PEP at top-tier US law firms £245,000 higher than at UK elite

More top-100 UK law firms have recorded growth in fee income than at any time since 2008, suggesting a return of stability and confidence in the market.

That's according to PwC's 23rd annual UK legal market survey, which found that 80 per cent of the top 100 recorded a growth in fee income, compared with 63 per cent last year. In addition, 70 per cent of firms recorded above-inflation increases in UK revenues.

"The survey paints a brighter picture for the future of law firms than a year ago," said David Snell, partner and head of PwC's law firm advisory group.

"The majority of firms surveyed expressed confidence about their growth prospects over the coming three years, although uncertainty remains about growth prospects for the sector as a whole. Merger activity looks set to continue, and international expansion remains a priority for many."

The survey found that the top 10 firms recorded their highest ever average net profit margin, at 40 per cent.

Firms ranking in the 11 to 25 positions finally started to reverse their previous five-year trend of margin deterioration, posting a 2.2 per cent increase to 28.2 per cent.

The report notes that the increases in net profit margins were mainly achieved through reductions in fee-earner numbers and increases in chargeable hours.

Firms in the top 26 to 50 posted a fifth consecutive year of profit margin decline to 24.1 per cent, 0.2 percentage points below the average net profit margin of top 51 to 100 firms.

This drop may be due to firms in the top 26 to 50 category having, on average, increased fee-earner numbers but experienced lower levels of utilisation, according to the research.

Pricing increasingly under pressure

Chargeable hours have increased to near 2008 levels, but pricing pressure has resulted in a drop in fee income per chargeable hour across the board. It is down by 8.1 per cent among top 10 firms, 2.8 per cent among top 11 to 25 firms and 9.3 per cent among top 26 to 50 firms.

The report says this drop may be partly driven by a greater shift towards fixed and contingency-based fee structures.

Time and materials now constitute only three quarters of fee arrangements among the top-50 firms, down from 83 per cent in 2010.

Strikingly, 40 per cent of firms reported unplanned work-in-progress write-offs greater than 10 per cent of fee income, indicating that many are still falling down on scoping, pricing and matter management.

"Firms need to have increasingly sophisticated management information to properly budget and monitor client and matter profitability, and it is therefore no surprise that our survey lists pricing and profitability, process efficiency and business analysis/reporting as the top priorities for finance departments over the coming year," the report says.

"Firms are attempting to address these challenges through the introduction of pricing directors, the use of pricing tools and methodologies and increased governance to hold partners accountable for pricing execution."

The research found a sizeable gap between actual hours recorded and target hours (by 9 per cent on average in the top 10 and 12 per cent in the top 11-25).

This suggests that there is still spare capacity within firms, with the greatest gap between actual and target hours at partner and trainee level.

The gap between target and actual chargeable hours indicates spare fee-earner capacity of 9 per cent in top-10 firms and 12 per cent in top 11 to 25 firms, according to the research.

The top 10 firms' gross profit margin per chargeable hour is 4.3 percentage points ahead of the mid-tier, while the difference among the top 11 to 100 bandings is 3.1 percentage points.

Top-tier US law firms outperforming UK counterparts

Improving profitability appears to have been a key focus for the majority of the UK's top-100 law firms.

Fifty-eight per cent of all firms (compared with 45 per cent in 2013) recorded profit increases at a higher rate than fee income.

The number of firms reporting both fee income and profit reductions is just seven per cent this year, compared to 25 per cent in 2013.

However, top-tier US firms (generating global revenues in excess of £1bn) continue to be significantly more profitable than their UK counterparts.

The research found that, while there is consistency in fees per full equity partner in UK and US top-tier firms, profits per partner at UK firms are 21.5 per cent behind those of US firms.

UK top-tier firms also fall significantly short of their US counterparts in terms of both fees and profits per fee earner - at 20.5 per cent and 36.3 per cent, respectively.

Strikingly, US firms have an average net profit margin of 47 per cent, compared to 37 per cent at UK firms.

That gap equates to a profits per equity partner (PEP) difference of £245,000 on average.

The report suggests that, with US law firms continuing to expand in the UK - often unconstrained by top-of-lockstep limits - the lure of higher PEP may be effective in drawing away some of the UK firms' best legal talent.

Profits per full equity partner at UK law firms are between 21 and 29 per cent behind 2008 inflation-adjusted levels.

"With a pickup in market activity, shortage of talent is an emerging concern for a number of firms, particularly given their intention to increase fee earner headcount as the economy grows. Recruitment, retention and reward strategies will be key in differentiating firms," it notes.

PEP has improved across all of top-100 UK firms, with the top-10 average exceeding the £1m barrier for the first time since 2008.

However, more than half of the year-on-year increase was driven by a five per cent reduction in full equity partner headcounts.

Greater impetus to deliver services differently

A key concern among respondents is the trend towards disaggregation of work, with clients appointing different types of firms for different tranches of work.

Matters are increasingly being carved up between traditional firms, alternative business structures and legal outsourcers.

"The ability to deliver differently, as well as to price differently, has become a critical success factor," the report notes.

The research suggests that legal process outsourcing is still in its infancy and that there is potential for it to be used more effectively for litigation support, document preparation and legal research.

Innovations in technology should also be further leveraged to increase efficiencies in accessing content, streamlining processes and sharing knowledge, it says.

"With challenges around the business model, changing client demands, and talent retention, law firms are operating in a very different market to that of five years ago. Recent law firm failures and enforced mergers are a reminder that the tide can turn very quickly," commented Snell.

"Change in the legal sector is set to continue, and firms looking for success and substantial growth will require clear leadership and vision, strong discipline over business practices and agility to ensure they are able to take advantage of new and emerging opportunities."

International expansion continues to be a strategic priority for all top-50 firms, with Asia, the Middle East and Africa the preferred locations, according to the research.

Manju Manglani is editor of Managing Partner