THREATS TO PROFITABILITY & OPPORTUNITIES FOR GROWTH A SURVEY AMONGST THE UK S TOP 100 LAW FIRMS

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Jean Greene
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1 THREATS TO PROFITABILITY & OPPORTUNITIES FOR GROWTH A SURVEY AMONGST THE UK S TOP 100 LAW FIRMS A SWEET & MAXWELL REPORT SPRING 2010

2 1. EXECUTIVE SUMMARY: Introduction This is the fourth year Sweet & Maxwell has undertaken research amongst the Finance Directors of the Top 100 UK Law Firms. As previously, we have asked Finance Directors what they believe to be the biggest threats to the profitability of commercial firms over the coming year. In this 2010 survey we also asked for the first time what steps the respondents firms were likely to take over the forthcoming year to improve profitability. In addition, Finance Directors were questioned on what they expect from their key practice areas during 2010 will they show fast or moderate growth, no growth, or an actual contraction? We would like to thank everyone who participated in the research and hope you will find the results useful. Risks to profitability of commercial law firms The research confirms that downward pressure on fees from clients and cost overruns on fixed fee work are the main potential risks identified by Finance Directors in This focus on the pressure on fees and cost overruns leapfrogged the principal recurring threat mentioned in previous years surveys (2007, 2008, 2009) a continued downturn in corporate work. Just 37% of FDs now view a continued downturn in corporate work as a significant risk to profitability compared to 72% a year ago. The Office for National Statistics confirmed GDP finally returned to growth in the last quarter of The results of our 2010 survey suggest that Finance Directors in law firms are optimistic that this will lead to a gradual increase in corporate finance and M&A work. Steps planned to improve profitability in 2010 Finance Directors seem quite aggressive about plans for growth in As a result, 2010 could see substantial activity in the following areas: hiring of senior teams (40% are likely to hire senior teams to boost profitability) overseas expansion (20% are likely to expand overseas to boost profitability) merger activity (10% are likely to merge to boost profitability) This hiring forecast contrasts greatly with 2009 when so many top professional services firms implemented headcount reductions. The relatively strong emphasis on overseas expansion could indicate that Finance Directors are keen to ensure they have exposure to economies, such as the emerging markets, which are growing faster than the UK.

3 Key areas for growth in 2010 Finance Directors were also asked which areas of the legal sector they expected to grow in Growth was anticipated in most areas, with the fastest growth predicted in: Restructuring / Insolvency (90% of respondents expect fast or moderate growth within this sector) Commercial Litigation & Dispute Resolution (90% of respondents also expect fast or moderate growth within this sector) As the repercussions of the credit crunch continue, Finance Directors are expecting regulatory work to increase, as well as fraud work. This is to be expected with the FSA and SFO promising an increase in activity. 2. RISKS TO THE PROFITABILITY OF COMMERCIAL LAW FIRMS IN 2010 Downward pressure on fees from clients 60% of Finance Directors surveyed perceived downward pressure on fees from clients as high risk to the profitability of firms. Law firms reported that the recession has prompted the first real sustained efforts from clients to negotiate down hourly rates something that many lawyers haven t encountered before in their careers. However, as the economic recovery shifts the focus from cost cutting to expansion and demand for legal advice picks up, the pressure on law firms to cut their hourly rates may lift. Law firms are also making greater efforts to defend their hourly rates by offering clients added value services such as providing onsite legal training. Cost overruns on fixed fee work During the recession end users of legal services have been more actively pushing law firms to switch from billing by the hour to fixing the cost of work in advance. With fixed fee work comes the risk that any extra hours delivered beyond the estimated time will not be paid for by the client. Finance Directors anticipate cost overruns on fixed fee work will be a far more prominent threat in 2010 than in 2009 with 47% of Finance Directors viewing this as a very significant risk, up from just 12% in Overall this is seen to be the second most important threat to profitability of commercial law firms. Accepting a higher proportion of fixed fee engagements may require law firms to build more sophisticated billing models to protect the profitability of the firm.

4 Competition between law firms over fees The threat posed by competition over fees continues to be a big concern for Finance Directors. In this year s survey, 27% of Finance Directors cited this as a major risk to profitability, up from 24% in Percentage of Finance Directors of Top 100 law firms assessing the risks to profitability from competition between law firms over fees 80% 70% 60% 50% 40% 30% 20% 10% 0% 67% 27% 7% High Risk Medium Risk Low Risk Late payment by clients Late payment by clients is still a concern, with 27% of Finance Directors assessing this as a very significant risk, slightly down on last year s figure of 28%. Many Finance Directors have made reducing debtor days a priority, and this has proved crucial in their efforts to maintain profitability over the last two years.

5 Percentage of Finance Directors of Top 100 law firms identifying different risks to profitability as very significant (%) (%) 2010 (%) Continued downturn in corporate work Late payment by clients Credit risk of clients Competition between law firms over fees Cost overruns on fixed fee work Guaranteed pay to lateral hires Results summary: Risks to the profitability of commercial law firms (Percentage of responses) Risks to the profitability of commercial law firms High Medium Low 1. Downward pressure on fees from clients 60% 40% 0% 2. Cost overruns on fixed fee work 47% 30% 23% 3. Continued downturn in corporate work 37% 57% 7% 4. Competition between law firms over fees 27% 67% 7% 5. Late payment by clients 27% 33% 40% 6. Credit risk of clients 17% 53% 30% 7. Work being taken in-house 10% 47% 43% 8. Disputes with clients over bills submitted 7% 50% 43% 9. Professional negligence claims 7% 37% 57% 10. Guaranteed pay to lateral hires 3% 34% 62% 11. Poaching of staff by competitors 3% 41% 55% 12. Cost of the law firm s own property 3% 40% 57% 13. Competition from other legal services providers as a consequence of the Legal Services Act 0% 30% 70% 14. Lack of capacity to meet increasing demand 0% 10% 90%

6 3. STEPS TO BE TAKEN IN 2010 TO IMPROVE PROFITABILITY Increased cross selling Increased cross-selling was the measure most often mentioned by Finance Directors as part of their plans to improve profitability. This is always a popular target for professional service firms, but can be notoriously difficult to implement, particularly if partners are protective of their own clients. Many lawyers may also feel that they lack the necessary experience and knowledge to cross-sell effectively. More firms may have to introduce carefully designed incentive schemes, which recognise cross-selling initiatives and achievements if this strategy is to succeed. Charge out rates and credit control Finance Directors remain conscious of the sensitive charge-out rate environment as pressure on fees remains, with 43% saying they are unlikely to increase their firm s charge out rates to improve profitability this year. Law firms can be particularly susceptible to slow payment by clients during a downturn. 77% of Finance Directors are looking to tighten credit control during Mergers and team hires 2010 could be an ambitious year for mergers and team hires amongst top law firms. This is in stark contrast to an austere 2009 when many top law firms streamlined operations. 40% of Finance Directors said that they intended to make lateral hires of senior teams this year and 10% were considering mergers.

7 Percentage of Finance Directors of Top 100 law firms taking the following steps to improve profitability 90% 80% 77% 80% 70% 60% 50% 40% 30% 20% 10% 10% 20% 20% 27% 40% 0% Merger Expand overseas Cut Increase budgets of charge out support rates functions Lateral hires of senior teams Tighter credit control Increase crossselling Redundancies and support function budgets There is also cause for more optimism amongst support staff working within major firms, with only 20% of Finance Directors planning further cuts in their budgets. This suggests that redundancies are no longer viewed as a key strategy for improving profitability. A number of leading firms felt they had reduced their staffing levels to a point where they were as lean an organisation as was commercially sensible. Overseas and sector expansion Law firms are more likely to expand overseas than expand into new sectors, with 20% saying that overseas expansion is likely but only 10% are likely to expand into new sectors. Does this mean that Top 100 law firms believe that it will be easier to expand into new overseas markets than break into and establish a credible track record in a new sector? It might also suggest that many top firms believe that their activities are already well diversified and that there are no obvious lucrative new areas of business for them to move into.

8 Over the next year how likely are you to take the following steps in order to improve profitability? (Percentage of responses) Likely Possible Unlikely 1. Increase cross-selling 80% 20% 0% 2. Tighter credit control 77% 10% 13% 3. Lateral hires of senior teams 40% 50% 10% 4. Cut unprofitable services 33% 53% 13% 5. Expand overseas 20% 20% 60% 6. Expand service lines 13% 50% 37% 7. Merger 10% 37% 53% 8. Use outsourcing or shared services 13% 53% 33% 9. Cut budgets of support functions 20% 43% 37% 10. Increase charge out rates 27% 30% 43% 11. Expand into new sectors 10% 40% 50% 12. Redundancies 7% 47% 47% 4. KEY AREAS OF LEGAL WORK GROWTH OR DECLINE IN 2010 For the first time Finance Directors were also questioned on areas they expect to grow during Only one area of legal work is expected to contract substantially in 2010 the public sector. Growth is expected in most other categories, with the fastest increase expected from restructuring/insolvency, commercial litigation and fraud. Public Sector 27% of Finance Directors expect public sector business actually to decline in 2010 and a further 27% expect no growth. In 2009, as the private sector cut legal spend, many law firms benefited from their exposure to the more defensive nature of public sector work as the Government was fully committed to protecting public sector budgets. The need to reduce the Government deficit suggests those days are past and whatever party comes to power, public budget cuts are widely anticipated.

9 Restructuring and Insolvency 90% of Finance Directors expect moderate or fast growth within Restructuring and Insolvency. Insolvencies and liquidations usually peak as an economy emerges from recession. Employment Employment is expected to be the 5 th fastest growth sector for 2010, with 93% of Finance Directors expecting fast or moderate growth. Clearly Finance Directors are anticipating a rising number of employment cases as the backwash from the recession continues to flow through the UK economy in Commercial litigation and dispute resolution Another area of predicted growth is Commercial Litigation and Dispute Resolution, with 90% of Finance Directors predicting fast or moderate growth within this sector. Past experience shows that an economic downturn generally leads to a rise in commercial litigation. With London established as one of the few global banking centres, many of the financial instruments issued around the world such as bonds or derivatives use contracts, which are written under English law. These are more likely to end up in the UK courts as the fallout from the financial crisis rumbles on. Corporate Finance / M&A None of the Finance Directors surveyed expect fast growth in corporate finance and M&A but a healthy 48% are looking for moderate growth and none expect this practice area to decline.

10 Over the next year how do you expect the following areas of legal work to perform? (Percentage of responses) Fast growth Moderate growth No growth Contraction 1. Restructuring / Insolvency 38% 52% 10% 0% 2. Commercial Litigation / Dispute Resolution 24% 66% 10% 0% 3. Fraud & other white collar crimes 22% 65% 13% 0% 4. Regulatory Work 18% 75% 7% 0% 5. Employment 10% 83% 7% 0% 6. Energy 21% 50% 29% 0% 7. Professional Negligence 11% 52% 37% 0% 8. Intellectual Property 4% 57% 39% 0% 9. Corporate Finance / M&A 0% 48% 52% 0% 10. Commercial Property 0% 52% 45% 3% 11. Construction 4% 46% 50% 0% 12. Projects / PFI 4% 50% 42% 4% 13. Tax 0% 52% 48% 0% 14. Private Client 9% 33% 50% 8% 15. Media 5% 45% 41% 9% 16. Personal Injury 0% 36% 64% 0% 17. Public Sector 4% 42% 27% 27%

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