Intelligent Office: Adopt the brace position – Law firms need to prepare for some financial turbulence

This may not be the most promising start to a blog but hopefully it is at least intriguing: “some of the events described below may never happen”. Too many times predictions of impending doom for the law firm financial model have been utterly wrong or, at best, incredibly premature. Only two years’ ago, the legal sector was slowly waking up to the fact that most firms were not, in fact, facing immediate ruin as a result of the global pandemic. Indeed, for many the 2020/21 period ended up being one of the most profitable on record.

So, this is not a dire warning or ‘asteroid killing off the dinosaurs’ piece. The title predicts turbulence, not a crash landing. All I am trying to do here is pull together what we are hearing out in the market and concluding that the economic outlook is even more uncertain (and, yes, volatile, complex and ambiguous to cite the full VUCA acronym) right now. And give some thought to what law firms are experiencing and might experience over the next year.

The immediate post-pandemic and lockdown period was bound to see law firm costs rise, quite regardless of increased inflationary pressure. That is down to an unavoidable rebound in consumption and demand for a whole range of goods, services and support. As the return-to-offices picks up momentum, workplaces are switching from near moth-balled conditions to something much closer to fully open for business. That has driven demand for energy, food and drink, paper stocks, IT consumables and staffing (the latter in the wake of furloughs, some redundancies and ripples from the much-discussed great resignation) across a range of onsite functions. At the same time, the reopening business community has brought with it renewed spending on events, national and international travel, lunches and dinners and sponsorship – with many individuals and firms trying to make up for a lot of lost time. Government support through furlough schemes and emergency support has been withdrawn, further driving up year-on-year cost increases.

If this was the whole story, firms would probably be able to shrug off the U-shaped cost curve as a one-off without long-term damage; even if it does make maintaining partner profits in 2022 that bit harder. But surging inflation, with input costs rising at near record highs, has made the challenge a much more difficult one. Inflation is predicted to exceed 9% and, at the same time, businesses are facing shortages and supply-side disruption. This trend was underway even before the outbreak of war in Ukraine after the Russian invasion in March 2022, but that historically significant event has driven prices much higher, especially for energy, food and raw materials. Meantime, central banks have felt obliged to raise interest rates in order to try to cool inflationary pressures but, in the near-term, adding to household and business costs. The reality is that costs have rocketed and show no sign of reducing in the near-term.  Firms will have to scrutinise all areas of spending and take an open-minded view to all and any sustainable ways in which overheads and support costs can be managed.

For law firms the inflationary issue that stands out and keeps their leaders awake at night is escalating staff costs. We have been using that War for Talent phrase for years but it feels more valid and accurately descriptive than ever right now. Firms of all shapes and sizes, in all locations, are struggling to find the people they want. The primary battleground is for lawyers, but as the speakers at the Legal COO Network session I chaired recently all underlined, business support skills and resources are also in short supply. Obviously, the legal industry is hardly unique in suffering from a dramatic lack of supply and accelerating salary pressure. But there is something particularly intense about the cost implications for law firms. The domino effect of US firm pay rounds has impacted on the whole of the London market and then out into the regions. Newly qualified rates at the leading US firms in London have hit £150,000 and at some of the Magic Circle firms £125,000. Firms have reported average 2022 pay rounds of anything from 4% to 10% so far this year. ‘So far’, because many firms are already gearing up for the prospect of a 2nd round of 2022 rises, as well as generous bonuses. That could bust the budgets set just months ago and create further pressure on fee income targets just to keep profitability where it was. And that ignores the additional, less visible inflationary impacts of sign-on bonuses, buy-backs to retain staff who have other offers on the table, accelerated promotions and enhanced flexible benefits. Is all of this really sustainable? Well, maybe if clients were willing to sign-up to double-digit increases in what they pay for their legal advice. Which is by no means a likely prospect – something I’ll return to shortly.

Taking a macro and slightly longer-term view, law firms have to be ready for more than just dramatically rising costs. The OECD’s latest outlook suggested the UK economy was heading for stagnation and the weakest growth in the G20 outside Russia next year. There is now a wide consensus that the prospect of a recession is looming and that will impact on both the personal and corporate legal service markets.

The soaring cost of living, especially in terms of energy and food, is already driving plummeting consumer confidence. As more households struggle with day-to-day living costs and others, better insulated economically, also look for ways to cut other outgoings in order to afford the spiralling cost of eating and heating, consumers are going to be tempted to cut back on any but the most essential recourse to legal advice. Alternative, lower-cost and online legal service providers, already given a boost as successive lockdowns pushed clients towards remote service delivery, will be looking to seize on this more price sensitive market. It is hard to imagine a 2023 scenario that doesn’t feature yet more aggressive price wars in the highest volume personal legal categories, including conveyancing, wills and claims.

Corporate clients will hardly be immune to the same trends, of course. Facing the same exponential cost inflation as law firms across payroll, financing and overheads, corporates are already looking for savings in other categories. External legal spend will remain a popular well for CFOs and CEOs to return to. The result may be further direct price pressure, with demands for discounts and alternative fee arrangements, or the more insidious and often invisible (until it is too late) redirection of legal work to in-house legal teams and away from private practice firms.  The latest survey by Association of Corporate Counsel and Major, Lindsey & Africa showed that 54% of corporate legal spending is now staying in-house, up from 49% a year ago.

After a few years of dramatic, somewhat surprising, record billings for some of the largest law firms, there is real potential for turnover to drop back at exactly the time cost pressures are eating into margins from beneath. This is the time for firms, whatever their year end date, to do a thorough reforecast exercise, developing a few scenarios based on the kind of factors I’ve outlined above. Some firms will want to put a brake on imminent spending and investment plans; although many have built up significant cash reserves that they can utilise. All firms should be examining again how to maximise gross margins – looking at the all-important factors of pipeline, price, utilisation, realisation and efficiency. And many need to be preparing themselves for the strong possibility of lower overall profits as a result; prepare partners for a period of lower incomes – or to recalibrate equity partner numbers and profit-sharing mechanisms to ensure that doesn’t happen.

I will, briefly, return to the caveat I introduced in the first line of this article. Many law firms are in rude financial health and many markets are still recovering and rebuilding as the world slowly bounces back from the pandemic years; shocks like the Ukraine crisis notwithstanding. Some firms will see top-line growth that continues to cover rising inflation and the market as a whole will most likely, as usual, take a year or so to catch the cold the wider economy is suffering from. But planning and preparing for difficult times ahead is still the right thing to do.

In the midst of all this uncertainty, it is easy to lose sight of the lower-hanging fruit available to firms who are open-minded, innovative and bold in redesigning their basic working practices and support functions. The success of firms in transforming themselves into remote or hybrid working organisations during 2020 demonstrates the underlying infrastructure advantages and ability to adapt law firms possess. And yet we are already seeing examples of advances in digital workflows, hybrid working and smart use of tech tools being pared back. Surely this is the time for firms to do the opposite – look to continue the acceleration towards a more streamlined, digital, rapid and flexible environment, rethinking how, where, when and by whom work is done. For Intelligent Office supporting 60-plus law firms with this kind of efficiency-focused transformation is at the core of our mission and demand for that insight is, understandably, rising again as financial turbulence looms larger.