Business and professional services industry outlook
Quarterly economic outlook for professional services firms
Volume 8, Summer 2021
As workforce shortages continue, business and professional service firms are still fighting the return-to-work battle. Many aim to reopen their offices, so to speak, around Labor Day with hopes that productivity can return to pre-pandemic levels. With operational shifts at the forefront of strategic planning, many firms continue to focus on how spending more on technology could minimize inefficiency, increase operating profits and protect their firms against the growing threat of cyberattacks.
Key takeaways from the summer 2021 business and professional services industry outlook
- Law firms focused on efficiency are seeking quick wins by improving back-office processes, while technology implementation and cloud migration remain key challenges.
- Despite increased awareness of cybersecurity risks and challenges, there is little evidence of elevated measures to combat them.
- Government contractors anticipate growing opportunities to address broad national needs relating to information technology, cybersecurity, and research and development.
- Introduction of the Cyber Response and Recovery Fund signals the federal government’s pointed focus on cyber response and provides a powerful vehicle for future investment.
- Increased deal size and fundraising levels involving human capital management services reflect how the nation is placing an emphasis on employees.
Firms will operate through the remainder of 2021 with a heightened focus on efficiency, as they look to achieve quick wins by improving back-office processes. Technology implementations and cloud migrations continue to be key challenges, but they are more likely to be investments in 2022, as firms prioritize lower-investment and less-disruptive improvements in the short term. There is also more awareness around cybersecurity risks and challenges, but little evidence of elevated measures to combat them.
MIDDLE MARKET INSIGHT
A significant amount of space subleased by law firms will be coming to most U.S. markets.
Further reduction in real estate spending
Although many law firms have been downsizing their office spaces for the last decade, the pandemic’s remote-work model has accelerated the opportunity for further reduction. Almost two-thirds (64%) of law firms plan to spend even less on real estate in the next three to five years, according to the Aderant Business of Law and Legal Technology Survey, conducted in late summer 2020. This indicates the decade-long downsizing trend will continue, with more firms making remote or flexible working arrangements permanent.
It also signals that a significant amount of space subleased by law firms will be coming to most U.S. markets. While law firms accounted for 5.9% of all office leases signed in the United States in 2019, according to CBRE Group, a 15%−25% reduction in space occupied by law firms is expected in the near term, Vice Chairman Stephen Bay told WMRE magazine in October.
This long-term adoption of a remote-work environment is probably driving the top challenges of 2020 cited in the Aderant survey. Operational efficiency (39%), technology adoption (32%) and cybersecurity (30%) were the most frequently cited challenges in a list of 15.
Operational efficiency in the back office through process improvement
The pandemic has boosted business at many law firms, exposing the long-overdue need to improve operations in order to scale efficiently. However, only 48% of law firms plan to achieve these efficiencies by spending more on software, while 70% plan to do so by increasing investment in process improvement, according to the Aderant survey, which was published in May.
This shows that law firms are looking to optimize current processes using the technology stack in which they already have invested. Process improvement also is usually less disruptive to internal operations than technology implementation and is preferred when looking for quick wins or a short-term return on investment.
MIDDLE MARKET INSIGHT
The pandemic has boosted business at many law firms, exposing the long-overdue need to improve operations in order to scale efficiently. However, firms’ strategic approach to this varies.
But what about growing revenues?
Firms might finally be ready to address many of the front office operational issues they have been avoiding or putting off. This realignment of priorities is evident in how Aderant survey respondents identified the top three challenges facing their firms: 29% said retaining and growing existing business from clients, up from 19% in 2019. It is the first time in the four-year history of the survey that more firms cited this challenge than pricing pressure (28%). In other words, firms are seeking to improve profits by growing revenue instead of by just cutting costs.
However, based on our conversations with law firm executives, while the desire to grow a firm’s top line is preferred over continuing to cut costs, many firms still don’t know where or how to start.
Because of the pandemic, firms have a litany of opportunities to embrace the change that has been forced upon their leadership teams, and they should incorporate these opportunities into their strategic planning sessions at their partner meetings this summer and fall. Whether it’s addressing go-to-market approaches, sales, networking, training of rising stars, building cross-functional working teams, understanding the profitability metrics and opportunities within its current client mix, or even the continued importance of succession planning, firm leaders have finally reached a point where these difficult conversations must be on the agenda.
Cloud migration: Immediate challenge but long-term solution
The top three technologies with the biggest impact on efficiency at a firm continue to be document management (82%), financial management/enterprise resource planning (75%), and time and expense management (74%), as determined in the Aderant survey. We expect a sizable portion of technology investment will be to move these technologies and similar ones to the cloud.
Although many firms desire to move document management and time and expense management systems to the cloud, they are reluctant to make this investment until their older, on-premises financial management (enterprise resource planning, or ERP) systems are updated or migrated—and migrating the ERP system can immediately disrupt daily operations. With operational efficiency being a top challenge, even a short-term disruption for long-term improvements is not palatable, given the tumult caused by the pandemic. This reluctance is creating a bottleneck of technology improvements, which will continue to hold firms back from the operational efficiencies they desire.
The current focus on process improvement over tech adoption shows that although a cloud migration may be on the road map, implementation may be delayed in order to tackle less daunting process improvements in the short term. Aderant reports that only 8% of firms plan to move their practice management solution to the cloud within the next 12 months, and 31% plan to at least a year from now. But firms can’t afford to wait much longer to join the cloud migration. Some are annually spending tens of thousands of dollars—or even more—to maintain on-site server rooms and the associated salaries for technicians, security upgrades and other related support. Firm leaders need to recognize that migrating to the cloud benefits their attorneys and balance sheets more than maintaining the status quo.
Cybercriminals take aim
Cybersecurity is increasingly challenging law firms, a trend consistent with what the entire middle market has experienced during the pandemic. The number of firms that rate cybersecurity as a top challenge increased to 30% in 2020 from 17% in 2019, according to the Aderant survey. The American Bar Association’s 2020 Legal Technology Survey found that 29% of respondent firms experienced a security breach last year, compared to 26% in 2019.
Cybercriminals probably will continue to target law firms with ransomware, as firms are becoming increasingly paperless and hold terabytes of highly sensitive and valuable information. For firm executives, the associated operational and reputational risks are worth losing sleep over.
To deter and repel hackers, firms can implement technologies such as firewalls and two-factor authentication, ensure that software is updated, patched and maintained, and back up files in secure repositories. However, many firms face a pair of challenges: deciding which technology makes the most sense depending on the makeup of the firm, and obtaining approval for increased spending to protect the firm. We have found that if a firm can align its security programs to an appropriate security framework, it is much more likely to obtain the funding and support it needs to sufficiently secure the firm.
The view forward
It’s clear that law firm leaders continue to look to manage expenses in the back office as a strategy to increase profits, especially through identifying quick wins and making any relatively easy changes. However, we are seeing a reluctance to invest in strategic technology and revenue-growing activities—which might negate cost-management efforts relative to other firms that are strategically aligned to grow revenue, scale, and gain market share.
Government contractors are looking forward to increased federal spending under the Biden administration and more opportunities to work across agencies to address broad national needs relating to information technology, cybersecurity, and various forms of research and development. The comprehensive need for innovation, modernization and security across the government will require collaboration, agile procurement and aligned missions. The federal government continues to lean on its partnerships with private commercial businesses to tap into the brightest minds and ensure the flexibility and agility to innovate in an economical manner.
MIDDLE MARKET INSIGHT
Under a Biden administration intent on increasing federal spending, contractors continue to acquire the experts, technology and capabilities needed to beat the competition and ensure delivery of cost-effective solutions for the government.
IT modernization across the federal enterprise
President Biden’s fiscal year 2022 budget request, released in late May, includes $58.4 billion of top-line spending on information technology at civilian agencies. The White House Office of Management and Budget said this is intended to encourage the “strategic use of IT to enable mission outcomes” and, more specifically, “support the modernization of antiquated and often unsecured IT; agency migration to secure, cost effective commercial cloud solutions and shared services; the recruitment, retention and reskilling of the federal technology and cybersecurity workforce to ensure higher value service delivery; and the reduction of cybersecurity risk across the federal enterprise.”
Large public government services contractors, as well as small and middle market contractors, are positioning their businesses for related proposals to drop. Specifically, contractors continue to acquire the experts, technology and capabilities needed to beat the competition and ensure delivery of cost-effective solutions for the government.
The top five agency requests as a percentage of the $58.4 billion top-line figure are from the Department of Veterans Affairs (14.5%), Department of Homeland Security (13.9%), Department of Health and Human Services (11.9%), Department of the Treasury (10.2%) and Department of Transportation (6.3%). The recent uptick in telemedicine and related digital services for the Department of Veterans Affairs alone supports its allotment of the lion’s share. However, a continued focus on pandemic recovery and national security also makes DHS and HHS expected leaders of the pack.
A significant increase in federal outlays (excluding defense) in fiscal years 2020 and 2021 resulted from a combination of COVID-19 response and recovery, low interest rates and a new administration supportive of bigger government. However, federal civilian IT spending has been on a steady upward trajectory over the last decade. Contractors should be confident that government services related to IT modernization and security will continue to be in demand, with even greater upside associated with new issues or those exacerbated by the pandemic.
The president’s budget request includes an additional $500 million for the Technology Modernization Fund (TMF), a program targeting investment in critical IT modernization and innovation efforts. The TMF received a $1 billion dollar boost via the American Rescue Plan and recently announced greater prioritization and looser payback requirements for programs focused on cybersecurity and COVID-19 response. The TMF was created in March 2019 and has awarded $79.4 million in funding to date, underscoring the significance of the recent large influx of TMF funding and signaling a commitment to long-term technology modernization efforts spanning the federal government.
A consistent, unified approach to cyber
With any IT modernization effort come cybersecurity implications; $9.8 billion of the $58.4 billion civilian IT budget request is for cyber-related activities, 14% greater than the estimated expenditure for FY 2021. Nine major agencies expect double-digit growth in cybersecurity spending in FY 2022. The Departments of State, Education and Justice lead, each with expected spending growth exceeding 30%; Treasury and NASA each project spending growth of more than 20%; and HHS, Interior, DHS and Energy each expect percentage growth in the teens.
Not included in these figures is cyber defense spending, which is also supported by the new administration, as well as a proposed $20 million investment for a new Cyber Response and Recovery Fund focused on strengthening critical infrastructure and the federal government’s ability to respond to cyber threats and attacks. While $20 million isn’t a huge number, the introduction of this fund signals a pointed focus on cyber response and provides a vehicle for future investment that could grow meaningfully, like we saw recently with the Technology Modernization Fund. The president’s budget and related OMB documents regularly mention the SolarWinds hack as an impetus for accelerated investment in and a laser focus on protection and security.
Contractors ready to execute
During the FY 2021 budget cycle, agencies were required for the first time to report IT spending data categorized by cost pools and IT towers via the Technology Business Management (TBM) framework in an effort to better understand the federal government’s spending and results in a holistic manner. Contractors provide nearly all products and services related to each cost pool except for internal labor, which reflects the work performed by government employees. Per the FY 2022 budget request (excluding defense), only 16% of costs are allocated to internal labor, leaving roughly 84% as open opportunity for contractors.
The federal government continues to lean on government contractors to execute on strategic initiatives in a way that is innovative, secure and efficient. We expect great opportunity for contractors serving the federal government in the coming year as IT modernization, cyber and COVID-19 recovery initiatives continue.
Human resource management and technology has been a thread in macroeconomic conversations since the pandemic began, with topics ranging from unemployment rates and wages to digital solutions that connect the labor force and enhance employee-related efficiencies. Halfway through 2021, workforce solutions providers are capitalizing on widespread opportunities to help businesses in all industries position themselves for their post-pandemic state.
Opportunity and demand meet private equity
Investments in human capital tools and resources are on the rise as companies aim to improve the talent experience at their organizations. Private equity funds that target the human capital services sector raised $5.2 billion in capital between October 2020 and May 2021, according to PitchBook. That eight-month total is almost $2 billion more than any annual total dating to 2012. It reflects how the nation is placing an emphasis on employees by investing in employment services, recruitment, training, career development and human resource technology.
Of the $3.9 billion these private equity funds raised in 2020, $2.9 billion was raised in the fourth quarter as the nation neared the release of COVID-19 vaccines and began to see how the post-pandemic workforce environment might be structured. The momentum continued with $2.3 billion raised from January through May—more than was raised in all of 2019 ($2.1 billion). As the country continues to evaluate what our workforce will look like, one thing is clear: The tools and technologies in place at our organizations are becoming increasingly vital to their success.
MIDDLE MARKET INSIGHT
Private equity funds that target the human capital services sector raised $5.2 billion in capital between October 2020 and May 2021, according to PitchBook. That eight-month total is almost $2 billion more than any annual total dating to 2012.
Valuations and growth
As companies become more permanently dependent on virtual meetings, and even as some return to work in a hybrid format, many organizations are relying on search firms to replenish and strengthen their workforce. Companies are engaging with firms that offer training and professional development to help their employees and executives be better skilled to deal with the next crisis.
Valuations of companies operating in these spaces and providing these services are steadily increasing as they go to market, leading to larger deals and ultimately an influx of capital. The average deal size of organizations operating in the human capital services sector from the start of 2020 until May 2021 increased from $365 million to $468 million, according to PitchBook. The average post valuation over that same period increased from $357 million to $765 million. This represents a great opportunity for those businesses to invest in technological advances and expand service offerings.
The ‘magic’ combination
Even for human capital services providers not seeking to transition ownership, opportunities are inspiring executives to pursue new ideas and capabilities.
Krishnan Rajagopalan, president and CEO of Heidrick & Struggles, on an April 26 earnings call described that push within his firm. “This involves broadening our service offerings across search and consulting while moving into adjacent and complementary areas with an increasingly tech-driven approach,” he said. “We see technology as the backbone for our expanded service offerings, allowing us to deliver our solutions in a more rapid, automated and scalable way.”
For example, digital solutions that leverage data and artificial intelligence to identify and rank job candidates are enabling recruiters to proceed more quickly with the interpersonal components of the recruitment process—and do so remotely. Transactional activities that used to require a lot of time are becoming more efficient as technology helps providers fill orders faster and match job openings with quality candidates.
“It's the combination of the human talent with the enabling technology that's creating the magic,” Jonas Prising, chairman and CEO of ManpowerGroup, said on an April 20 earnings call. “And we think we are still at the very early stages of this. So we still have a long way to go growing our business, as well as gaining further efficiencies.”
Renewed and improved
As the economy strengthens, we can expect a refurbished work environment that invests heavily in workforce needs and efficiencies. Companies offering services and technologies to fulfill those needs and increase those efficiencies can expect to grow in the near term as demand for them rises and the supply of workers normalizes. The long term appears bright, as well, as technology becomes ingrained and gives longevity to improved human capital management practices and processes.
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