoning associated with the trillions of relief and stimulus dollars spent this calendar year will likely contribute to an active fourth quarter for M&A. A reduction in federal spending may be on the horizon in an effort to reduce the rapidly expanding federal deficit. Additionally, the likelihood of higher taxes (especially capital gains) to increase federal and state revenues may be the impetus to get deals done sooner rather than later.
Staffing married to employment
According to IBISWorld, employment and recruiting agencies in the United States annually generate approximately $24.2 billion in revenue, $1.6 billion in profit (6.7% margin) and $11.9 billion in wages. The industry grew approximately 4.0% annually from 2014 through 2019. Prior to the pandemic, the industry was expected to grow only 0.2% between 2019 and 2024. Sector growth is driven inversely by the nation’s unemployment rate, which skyrocketed to more than 14% in April and was 8.4% in August, according to the Bureau of Labor Statistics.
Demand for traditional executive search and staffing services correlates tightly with the national rate of employment. Strong labor markets increase the need for placement services as the competition for talent heats up, while a weakening labor market is problematic for industry players. In addition, businesses tend to hesitate to invest in permanent hires during periods of significant technological advancement or structural change in an industry. Uncertainty around permanent job loss, and the necessity for labor force retraining and restructuring after the pandemic, results in additional hesitation.
The U.S. Department of Commerce Employment Services Index, which measures quarterly sales for the sector, hit a 15-year high in the fourth quarter of 2019. Sales decreased in the first and second quarters of this year, aligning with levels experienced in the second quarter of 2017. We expect further decline in third-quarter data as U.S. businesses continue to weather the COVID-19 storm with lean workforces.
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One bright spot for payroll processing service providers has been the added complexity associated with payroll tax deferral opportunities, PPP loans and related forgiveness calculations, and other government regulations that accompany relief initiatives.
The number of U.S. employees on employment services payrolls remained consistent over the last five years (3.51 million to 3.67 million) until the COVID-19 outbreak in March. Total employment bottomed at 2.64 million in April, approximately 870,000 less than the lowest period over the last five years. Employment has gradually increased since, but it remains below pre-pandemic levels.
Demand for workforce solutions is also driven by the number of businesses operating in the United States, as every new business must establish a workforce. Companies going out of business due to pandemic lockdowns, as well as shifts in consumer spending, place additional downward pressure on demand. We expect continued headwinds in the employment services sector as government assistance wanes and the consequences of the recession settle in.
Technology disrupting the traditional staffing model
Technology-driven employment platforms, such as LinkedIn and Monster, continue to be disruptors in the employment services sector. It can be difficult for traditional staffing firms to compete with the network effect that stems from widespread adoption of these platforms.
“It certainly has become more about how do you handle remote. The investments we've made in online, in our SaaS (software-as-a-service) products and mobility in all of our designs have been very helpful because you will still see us as an HR company, but it becomes much more all-encompassing, and that definition of HR gets broader and broader.” Martin Mucci, Paychex president and CEO, Aug. 13 fourth-quarter earnings call
Per the LinkedIn August Workforce Report, more than 169 million workers in the United States have LinkedIn profiles; more than 20,000 companies in the United States use LinkedIn to recruit, and more than 3 million jobs are posted on LinkedIn in the United States every month. However, even LinkedIn was not immune to the challenges caused by the pandemic. The company laid off 960 individuals (roughly 6.0% of its workforce) as communicated in a message to employees in July.
Additionally, data security is a key risk for businesses with access to large volumes of user data. Monster was notified in September 2019 of a data breach that occurred between 2014 and 2017 when a web server storing user resumes was exposed by a third party. Therefore, technology has the ability to continue to disrupt the industry, but only if data security is prioritized.
Payroll processing in a similar dilemma
Like staffing and executive search firms, demand for payroll processing services is driven by national levels of employment. Leaner workforces and hiring freezes instituted in response to the pandemic have stymied growth.
However, one bright spot for payroll processing service providers has been the added complexity associated with payroll tax deferral opportunities, PPP loans and related forgiveness calculations, and other government regulations that accompany relief initiatives. Solvent firms taking advantage of these benefits will lean on their service providers to help them navigate the complexities.
Payroll service providers have also begun to look toward the election as an opportunity to expand service offerings in light of the pandemic. Carlos Rodriguez, ADP president and CEO, stated as much in ADP’s fourth-quarter (fiscal June 30) earnings call with analysts. “We're apolitical as a company. But usually when there's change, there is change for employers,” he said. “Employers are an instrument of policy of the government. It's how public policy gets effectuated, whether it's through tax or all the various safety policies [such as] these changes in leave policies now to help manage through the health crisis. And so that's [an] incredible opportunity for us to help our clients. And when there's opportunity to help clients, that's opportunity to sell new business as well.”
As U.S. lawmakers implement various initiatives to support and bolster the economic recovery, payroll processing providers will be positioned to help their clients navigate the nuance while also reclaiming growth opportunity from increased employment levels.
New workforce opportunities on the horizon
Human capital management (HCM) is becoming crucial to operations as companies assess how their employees are faring in a remote environment and look to change benefit offerings. By combining cloud-based, next-generation technology and data-driven insights, HCM experts are providing flexible work plans, global compliance and adaptable technology solutions in an effort to build, maintain and equip the best teams for the job with the most suitable people across borders. While investment in HCM may be difficult in the near term due to depressed revenues, firms with enough cash flow will invest to better position themselves for the future.
“Usually when there's change, there is change for employers. Employers are an instrument of policy of the government. It's how public policy gets effectuated, whether it's through tax or all the various safety policies [such as] these changes in leave policies now to help manage through the health crisis. And so that's [an] incredible opportunity for us to help our clients.” Carlos Rodriguez, ADP president and CEO, July 29 fourth-quarter earnings call
Paychex President and CEO Martin Mucci discussed the fluid environment during Paychex’s recent second-quarter earnings call. Success has begun to center on handling remote work, Mucci said, trumpeting Paychex’s investments in online services, software as a service and mobility in all of the company’s designs. “You will still see us as a human resources company, but it becomes much more all-encompassing, and that definition of HR gets broader and broader.” In the context of Paychex’s widening range of services, Mucci forecasted an increased role for data analytics in HR to help clients and people make decisions.
Finally, as U.S. and international communities continue to grapple with the social challenges brought about this year, companies are prioritizing diversity and inclusion (D&I) leadership training, policy enhancements, and their ability to measure impact and meaningful change. For providers that had already begun complementing traditional workforce solutions with HCM consulting, this has allowed the opportunity to reposition underutilized resources by shifting their efforts towards D&I opportunities.
Mark Harris, chief financial officer at Heidrick & Struggles, recently detailed the expectation within his worldwide executive search firm. “With the distributed workforce due to COVID and the sharpened lens on racial and social disparities,” he said, “we expect our clients will need more support to help them keep employees engaged around purpose and values, create and maintain inclusive cultures, and understand leadership capabilities.”
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