PEER MONITOR INDEX
Q4 2011 EXECUTIVE REPORT - ISSUED 01.27.12
PMI Falls Again in Fourth Quarter
Demand, Expenses, Productivity, Realization Trending Negative
The HILDEBRANDT INSTITUTE’S PEER MONITOR ECONOMIC INDEX (PMI) 1 fell another 7 points to 49 in the fourth quarter – its second consecutive drop, and the worst performance for the PMI in over two years. Sagging demand combined with accelerating headcount and expense growth to sharply curtail firm profitability. PEER MONITOR ECONOMIC INDEX (PMI)
Rate growth weakened slightly in the fourth quarter, but more troubling, realization rates resumed their long‐term downward trend and hit a new historic low. 60
After beginning the year on a mildly positive and encouraging note, growth in demand 2 for legal services weakened in every quarter of 2011, finally turning negative in the fourth quarter, down 1.1%. For the year, demand was up a scant 1.0%. While litigation was positive for the year, as were IP‐related practices, a sudden drop in transactional practices in the second half of the year pulled overall demand steadily downward. 45
Rate growth eased slightly, up 3.0% compared with the same period a year ago. Expenses continued to climb in the fourth quarter. Both headcount and overhead expenses rose to their highest levels of the year. 80
70
55
50
40
35
30
Bankruptcy declined in all four quarters, falling 4.3% in the fourth quarter. The 6.1% drop for the year exceeded the 4.0% decline in 2010. 1 The PMI is a composite index score, representing the quarter‐over‐quarter change in drivers of law firm profitability, including rates, demand, productivity and expenses. Positive factors driving firm profitability will produce a higher score. A score exceeding 65 generally indicates a healthy operating environment. 2 Demand is defined as the growth in billable hours. Q1 Q2 Q3 Q4
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007
2008
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2009
2010
2011
PMI KEY FACTORS
Q4 ‘11 Q4 ‘10 Q4 ‘09
Demand
‐1.1%
1.0% ‐0.6%
Productivity
‐3.8%
0.7%
2.3%
Rates
3.0%
2.0%
4.7%
Direct Expenses
5.2%
‐4.5% ‐5.2%
Overhead Expenses
3.4%
‐0.6% ‐2.7%
‐12 ‐8 ‐4 0 4 8 12 16 20 24 Current Reading (Q4 2011)
Change from Q4 2010
3‐Year Range
Up Flat Down
DEMAND GROWTH BY PRACTICE: ALL SEGMENTS
10
Period over Period Growth
5
Growth Rate (%)
Labor & employment was up every quarter, rising 2.0% in the fourth quarter, and up 3.0% for the year. After rising for three quarters, real estate fell 2.9% in the fourth quarter, finishing 2011 up 1.3%. Tax work declined 4.0% in the fourth quarter, down 1.9% for the year. Q1 Q2 Q3 Q4
2006
The PMI represents the relative rate of change among the major factors influencing law firm performance. These factors are tracked individually in the graph below.
Demand by Practice Areas
However, transactional practices peaked in mid‐year and then declined sharply in the fourth quarter. General corporate work was down 4.7%, capital markets fell 5.0% and M&A dropped 5.1%. For the year, capital markets and general corporate both dropped 0.5%; M&A was down 1.2%. Credit Crisis
65
In short, the market fell sharply out of balance between demand and capacity in the fourth quarter, as demand turned negative but expenses continue to climb. While the market could quickly recover some of the lost ground if the economy continues to grow, 2011 ended with worrisome trends that warrant continued attention as we move deeper into 2012. Demand patterns in 2011 were a near‐complete reversal from 2010 when litigation declined and transactional practices were strong. In 2011, litigation demand growth was positive every quarter, including 1.1% in the fourth quarter, ending the year up 2.4%. IP litigation was even stronger in 2011, rising 5.1% in the fourth quarter and 6.2% for the year. Q4 PMI Score: 49
75
0
-5
Proportion of Overall Market
-10
5%
8%
9%
33%
6%
6%
11%
3%
3%
3%
IP-Lit
L&E
L&E
Litigation
Real
Estate
Capital
Markets
General
Corp
M&A
Tax
Bankruptcy
Q4 ‘11 v Q4 ‘10
Performance by Market Segments
Am Law 100 firms faced significant headwinds in the fourth quarter due to the marked drop in transactional practices. Demand fell 1.7% – the only market segment to show negative demand growth. A slight rise in litigation and strong growth in IP litigation were not enough to offset sharp drops in M&A, capital market and general corporate work. For the full year, however, Am Law 100 tied with Am Law Second Hundred for the highest demand growth, up 1.1%. Demand rose 0.5% in the quarter for Am Law Second Hundred, which showed rate growth of 2.7%, the lowest of any market segment. Midsize firms had flat growth for the quarter, but also had the lowest headcount growth and the lowest decline in productivity. Los Angeles was again the strongest major U.S. market in the fourth quarter, up more than 3%. Along with Boston, up 2% in the fourth quarter, the two were the only major markets to show consistent demand growth throughout the year. Chicago declined 1% in the quarter; Washington, D.C. fell 2%; and New York was down 4%. Demand in London was up 4%. One noteworthy bright spot was Silicon Valley, which rose 10% in the quarter and rose every quarter, reflecting strength in IP practices. Rates
Rate growth eased slightly to 3.0%. For all of 2011, rates were also up 3.0%, a marginal improvement over the 2.8% gain in 2010. However, realization, after a brief pause throughout much of 2011, has now resumed the long‐term downward trend that has largely been in place for the last several years. The drop in realization effectively negated much of the increase in negotiated rates for the year. The reality is that despite gains seen in negotiated rates, significant pricing pressure remains. Taking into account the drop in collections, collected rates declined in the fourth quarter, and for all of 2011 were up barely 1.6%. The troubling trend in real rates is discussed in greater detail in the special section of this report. Expenses
3
Cost growth continued to accelerate in the fourth quarter. Direct expenses jumped 5.2%, while overhead expenses were up 3.4%. While only slight increases over the third quarter, they are the highest growth rates seen in the last three years. As was the case in the third quarter, expense growth dramatically reduced firm profitability in the fourth quarter, and was one of the most important factors contributing to the decline in the PMI. After turning positive in 2010, attorney headcount rose steadily in every quarter of 2011. Headcount rose 2.8% in the fourth quarter, and 1.4% for the year. The attorney replenishment ratio eased slightly to 1.1 for the overall attorney population – an increase in retirements, layoffs and other departures helped offset the influx of new hires and lateral hiring. Overhead expenses similarly continued to climb. Our 2011 Staffing Ratio Survey found that best practice firms are more strategic in adapting their staffing model to balance staffing levels in areas such as marketing, technology, finance and administration as part of evolving the law firm business model into more nimble, business‐like organizations. Productivity
5
After rising early in 2011, productivity fell steadily throughout the year, turning negative at mid‐year, as headcount growth surpassed growth in demand. Productivity fell another 3.8% in the fourth quarter, and was down 0.5% for the year. 3 Includes both direct expenses (salaries, fringe benefits and professional fees associated with billable timekeepers) and overhead expenses (all other nondirect expenses, including staff compensation, marketing, technology, occupancy, office expenses and research). 4 Attorney replenishment is the ratio of new attorneys to the firm divided by those departing. A result greater than 1 indicates growing capacity, while a result less than 1 signals a contraction. 5 Productivity is defined as hours per attorney and represents the ratio of capacity to market demand. Firms did a commendable job of balancing headcount against demand through the first eight months of the year. However, even as demand growth decelerated – and eventually turned negative – headcount growth accelerated through year‐end. Without a sharp recovery in demand, it is likely that productivity will continue to drop in the near‐term until firms can achieve better balance between capacity and demand. 2012 Outlook: Clear Trends
Demand turned sharply lower in the fourth quarter, its decline accelerating each month. And after several months of stabilizing, realization rates fell sharply. Both contributed to a weak end to the year, setting up a challenging 2012. In addition, there were clear year‐long trends. Demand slowly but steadily declined and finally turned negative in the fourth quarter. Meanwhile, expenses and headcount rose steadily. Rates eked out minor gains, but those were largely offset by a drop in realization late in the year. The clear message the market is signaling is that firms can no longer simply wait for things to get better. Thoughtful market analysis and strategies need to be translated into prompt action to reverse the diverging demand and cost trends. With demand softening and rate growth weak, expense growth has effectively wiped out much of the profitability gains seen over the last two years. Some of the hiring and spending was a result of firms finally biting the bullet on long‐deferred new associates and tech infrastructure investments. Nonetheless, it will be incumbent upon firms to closely manage attorney headcount, staffing and capital expenditures against whatever demand picture emerges this year. In addition, new approaches such as relocating administrative functions and use of legal process outsourcing need to be considered. The outlook for overall demand is unclear, being significantly influenced by external market forces such as the overall economy and geopolitical events including the Eurozone crisis. However, some practice areas are showing pockets of strength, including litigation and especially IP‐related practices. Nimbler firms that can redeploy assets to focus marketing and practice strength in areas of growth will be better positioned to take advantage of opportunities and separate themselves from the pack. We are seeing a widening disparity as firms with strong strategic focus on market segmentation, innovative business models, effective project/matter management processes, and well‐executed rate strategies are achieving growth sometimes significantly above the averages. For more information on the PMI, and how Peer Monitor can help your firm successfully manage through today’s economy, please contact Mark Medice at 412‐203‐2155 ([email protected]) or visit peermonitor.thomsonreuters.com. Special Focus: Realization & Collected Rates Amidst the slow, steady deterioration of demand and expenses in 2011, PMI is tracking a steady long‐term deterioration in realization that has been slowly, insidiously eating away at rate growth, revenues, and ultimately, profitability. From Q4 2008 to Q4 2010, collections fell fairly steadily from 87.5% to 85.2%. During the first part of 2011, collection rates were largely stable, and actually rose in the second quarter. The improvement, however, was only fleeting. Collections in the fourth quarter showed their biggest quarterly drop since Q1 2009 during the depths of the economic downturn. Collections have now hit a new historic low of 84.0%, a drop of 1.2 percentage points for the year. The weak realization thus effectively wiped out nearly half of the gain in negotiated rates seen in 2011. Taking into account the impact of realization, collected rate growth is arguably barely keeping pace with inflation. But as in the case with demand, we are seeing a wide disparity in collected rate growth. Firms with well‐focused rate strategies that carefully manage resources and timekeeper mixes applied against matters, in combination with effective collection strategies are able to achieve strong, meaningful rate growth. For further discussion on how advanced market analytics can help drive successful firm strategies, contact your Peer Monitor consultant. PEER MONITOR INDEX
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