Originally published in The Legal Intelligencer/law.com
Smart Strategy
Law firm rates have been on the rise for years – and continue to climb. Yet rumblings indicate clients may have just about had enough. Is the era of continuously rising rates about to hit a snag? Or is it all smooth sailing? Renowned pricing expert and former Chief Practice Officer Toby Brown, Founder of DV8 Strategies and Marcie Borgal Shunk, industry analyst and Founder of The Tilt Institute share their (sometimes divergent) viewpoints on the future of rates, profitability and more.
The Backdrop
A remarkable 86% of law firms expect to increase rates in the next 12 months, according to Wells Fargo, and over a decade of data from Thomson Reuters indicates worked rates have increased somewhere from about 3% to 7% year-over-year since 2007 (only once, in 2022, not exceeding the rate of inflation). Over the same timeframe, billable hours dipped, with monthly hours clocked per lawyer sinking from close to 140 (1,680 annually) to just about 115 hours per month (1,380), according to Thomson Reuters. This combination highlights a stark fact – lawyers are working less and charging more.
Clients, for the most part, have accepted (or at least been tolerant of) rate increases. Barring notable economic disruptors such as the financial crisis of 2008/2009, rate hikes have been the norm, especially outside the largest legal departments. Sophisticated law firm pricing analysts optimize profitability by giving the illusion of discounts – higher standard rates in exchange for “deals” to clients in the form of deeper and deeper discounts (as reflected in dipping realization which landed at a sad 79.5% in recent months according to ALM data). In turn, law firms sustain strong profit margins – 36% on average for AmLaw 200 firms in 2023 – and have enjoyed inflation-adjusted growth in PEP and PPL of 32.6% and 16.6% respectively over the past decade.
As 2024 comes to a close, with political headwinds, economy uncertainty and inflation still exerting pressure, will clients continue to tolerate planned rate increases? Is the modus operandi of using rate hikes to propel growth and profitability sustainable?
Marcie Borgal Shunk (MBS) – I'm not sure that it is. While inflation-adjusted data shows that PPEP growth is just a few percentage points a year, that's just not what clients are experiencing. In many respects, law firms have a publicity problem. What clients tend to see in the news is exorbitant increases in associate salaries, with first-years making a quarter million. Or they read reports of partners taking home a million or more. It’s out of touch with their reality. And the prospect that many of the tasks currently performed by first, second, or even third year associates are likely to be displaced in the near term by AI and similar capabilities is real.
The most sophisticated legal departments are already exploring how to use AI and looking for innovative ways to decrease their overall legal costs. Now, whether law firms necessarily want to retain that lower-level work in the long-run remains to be seen, but until now that’s been fertile training ground for newer lawyers.
To bring this back to the topic of rate increases, the approach of using rate hikes to drive collected rates has definitely worked. Don’t get me wrong. Law firms have benefited, and clients have absorbed much of the soaring expenses law firms have faced – but I’m not sure I would bank on that continuing. The year-over-year climb is just too steep and the broader economic headwinds too strong, especially in cyclical practice areas.
It is interesting to note, also, that ALM’s recent Mid-Level Associate survey revealed being replaced by technology as the number one potential concern or threat held by that cohort – that’s a pretty powerful statement. I’m not convinced law firm leadership fully grasps this concept.
Toby Brown (TB) – First off, yes, absolutely law firm profit increases can be tied very closely with rate increases. However, I would add recently de-equitization is moving up the list of drivers for PPEP increases. But looking back over whatever sequence of time you choose, rates are a powerful driver of profits for law firms.
To the sustainability question, I refer to the looking back statement I just made. It obviously is sustainable. I have been listening to this gnashing of teeth for far too long. It’s the same every year. And every year firms realize their rate increases. Or at least the ones smart enough to do them.
More to the point – there is a market for law firm rates, with data. It’s actually quite simple to have a rate strategy, access the market data, and then set your rates at the market to align with your strategy. Although simple sounding, it is a very political process inside firms, since these extremely talented lawyers somehow don’t think they are worth market rates. But that’s an issue for another day.
With regards to clients, do clients really push back on increases? Some definitely do, but from experience those are clients at the high-end of the market with significant legal spend. And those clients are going to push back or negotiate regardless of what the rate increase is. The vast majority of clients, especially new ones, pay the freight.
I have also seen situations where having higher rates gives the law firms a better starting point for negotiations. Far too many clients shop on discount, not actual rates. So higher rates give more room for discounting.
Finally, with respect to financial crises, they can play a role, especially in client industries hit harder by the crisis. Many times, there are requests for rates freezes. It’s not unreasonable for firms to take a temporary hit to help their client through a crisis. But they should also make clear that when things rebound, there will need to be a rate conversation.
Part of the reasons law firms raise rates is to protect PPEP and there has been a huge uptick in Associate salaries which is adding to direct expenses – do you have expectations for fewer or different hiring patterns in the future?
TB – Like the market for billing rates, there is also a market for talented associates. In order for firms to attract and retain these people, they need to have competitive compensation packages. In contrast to the rate market, I do see some irrational behavior when it comes to associate compensation. When (insert NY white shoe firm name here) increases salaries or bonuses, I don’t see why down-market firms (below the top 50) need to match these. The way I read it is that the firms a notch below the NY firms match, then the firms below them match and so on, until firms operating well below the top ones have matched their salaries. Then, all of the firms in this lower segment feel compelled to match in order to get good associates. Again, not rational in the economic sense.
What rational would actually look like would be tiers of compensation, based on the types of practice. The value of a labor lawyer is not the same as an M&A one. But good luck getting a firm to do that.
The point about increasing direct costs is a good one. Because this is what inflation looks like for law firms. What firms will most likely do to deal with this, is what they always do: Cut overhead. So, I don’t see it impacting associate hiring.
One last and important point while we’re on the topic of associates is their professional development. I know what you're’ thinking: What professional development? Firms would be wise to develop better programs for this. Associates are very expensive investments that are constantly walking out the door. They usually don’t say it explicitly but being an associate sucks. They get little to no direction from partners and then little to no acknowledgments about their work. A few years back one was explicit about it in a departing email. I thought it was a loud ringing bell. But apparently no one else heard it.
Bottomline, associates are very expensive, but they are the people who generate the profits to pay partners. They deserve better than large firms give them.
MBS – Different hiring patterns? Absolutely. I think there are already signs that law firms are trying to understand how best to utilize their associates. Some are delaying start dates, others are shrinking summer classes and one Magic Circle firm just announced deploying an aptitude test to identify Associates who are the most tech-savvy. First through third year associates, in particular, seem to be on the radar with firms suggesting they’re not getting up to speed quickly enough to be an added value to the clients. And the traditional models of developing associates – the mentorship model or the investment of time or apprenticeship model – those just aren't working the way that they used to in the past. Now, who's to blame for that shift? I suspect it could go in many different directions. While the older generations like to suggest the newer generations simply don't have enough initiative we also can see that the older generations (particularly Gen. X) are just simply not spending the time with associates that their predecessors did. Work models have changed and law firms are going to need to find ways to change with them.
I strongly believe this is going to be one of the most potent competitive advantages of the future. Figuring out how to attract and retain the right talent and not necessarily the top talent or just associates but the right talent because as we see more and more advances in technology and changes in the workforce we are going to see also a shift in how we do business. Clients are going to have more options than just going to law firms.
There are lots of unanswered questions about the potential impact of AI – what do you expect to see in the coming years with respect to law firms leveraging AI to enhance profit margins? How will this impact rates, if at all?
MBS – there are just so many barriers when it comes to law firms in terms of their ability to change in any way let alone to change in such a significant way that they will be able to leverage technological advances such as AI. The risk averse nature of firms combined with a lack of technological sophistication and the…misguided…belief that committees of lawyers are best equipped to create a tech-based strategy for the firm. All of those are going to stand in the way of law firms truly gaining advantage. I suspect it will be like most things in legal: a slog . Much in the same way the transition from WordPerfect to Microsoft Word or adoption of cloud-based computing took the legal sector a decade longer than most industries, the transformation potential of AI will be hampered.
In the meantime, other entrants will claim stake to swaths of lower level work, continuing to put pressure on law firms to figure out exactly how to utilize 1st through 3rd year Associates, what leverage model will benefit in the long run, what skills they need to be hiring for and – perhaps most critical and most challenging – what professional support structure they need to sustain the profit margins they’ve enjoyed for so long. So, I guess the short answer is I don’t see a cliff related to AI adoption but like other evolutions, it will benefit other players in the legal industry far more than it will law firms. And it will continue to narrow the scope of what law firms are called upon to do – and that, in turn, could transform the very nature of legal services delivery.
TB – As I noted above, associates generate the profits that pay partners. AI is going to decrease the amount of associate time needed to complete legal tasks. When billing by the hour, AI will decrease both revenue and profits.
The most common reactions to these statements are: 1) we will use fixed fees, or 2) we’ll add a premium to our rates. One or both of these approaches will help a firm sustain its margins.
Right, except…
Clients do not know how to buy under fixed fees. That would require them to have scope and SOWs and they do not have the skills to do that. Second, clients fully expect their legal fees to go down when AI is used.
We have already talked about rates. Firms attempting to raise rates above what the market will bear will struggle to get and retain clients.
But here is the real issue with AI for law firms. I don't see them getting this right. First, with poor to no access to actionable information on profitability, developing a true ROI will be nearly impossible. Not that firms even think about that when they innovate. Second, firms are not really one business, they are more like a hotel, providing back-office services to their tenants. This means partners have significant autonomy in how they practice. Therefore, most law firm innovations are pocketed to one partner or a small group. Third, AI will be best deployed at the commodity layer of the market. Most firms see themselves above this layer. Firms could deploy it at the low end of the core layer…but that is only theoretical. Fourth, firms will be slow to make the right human capital investments, which they refer to as ‘overhead.’ Teams of very expensive, non-billing people are needed to do AI right. And fifth, firms don’t have access to capital to make these investments.
The one way to do this profitably would be packaging up portfolio fee deals with lower risk work. These would be billed by matter and a firm would be able to extract healthy profit margins and win high volumes of work. As I already said, I don't see them figuring this out. ALSPs on the other hand are very well positioned to do exactly that.
The End ...?
Everything is there, right in front of them, for firms to make smart moves. Sadly, the business model and business structures they use are not conducive to success. Partners value their autonomy. When you hear them reference their cherished culture, what they mean is that they have great autonomy, and they don’t want to let go of it. This is at the core of why firms struggle so hard to act like a business. This new frontier will raise the stakes considerably around the consequences of this. Firms will not start folding anytime soon, but the cracks in the foundations are already appearing.
Reprinted with permission from the [September 20th edition of the Legal Intelligencer] © 2024 ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or asset-and-logo-licensing@alm.com.