Insights

"Seismic shift in economic contract between lawyers and their clients starts to have an impact."

by Simon Slater, Managing Director, Intelligent Office Consulting Services

Two years into the worst downturn in six decades, there is no better time to take a long hard look at the effect on the UK legal market. Every September, The Lawyer magazine publishes its Top 200 Report. Our own analysis of the profit margin data it provides for the leading 100 firms makes interesting reading.

There was a time when these firms routinely generated margins of 30% to 40% year after year. The average margin is now 25%, with London firms making 28% and regional firms 22%. Firms in the top 50 fare slightly better, producing 29% and 24% respectively. Those in the lower half achieve 27% and 20% respectively.

Profits have been eroded by a third. But the difference this time is that it's permanent.

More interesting still is the fact that whilst regional single site firms come close to matching the profit margins of London firms, at 25%, and national firms generate profits of 20%, multi-site regional firms (with a handful of offices but no London presence) struggle to make 15%.

Law firms need to produce superior profits in order to retain and attract good people and to invest in growth and development. A margin of 15% is not enough - in a high cost market - to allow for such investment. Even 20% makes it difficult.

Imagine how bad things are below the top 100. It would be reasonable to estimate that many of the firms in the 100-200 bracket are struggling to generate a margin of 15%. Beyond the top 200, eight thousand small practices are probably making between zero and 10%. Many are finding it difficult to maintain positive cash flow and numerous firms (of all sizes) are refinancing. There is little room for investment. In truth, it is unlikely even to be on the agenda.

So what does all this mean? And how can firms protect their profitability?

Firstly, the rate at which the market consolidates can only now accelerate. Firms need to combine to achieve economies of scale and to produce enough funds for investment. However, even for the more successful firms making a respectable 25% margin, the challenges ahead are substantial. The balance of power between general counsel and adviser has shifted forever. In order to sustain their own long-term futures, clients have changed the rules of the game for good.

Some of the trends now taking root as a result include:

• The death of the billable hour. Yes, it is slow to happen, but alternative pricing strategies are top of most firms' agendas and they are beginning to understand the difference between price and value.
• The structure of law firms is changing. There will be fewer equity partners in future and work will be pushed even further down the food-chain to improve efficiency. The role of partners will change. They will become client, team and project managers. Paralegals and Legal Executives will do the work of solicitors.
• A knock-on effect on career structures - already changing as a result.
• Remuneration systems being realigned around different competencies/behaviours.
• More and more firms adopting a corporate management model.
• The concept of research and development (R&D) is being investigated to see what role it can play in helping firms maintain competitive advantage.
• The hiring of specialists to work alongside lawyers in the delivery of service, the most obvious example being project managers.
• Firms looking to optimise the balance between back office and front office functions to ensure operational efficiency is improved.
• All forms of procurement and alternative sourcing being explored: off-shoring, on-shoring, near-sourcing, north-shoring, shared services. One size does not fit all.
• A few firms seeking to re-position themselves as legal process outsourcing (LPO) providers. Some would argue that law firms have always been LPOs, but that they now have to behave like them.
• Legal education institutions and training providers reshaping their programmes to create the lawyer of the future.

With all this transformation - and it is a heavy burden of change - one thing remains constant: the power of the brand.

While the UK legal market has spent two years swimming against an unrelenting tide, a handful of firms have actually seen their fee rates rise and their margins remain constant. The Magic Circle firms generated an average profit margin of 42% in 2009/10. Over the last five years, they have seen hourly rates for partners increase from between £425 and £525 per hour to between £625 and £725 an hour and rates for senior associates rise to £550 per hour (£300 in 2005)!

The UK legal profession has always been the most fragmented market but now it is becoming increasingly stratified and at an alarming rate. The message is clear: if a firm is not an efficient, well-run player in the top 100 generating a margin in excess of 20%, it had better be a truly exceptional niche or local legal business in which the equity is either held extremely tightly and/or in which the gearing is sufficiently high to produce a sustainable profit.

simon.slater@intelligentofficeuk.com
t: +44 (0) 845 658 9443
f: +44 (0) 845 658 9445
m: +44 (0) 7786 903 530

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