US law firm profitability drops for fourth consecutive quarter 

Demand has cooled and expenses have increased

Thomson Reuters has reported that US law firm profitability has continued to decrease after it soared to record high levels in 2021, as has demand cooled and expenses increased following substantial drops during the pandemic.

The Thomson Reuters Law Firm Financial Index (LFFI), powered by Peer Monitor/Financial Insights, has dropped for the fourth quarter in a row, which marks the longest consecutive slide in the history of the index.

The LFFI is a composite index of law firm market performance that uses real-time data drawn from major law firms in the US and key international markets. It tracks quarter-over-quarter changes in drivers of law firm profitability, including rates, demand, productivity, and expenses.

Demand for law firm services across all practice areas saw a 0.5 per cent annual decrease in terms of billable hours worked compared to the second quarter of 2021. This was driven by a drop in demand for legal services, including M&A related services, down 4.9 per cent year-on-year. Bankruptcy lawyers also saw a significant drop in demand for their services, down 11.2 per cent. The only major practice area to see an increase was real estate, up 2.5 per cent year on year.  

The other major factor that has fuelled the slump in profitability was growth in expenses. These have rebounded after enormous drops during the pandemic. Q2 2022, like the preceding quarter, saw double-digit growth in both direct and overhead expenses.

Direct expenses – defined by the index as compensation and benefits for all lawyers who are not equity partners – increased by 12.4 per cent, as the competition for talent drove associate pay to record high levels.

Overhead expenses – which include operational costs such as offices and technology as well as salary for ancillary staff – soared by 13.5 per cent. This was driven by firms investing more in functions such as recruitment and business development, that experienced sharp declines during the pandemic. Firms are also spending more on support staff (up 6.7 per cent) and benefits for support staff (up 10.8 per cent).

Investment in technology grew 10.5 per cent for the average law firm, the fastest rate in eight years. Thomson Reuters said this suggested much of the investment is in legal tech, as information technology prices tend to be deflationary.

Mike Abbott, head of the Thomson Reuters Institute, commented: “Last year’s tailwinds have turned into this year’s headwinds. Demand was inevitably going to drop following two years of exceptionally high growth. This combined with rising expenses, have dented profitability amongst law firms.”

“In addition to the current inflationary economic environment, law firms are still having to grapple with issues stemming from the return to the office and hybrid working. The tight labour market has forced firms to increase compensation at associate level, in order to attract and retain the brightest talent. However, there are signs that this growth may be beginning to slow down.”