Growing Revenue Matters More Than Managing Expenses

Editor’s Note: The author of this post works for Citi Private Bank Law Firm Group.

By Gretta Rusanow, Senior Client Advisor, Citi Private Bank Law Firm Group

With the ever increasing pressure on law firm pricing, where does the biggest opportunity lie for firms to improve profitability – focusing on revenue growth or doubling down on expense management?

For several years, our team at Citi Private Bank Law Firm Group has asked leaders of major law firms to report on the level of alternative fee arrangements (AFAs) they are encountering. To test whether certain market segments are immune to AFAs, we’ve also studied the level of pricing pressure on elite law firms. And with so much pressure on revenue growth, we’ve examined the degree to which margin growth has become more important to firms.

Our studies show that pricing pressure is on the rise, that no one is completely immune to it, and that firms feel they could do a lot more to understand and improve the profitability of individual matters and clients.

As an example of increasing pricing pressure, let’s look at AFAs. Our 2014 Law Firm Leaders Survey of 66 leading law firms showed that on average, firms estimated 16% of revenue would come through AFAs in 2014, up from 11.5% in 2010. This wasn’t about a few outliers - more than half projected that AFAs would account for at least 10% of their revenue.

Having heard from clients about the challenges to grow revenue, manage costs and maintain margins, when pricing is under so much pressure, we sought to answer the question, “what impact are AFAs having on profitability?”

To better understand this, we contrasted the 2014 financial results reported to us by firms at opposite ends of the AFA spectrum - those that rely the least on AFAs (accounting for less than 5% of firm revenue) vs. firms that depend the most on AFAs (defined as 30% or more of firm revenue). Among the latter group (“Most AFA Firms”), we found that their realization and their average realized hourly rates were lower. They are, on average, larger than the firms with the least proportion of AFAs (“Least AFA Firms”). They also maintain higher leverage and are more productive. So the first takeaway is that where pricing is under pressure, volume matters.

Beyond building higher leverage models, Most AFA Firms have built more junior models. They maintain a higher proportion of associates, and employ more than twice the proportion of temp and other lower cost lawyers than the Least AFA Firms.

There is a strong argument to be made that creating a lower cost leverage model is key to building a profitable leverage model when fees are fixed or capped. You would expect a significant cost advantage for those firms.

Surprisingly, when we examined the 2014 expense results of these Most AFA Firms with their lower cost leverage models, we found that they held less than a 3% expense per lawyer advantage over the Least AFA Firms. That advantage was driven slightly more so by lower overhead expenses per lawyer than by a salary advantage. Assuming that these firms have worked hard to manage their expense base, there may not be much more that they can wring out in terms of expense management. So the second key takeaway is that expense management, while important, can only go so far in helping the profitability of firms experiencing strong pricing pressure.

That takes us back to the revenue side of the equation. A higher and more junior leverage model can result in lower revenue per lawyer (RPL), due to lower average rates. Lower realization has further added to the pressure on RPL. Despite their higher productivity, these firms saw their RPL trail the firms with the least AFAs by almost 6.5%. The net effect of a greater gap in RPL than the size of their expense per lawyer advantage was that those firms saw lower margins and lower contribution per lawyer. (It’s important to note, however, that the Most AFA Firms saw a higher PPEP than the Least AFA Firms - the upside of the higher, more productive leverage model.)

Expense management is important, but the real opportunity is on the revenue side by growing volume, and improving realization. No doubt this is the view held by firms who have employed pricing specialists to help negotiate mutually favorable pricing, and project managers to manage efficient delivery of legal services. We’ve watched the presence of both roles grow rapidly in a short period.

For anyone thinking that AFAs still only account for a relatively small proportion of revenue, and only affect certain segments of the market, consider this – the same group of firms reporting 16% of revenue from AFAs, also estimated that revenue generated through pre-negotiated discounts to the hourly rate would amount to 46.5% of revenue last year. Even among the most profitable firms who report to us, we see a rising trend in AFAs and pre-negotiated discounts.

The level of pricing pressure in the legal industry is significant and widespread. Implementing more cost-effective leverage models, building volume, and employing experts in pricing and project management are key to growing revenue.

So are firms’ efforts to move the conversation with clients away from procurement’s focus on price to the General Counsel’s (and Board’s) focus on value and the right outcome.