Law firms - walking on sunshine?

Everyone will be familiar with Walking on Sunshine by Katrina and the Waves https://www.youtube.com/watch?v=iPUmE-tne5U. It’s tosh of course, but great fun.

I was put in mind of it whilst pondering the latest reports about law firm performance.

Global M&A deal value for 2023 was 15% down on the figure for 2022. High interest rates stifled deal flow and it was widely felt that there was a material gap between what sellers wanted for assets and what buyers were willing or able to pay. As Bain have observed, both sides were waiting for the other to blink.

Notwithstanding this, the results of big corporate law firms in the USA have been strong. Ninety firms in the AMLaw 100 reported gains in Gross Revenue in calendar 2023 compared to 2022, eighty-five achieved gains in Revenue per Lawyer and average Profit per Equity Partner (PEP) was up 9.3%.

Kirkland had Revenue of $7.2 billion and PEP of $7.9 million - figures that would not disgrace a Fortune 500 company - and Wachtell, working to a different firm model, had Revenue of $1.13 billion and PEP of $8.5 million.

And 2024 has evidently started strongly for large US firms. Thomson Reuters report demand for legal services up 1.9% in the first quarter of the year.

The leading UK firms have yet to report, as many run to a 30 April year end. But word on the street is that they have also had a financially successful year, with “record” being whispered occasionally. The mood at other international firms in Europe, Africa and Asia is also positive.

Walking on sunshine then? Seemingly yes, but are there clouds on the horizon?

The answer of course is “It depends”, as much will turn on the markets which firms serve. But it is worth pondering some potential “cloud themes” and how firms might respond.

1. Macro Uncertainty

The world is a worrisome place. The tragic wars in Ukraine and Gaza show little sign of resolution, US-China relations continue to be fraught, nationalists are on the rise in many countries, a Trump presidency is a realistic possibility and inflation has been more stubborn than expected.

Despite all this, the economic outlook has improved. The IMF expects global growth to be 3.2% for this year and 2025 and equity markets have been robust - over the last six months the S&P 500 is up 16.5% and the FTSE 100 is up 11.2%. Interest rates are expected to settle at around 2.5% in the EU and 3.5-4% in the US and the UK.

Global M&A volumes are finally on an upward path (global M&A value in Q1 2024 was $361 billion, the highest since Q2 2022), although it is harder to get deals done due to factors such as increased intervention from anti-trust regulators.

Whilst this sounds like good news for law firm leaders, they should keep the salt cellar at hand.

Some commentators are expressing concerns about the US’s debt pile and Jay Powell has said that “the US is on an unsustainable fiscal path” with regard to its debt (all of which could hit US Treasury bonds). Ray Dalio, founder of the hedge fund Bridgewater Associates, shares these concerns and, in a recent interview with the FT, is reported as saying that the US presidential election:

“will determine whether the risks that he sees - which also include climate change and the impact of more widespread use of artificial intelligence - will spiral out of control”.

And there are broader geopolitical risks - for example (i) tensions in the Middle East may escalate further, (ii) there could well be NATO dislocation if Donald Trump wins the US election, and (iii) a trade war with China may intensify.

All of this suggests that law firm leaders should:

• assume business and economic volatility over the coming few years;
• ensure that, to the maximum extent possible, the practice base of the firm is well balanced (eg litigation and bankruptcy vs M&A);
• be thoughtful about incurring long-term overheads; and
• stick close to clients in understanding how they are thinking about the likely challenges of the next five years and how best the firm can add value in formulating strategies to mitigate those challenges.

2. The Billable Hour

The billable hour retains a strong grip on law firm charging. It has the attraction of simplicity for the law firm and understandability for the client – the client can look at the time recorded and take issue with time which, in its view, has not been well-spent.

Over the years there has been much handwringing about the inadequacies of the system. It represents payment for inputs rather than outputs, it makes it hard for clients to budget and it can be an incentive to inefficiency, as many lawyers work to billable hour targets which incentivise the creation of big teams and the accumulation of hours.

Whilst alternative billing strategies have made some progress (for example, fixed fees for certain capital markets transactions and value-based billing for marquee M&A transactions), the billable hour has not been challenged as the default basis for billing.

I do wonder, however, whether this is sustainable in the medium to long term?

LexisNexis report that billing rates for partners in US firms increased by 5.4% in 2023 and headline rates for Big Law firms are high. Leading US firms are charging up to $2,500 per hour for top bankruptcy partners. Rates at UK firms have also accelerated over recent years.

There can be no doubt that, in an ever more complex world, the best legal skills will be in demand and can (and should) be charged at a premium rate.

The big question, though, is whether clients will increasingly recoil from high hourly rates and press for value billing arrangements within which clients and law firms can agree on key elements of value to be delivered as a result of a given mandate and a fair fee for that value add. As AI takes on greater shape (see below), moreover, it is likely to drive more conversations around billing and the composite value provided by the firm.

To be seen.

3. Talent Seepage

The big talent news is that Paul Weiss have recruited a team of 20 or so partners into their London office over the last nine months and clearly mean business. These partners have come from firms such as Kirkland, Linklaters and Clifford Chance. A team of counsel and associates has also been built up.

More generally, there is accelerated movement of lawyers between firms, driven in particular by competition for “Star Partners” in private equity and M&A and the need to acquire teams to support the Star Partners. Star Partners joining US firms can earn as much as $15-20 million per annum. They will also, in firms such as Kirkland, have the opportunity to co-invest in their private equity clients’ funds.

Although there has been a lot of movement between US firms, the pain here has been particularly felt by the UK firms. This is down largely to the materially higher profitability of US firms (Clifford Chance, for example, had PEP for its 2022/23 financial year of £2 million, less than 50% of US peers).

Law firm leaders, particularly in the UK, will thus have pushed talent retention strategies well up the worry list. Themes here include:

• increasing salaries for newly qualified lawyers. Freshfields and Linklaters have just moved these up from £125,000 to £150,000. Salaries also then need to rise for more senior lawyers so this can be quite an increase in overhead;
• faster tracks for promotion to counsel and partner and a trend for traditional all equity partnerships (like Cravath and Paul Weiss) to add a non-equity layer so that the “partner title” can be offered at, say, 6 years PQE - noting that this can also embellish PEP numbers;
• changing partner compensation structures - for example, to increase the bonus pool for “exceptional performance”. This can of course lead to internal anguish given that “comparison is the thief of joy”, a theme which has apparently led Paul Weiss to move away from partner pay transparency to a “black box” system;
• withholding profit distributions from departing partners and, where legally possible, enforcing gardening leave provisions (always a balance between disincentivising departures and irritating clients); and
• merger - an extreme strategy of course, but you can see that UK firms looking to maintain attractiveness and build their US presence could view attack as the best form of defence. Targets are not easy to identify (see relative profitability above), and execution risk is high, but A&O Shearman shows that it can be done.

There is some reason for UK firms to believe that the London transfer market will cool somewhat given that Paul Weiss must have reached some kind of critical mass.

However, even if the pace slows, London will continue to be the private equity nerve centre for Europe, with the attendant competition between firms for noted practitioners. And partner movements elsewhere, particularly between firms in New York and other US centres, will surely roll on.

So law firm leaders will need to continue obsessing about talent retention and attraction.

4. Generative AI

It is axiomatic that Generative AI is a massive disruptor to the practice of law. I commend to you an article from the Federal Bar Association’s blog https://www.fedbar.org/blog/the-times-they-are-a-changin-the-rise-of-generative-ai-in-the-legal-profession/, which, in a piece after my own heart, summarises the landscape and starts by quoting Bob Dylan’s metaphor of the waters around us rising:

*And you better start swimmin’

Or you’ll sink like a stone

For the times they are a-changin’.*

These “changin’ times” present law firm leaders with three big challenges:

1. which GenAI tools do we integrate into our work and how do we explain this to clients and recruits? For example, Linklaters have a helpful section on their website which describes their developing use over recent years of AI and Gen AI and their adoption of Microsoft Copilot in August 2023;
2. how do we model our future junior lawyer recruitment needs? Talking recently to a law firm leader in New York, he said that he was expecting that their annual intake of new associates would decline from 150 to 50 over the coming years. That is a bracing thought and it ripples through many other important topics, such as:
   • How do we nurture and train a diverse pool of leading lawyers of tomorrow?
   • What should law schools and colleges be doing to adapt their models?
3. how will this fold into our charging model over the next 5 to 10 years? If we can’t bill hours can we charge a technology fee or move more generally to a “value-added” model? Can we convince clients to pay for some lawyer time which could have been replaced by machine input on the basis that it is in the clients’ interest for young lawyers to be trained in the ways of legal research?

5. Culture

Call me an old fuddy duddy, but the rise of the highly paid, and portable, star lawyer and of GenAI (with its implications for the number of young lawyers coming in to the profession and learning by doing the basic stuff well) ring major alarm bells in my head for law firm culture. The work from home phenomenon also concerns me, but will divide opinion - on the one hand the team spends less time together learning by osmosis and imbibing the craft of lawyering but on the other hand the ability to work from home one or two days a week is generous to individuals.

At the end of the day, culture will be driven by the tone set, and behaviours exhibited by, the partners. The top 3 for me are:

1. kindness - demonstrating care for others, never “dumping” colleagues with jobs and always “having the backs” of your team members;
2. humility - never bigging yourself up, celebrating others and being authentically warm and accessible to everyone in the firm - from the security guard to the senior partner; and
3. curiosity - how can we be a better firm tomorrow, why will clients want to come to us and not our competitors and how can we do our bit to help those not as fortunate as we are?

These can surely help us to keep Walking on Sunshine.

Christopher Saul

Christopher Saul provides independent trusted advice to senior executives and key stakeholders within publicly quoted and privately owned businesses and professional service firms. His areas of focus are governance, succession and the moderation of differences.

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