Too many lawyers are chasing too little work. And meanwhile a number of law firms are effectively serving as bankers for cash-strapped clients struggling in a difficult economy.

Too many lawyers are chasing too little work. And meanwhile a number of law firms are effectively serving as bankers for cash-strapped clients struggling in a difficult economy.

Too many lawyers are chasing too little work. And meanwhile a number of law firms are effectively serving as bankers for cash-strapped clients struggling in a difficult economy.

After a “disastrous” fourth quarter in 2008, many law firms can expect an even more worrisome 2009, writes Dan DiPietro in the Am Law Daily. He serves as client head of the law firm group of Citi Private Bank, which is known for the financial surveys it conducts among its more than 600 law firm clients in the United States and United Kingdom.

First the bad news: Profits per equity partner were down 3 percent; this figure would have been a bit worse if the three Am Law 200 firms that failed last year were included. “Bad news?” you ask. “That’s much better than we’d expected. I guess law firms have once again shown they’re bulletproof.”

This sort of reaction shows why this is truly bad news. When I say at partner retreats that the average Joe and Jane are change-averse, but lawyers are even more so, I get a lot of knowing chuckles. It takes really, really bad news to move lawyers to accept change. My fear is that this 3 percent decline will be greeted with relief and complacency.

I have a story that supports my concern. Recently I had lunch with an executive committee member of a highly profitable New York firm. He told me how worried he and his fellow executive committee members are about 2009. I shared my view that firms need to take bold action, and that in fact firms have a fabulous opportunity to correct the sins of the past by reshaping associate compensation and revamping the hiring process. “Dan, these are really good ideas,” he said. “But we had an okay 2008, so the partners aren’t motivated to accept radical surgery. You know lawyers.” I do know lawyers, and I fear that they lack the collective intestinal fortitude necessary to break away from the herd mentality that most firms share.

Citi Private Bank provides financial services to more than 600 law firms in the United States and the United Kingdom. Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey. These reports, together with extensive discussions with law firm management conducted on an ongoing basis, provide a comprehensive overview of financial trends in the industry and insight into where it is headed.

Our latest survey is based on top-level data from 175 firms (74 Am Law 100 firms, 54 Second Hundred firms, and 47 others). Here’s the really bad news from the survey: Demand, which was flat through the first nine months of 2008, was down almost 2 percent for the full year. You know what that means: The fourth quarter was a disaster. When 2008’s fourth quarter is isolated and compared to 2007’s, we see that demand fell a whopping 7.9 percent.

This bad news isn’t confined to 2008. Our numbers show that firms entered 2009 with very modest growth in inventory (the sum of accounts receivable and unbilled time). At least part of this was due to the lengthening of collection cycles. Many firms are becoming back-door bankers to their clients–not a business they want to be in.

Year-end inventory levels are important because at firms that operate on a cash basis, they are a good predictor of the following year’s collections. For the 175 firms we surveyed, the average growth of inventory in 2008 was a mere 2.9 percent. To put this into context, inventory growth in 2002-07 averaged 7.8 percent per year.

There’s one more worrisome fact: Among our 175-firm sample, head count for fiscal 2008 was up 4.5 percent from fiscal 2007. I showed the flash report of our sample to a colleague of mine who lends money to Fortune 100 companies. Her response? “So, Dan, the way law firms make money is to grow head count when demand drops?” This is a neat way of summing up the problem firms faced as they entered 2009–too many lawyers chasing too little work.

So let’s talk about what kind of year 2009 will be. At a recent meeting of New York managing partners, I laid out my current thinking, which has become more pessimistic than it was last November, when Citi and Hildebrandt International put together our joint client advisory. I told the New York managing partners that I thought demand in 2009 would be down compared to 2008 and that rate increases would be more modest, discounting more severe, and premiums virtually nonexistent. This would translate to a revenue drop of somewhere between zero and 5 percent for the industry broadly.

With fairly aggressive layoffs evident in all but the top New York-headquartered firms, the decline in bonuses, and no foreseeable movement in salaries, expense growth will moderate, if not decline. This should net out to a 5-10 percent decline in profits per equity partner from 2008 levels. (After the meeting, several managing partners told me I was still too optimistic. To them and others at top New York firms I say: “Think layoffs.”)

The pessimism expressed at that meeting has been repeated to varying degrees in the 16 regional roundtables that my colleague Cindy Tambourine and I have just completed throughout the United States and in London. To put it simply, the mood in the U.S. outside of New York is grim; in New York it’s grimmer; and in London it’s the grimmest.

Citi’s fourth-quarter 2008 Managing Partner Confidence Index provides further evidence of this growing pessimism. In November 2008 about 110 law firm leaders told us what they thought profit growth at their firms would be in 2009. More than half (54 percent) believed that profits at their firms would be flat or down; only 9 percent gave that answer in November 2007. The primary reason respondents gave for their pessimism was lack of demand. Two-thirds of the respondents projected flat or declining demand in 2009, compared to only 24 percent making that projection for 2008.

So the need for bold action and innovative thinking is upon us. Firm leaders have the chance to fix a broken business model–a model that relies too heavily on leverage and billing rate increases to drive profit growth, thumbs its nose at the concept of pay for performance, especially at the associate level, and assumes clients will continue to accept the billable-hour model.

These are times that cry out for boldness and innovation. But the window will not stay open for long. Who among you will be the first to act?

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