Commercial Pressures

The financial dynamics of a law firm are relatively straightforward. Firms need to ensure that income grows at a faster rate than the cost base to ensure the operating margin is maintained or increased. Our research on the top 50 law firm accounts over the first full year of the pandemic showed the average operating margin increasing over this period – a surprise to me and certainly a contrast to many of the gloomy predictions made when the pandemic first hit.

However, for most firms, the pandemic flattered their operating margin. While income may not have risen much over this period, it remained stable. At the same time, most firms spent far less, with limited travel, marketing, training and entertaining expenditure. As a result the operating margin increased on average and for the top 50 firms for 2020/21, it rose above 30%. Not only has a significant element of this expenditure returned, inflation is pushing it higher still - around 10% per annum, based upon the latest Bank of England predictions.

The largest cost of a law firm is its people and if the supply of talent to the legal market was strong, wage inflation may not be a problem, but our survey this year (and for many previous years) identified recruitment and retention of talent as a key issue for firms. Anyone managing a law firm therefore has two key questions that need answering:

1) To what extent can we control the increase in our cost base, and
2) Are clients willing to pay higher fees to accommodate these increased costs (thereby maintaining the operating margin)?

While firms need to remain competitive on salary in the talent market, some of the more enlightened firms are looking at other elements of employee engagement to help with recruitment and retention. Whether this is more flexible or agile working, better quality work spaces, more focus around other benefits and the firms approach to ESG, some are clearly taking the view that trying to keep pace with ever-spiralling wages is a greater risk.

Whatever the cost base, partners and fee earners are now having to negotiate increasing rates and fees at a level not seen, arguably, in a generation. Whereas over the last few years increases of 2% or maybe 3% might have been accepted by a client, it is now necessary to seek at least a 10% increase just to maintain operating margin. Unless every client can be persuaded to agree to this, overall margin is likely to fall.

The impact of inflation may operate with a time lag. A number of firms will be on fixed price deals or contracts that run for an extended period during which costs have increased significantly. Even where rates have been increased, there are questions over whether this will be enough for work performed over the next few months.

While commercial pressures remain, the nature of those pressures has changed. Those firms that can balance their talent pool and their client base most effectively will be the ones that succeed with the numbers moving at a faster rate than we have seen for a very long time.