Can Rates Make Up for Expense Growth Much Longer?
April 18, 2023
A recent the American Lawyer story by Dan Roe, “Can Rates Make Up for Expense Growth Much Longer?,” reports that large law firms became more expensive to operate and less profitable in 2022, despite growing in terms of revenue and head count. While equity partners took home less money, associate and nonequity partner compensation continued to rise. Rate increases managed to keep gross revenue in the black as demand slid by nearly 2%. Still, the profit margin for The Am Law 100 fell 2 percentage points to 42%, wiping out the profitability gains of 2021 and putting firms below the average 2020 profit margin of 43%.
“The margin on the billable dollar is contracting, and that is causing law firms to increase their rates, and that is why GCs are saying, ‘Hey, maybe we bring this work in-house,’” says Aon Law Firm Advisory Team manager George Wolf.
Facing seemingly unavoidable increases in personnel expenses, law firms looked to technology for efficiency and real estate for cost savings in 2022. But despite realization rates holding strong, some observers believe legal departments are at the end of their rope on rate hikes, prompting Big Law to get smart or shrink in the coming years.
Head-Count Growth, Comp Increases and Tech Investments Drove Expenses Up
Head-count growth accounted for a majority of the expense increases in the Am Law 100 last year. Across the cohort of firms, head counts grew nearly 4.7%, compared to average expense increases of roughly 7%. Law firms that saw the most expense growth were mostly firms that hired aggressively: Goodwin Procter posted a 24% increase in head count and a commensurate 22% increase in expenses. Willkie Farr & Gallagher also saw a 22% increase in expenses with 19.5% more attorneys.
In addition to Goodwin, other tech-centric firms that staffed up to meet demand saw similar expense increases: Cooley was up almost 18% on expenses and 11.5% on lawyer head count, and Morrison & Foerster raised head count 6% with an expense increase of 11.9%. On average, law firms saw expenses rise 3 percentage points more than head count.
Among the firms where head count increases significantly trailed expense increases, firm leaders most commonly cited increases in attorney compensation—particularly for associates. “It’s a battle for talent at every level, and the reality is, for us to attract and retain and develop the best talent, we need to stay competitive with our peers in the market,” says Husch Blackwell CEO Paul Eberle, whose firm saw expenses rise 18.4% amid a 6.2% increase in head count.
At Baker & Hostetler, first-year associate compensation went up to $200,000 from $175,000, which partly influenced the firm’s 10% average rate increase in 2022. Vinson & Elkins saw a similar situation, with expenses up 7.5% and head count down 3.2%; firm chair Keith Fullenweider says associate compensation was among the primary expense drivers. Nonequity partners also got more expensive last year, with nonequity compensation per partner rising 2.7% in the Am Law 100 last year.
Big Law is also going big on tech, with firm leaders citing technology investments as the third-biggest source of expense increases in 2022 behind head count growth and compensation increases. “From an expense standpoint, we’re witnessing more of a reallocation of expenses than a raw increase in typical areas of spend,” says Alston & Bird chairman Richard Hays. “It’s less on space but more on technology.”
Law firms in the Am Law 100 are spreading their tech budget across multiple areas, but data analytics, automation and artificial intelligence appear to lead the way. Several firms including DLA Piper, Eversheds Sutherland, and Orrick, Herrington & Sutcliffe are testing an AI legal assistant called CoCounsel, and firms including DLA Piper and Debevoise & Plimpton are building out data analytics capabilities to improve efficiency and increase AI-oriented service offerings for clients.
Finally, the return of travel and events is also driving expenses up, although firm leaders had seen that coming. “Expenses went down dramatically in the form of events, travel, all those things,” says law firm management consultant Ralph Baxter, formerly the chairman and CEO of Orrick. “Every firm leader should be able to manage expectations. What we saw in those two previous years is not going to repeat.”
Rates Went Up, but Realization Held
The Am Law 100 raised rates by an average of 7.2% by mid-2022, according to data from Wolters Kluwer ELM Solutions released in February, although the report showed significant variance between firms. Roughly 40% of timekeepers didn’t raise rates at all through June 2022, but 9% raised rates by 20% or more. About 15 firms in the Am Law 100 brought rates up 10% to 20%.
“Rates typically go up with the consumer price index, maybe 3% to 5% annually,” says Chris Ryan, executive vice president at HBR Consulting. “Now you’re seeing this much bigger swing and variance, which is probably alarming to legal departments who are asked to do more with diminishing budgets, given the state of uncertainty.”
Data collected by The American Lawyer shows that fewer firms were willing to raise rates by less than 3% this year: Whereas more than 20 firms in 2021 kept rate hikes at or below 3%, only seven firms in 2022 reported sub-3% rate increases. This year will likely be a repeat of 2022, law firms indicated.
Despite raising rates more dramatically than usual, law firms didn’t report substantial drops in realization last year. Having raised rates 10% in 2022 after rate increases of 5.9% to 7.3% for the three years prior, BakerHostetler chairman and CEO Paul Schmidt says clients understood the situation. “Last year was a fairly strong (rate) increase, but with inflation, there was not much pushback on it,” Schmidt says.
How the Inflationary Cycle Ends
Ultimately, if Am Law 100 firms do nothing as billable hours continue to decline, that will indicate that work is leaving Big Law altogether. “You don’t measure demand for soybeans by how many hours you spend harvesting soybeans,” says Baxter. “People need legal services more than ever—there’s more regulation, more law, more controversy. But if you see fewer billable hours, that means demand is moving away from the Am Law 100 to somewhere else.”
That “somewhere” could be in-house legal departments, alternative legal service providers, or regional law firms with lower rates. “I’ve talked to a lot of regional firms over the past few years that get hired by a big client who has litigation in a place where (the firm) is centered. The client hires them because they’re there, but they see how good the lawyers are, how responsive they are, how much less expensive they are, and they take them to other places,” Baxter added.
Speaking with in-house counsel, Wolf says legal departments are incensed by associate rate hikes—see the $1,060/hour second-year Kirkland & Ellis associate bill that recently went viral on legal Twitter. “The rates that are being charged for younger attorneys are driving in-house counsel to start building staff again,” Wolf says. “The offshoot of that is that’s where the least amount of work is available in law firms—younger attorneys. And you need midlevel attorneys to help train them, and right now there’s a dearth of midlevels because of the Great Resignation. That’s causing a problem for managing partners and law firm leaders.”
Rather than pulling back on rate hikes, law firms are looking to squeeze more value out of their personnel using technology, with the goal of reducing staffing costs for clients and compensation costs for firms. “You’ve seen this shift toward looking at the profitability of individual practices and using data in a different way so they can position themselves in a better light with clients,” Ryan says. “I think that firms are looking at those kinds of models and are more open to them than ever.”
Firms like DLA Piper, Orrick, Debevoise, Winston & Strawn, Mayer Brown, and Gibson, Dunn & Crutcher have all made investments in AI practices of late, with promises to deliver more efficiency to clients in addition to using AI to help them solve their legal problems. “At its core, we think of it as making lawyers more efficient, increasing their quality of lives, increasing the work product if we can, or at a minimum ensuring it’s the same,” Orrick innovation adviser Vedika Mehera told Legaltech News in March.
Law firms’ substantial investments in artificial intelligence and data infrastructure could also have something to do with the existential threat such technologies pose to the billable hour. “Generative AI is making it possible to do a lot of the work law firms do way faster,” Baxter says. “If you continue to base how much you charge on how many hours it took you, then you’re going to have a material hit to your revenue—and an unnecessary one.”
However, on an aggregate basis, the Am Law 100 has made little progress on AFA adoption in recent years, with 18% of its 2023 revenue coming from such arrangements. In high-stakes litigation, some firms have had success keeping clients who might have been priced out of their services by organizing litigation funding. At Nixon Peabody, where rates went up 5% to 6% last year, chairman and CEO Stephen Zubiago says the firm has involved litigation funding with an increasing number of clients. Regardless of which levers they choose to pull, firms will have to find ways to outrun expense growth in a climate where clients are holding tighter to their dollars as firms are losing a grip on their own spend.