A sharp rise in expenses and a dip in demand have driven law firm profitability down for the second straight quarter, according to the Thomson Reuters Law Firm Financial Index.
Profit-per-lawyer fell 3.6% in the second quarter of 2022 compared to a 12-month rolling average, the profitability-focused index found.
The overall Thomson Reuters index score — which considers factors such as rates, demand, productivity and expenses — fell for a fourth straight quarter and reached its lowest-ever figure in Q2.
“While firms have two more quarters before they realize their profits at the end of the year, this downward trend should serve as a warning of potential trouble,” the report said.
Legal departments will likely monitor closely whether their outside law firms seek to raise rates further to compensate for rising expenses and the decline in demand.
Expenses increase
Direct law firm expenses rose 12.4% in the second quarter of this year, which followed a 13.1% increase in Q1. The report defines direct expenses as compensation and benefits for all attorneys who are not equity partners.
Compensation for associates, particularly those working at Am Law 100 firms, was the main contributor to such expenses increasing. Inflation and competition for talent were also factors.
Meanwhile, the separate category of overhead expenses saw a 13.5% increase in Q2, as firms have been pivoting to hybrid or in-office working arrangements.
Additionally, technology spending rose 10.5% last quarter, a figure that represented the fastest growth in eight years.
Such spending suggests that firms are not simply spending more due to inflation, but that they are making longer-term investments, the report said.
Demand slows
Strong demand for law firm services throughout 2021 continued into the start of 2022, with demand rising 2.7% in quarter one compared to the year prior, according to Thomson Reuters.
But in the second quarter, demand for legal services fell 0.5% compared to a year ago.
Corporate M&A work, an area in which law firms charge very high rates, saw demand drop nearly 5%.
Demand for corporate work, which the report said drove growth last year, fell 0.7% and demand for IP work dropped 2.3%.
“Last year’s tailwinds have inevitably turned into headwinds,” said Mike Abbott, head of the Thomson Reuters Institute.
Profits drop
Law firm profits had risen at a steady pace in 2020 and 2021 during the COVID-19 pandemic before the recent drop off.
The decline in profits came even as law firm rates rose 4.7% last quarter, a bump the report said was “robust” and was coupled with an uptick in rate realization.
But Abbott attributed declining profits to the “combination of slowing demand and rising expenses.”
These trends may give firms a chance to find “a new, acceptable profit equilibrium,” according to the Thomson Reuters index report.
“The index, having hit its lowest all-time score, serves to warn firms that they must keep a tight grip on the steering wheel now as future revenue tries to measure up against a spectacular second half of 2021,” the report said.
