Having weathered the pandemic, are law firms prepared for the next crisis?
Is the honeymoon over?
At the start of the pandemic, there were gloomy predictions of its likely impact. Law firms were talking about 30-40% falls in revenue, even insolvency. However, they have shown themselves highly adaptable, surviving and even thriving during the crisis.
However, with storm clouds gathering on the economic horizon, can law firms pull this trick off a second time? The crisis in Ukraine has collided with existing inflationary pressures to slow economic growth. Central banks are raising the cost of borrowing to try to curb rising costs and tax rates have increased. Law firm clients are facing an uncertain climate, with their margins being squeezed and potentially confidence falling.
The pandemic represented the biggest challenge for many law firms since the second world war. In spite of real fears, law firms adapted skilfully to the demands of a changed environment, shifting their working arrangements, shoring up their cash balances and working flexibly with clients. In many cases, firms emerged from the pandemic with greater resilience than they entered it.
Our analysis of the annual accounts for the year 2020/2021, the first year of the pandemic, shows that revenue broke through £20bn, up 4.2% over the previous year. This is an astonishing achievement at a time of considerable uncertainty.
Clients proved loyal to their advisers and plenty needed advice to help them through the crisis. However, law firms can take credit for swift and prudent action to strengthen their positions. They built up strong cash reserves over the year, with £3bn cash on their balance sheets by the end of the year. Debt levels almost halved. Many firms took out additional loan facilities at the start of the pandemic, but realised they didn’t need it later in the year. In addition, debtor days fell from 112 to 103.
However, during this period, total salary costs surprisingly grew at an above inflation rate of 4.8%, despite overall headcount falling slightly. Gross margins therefore fell, but, with far less spend on travel, entertaining, training and other overheads, operating profit margin increased year on year, breaking through 30% mark to 32.1%.
The pandemic imposed certain important disciplines. Historically, decision-making has involved many of the partners, but the pandemic required speedy action. Having seen the success of management teams in responding to the pandemic, partners may be more willing to delegate, streamlining decision-making in future. Law firms’ performance shows they are arguably better run today than they were during the global financial crisis.
An uncertain environment
But just as law firms put the pandemic behind them, they face a new series of challenges. The economic environment is a significant cause for concern. The UK is currently experiencing an inflation shock not seen since the 1970s. The Bank of England is predicting that inflation will peak at 11% this year (https://www.bankofengland.co.uk/knowledgebank/will-inflation-in-the-uk-keep-rising) before falling back next year.
This is creating a tough environment for companies, who are seeing input costs rising. This is already being seen in corporate confidence and, by extension, corporate investment. The first quarter of this year saw merger and acquisition activity drop by one-fifth compared to the same period last year, the slowest first quarter since 2020. There were month on month declines from January to March, a significant slowdown in momentum. A few mega-mergers have flattered the figures, but mid-market mergers have been particularly hard hit. (https://www.refinitiv.com/perspectives/market-insights/ma-touches-1trn-in-q1-despite-market-jitters/)
Consumer confidence is also weak, with households seeing the largest drop in their disposable income since the 1950s (https://www.thisismoney.co.uk/money/news/article-10643657/Britain-faces-biggest-drop-living-standards-1950s-OBR-says.html). This will also dent economic growth and there are increasing fears of recession. The post-pandemic normality is not nearly as good as hoped.
The legal sector
For the legal sector, many of the pressing issues from before the pandemic are still there: retention of talent, strategic direction, brand awareness and differentiation, succession planning and long term funding, for example. Costs are coming back – including business development and travel which is putting renewed pressure on margins.
Perhaps more importantly, salary rises are back with a vengeance. The competitive spiral on lawyer salaries has resumed at a time when wage inflation is already high. If law firms are unable to pass these costs onto clients, which seems more challenging in a weakening economic environment, they face declining profitability.
While law firms have worked hard to shore up their cash balances, debtor days are still too high. It is hard to think of another industry that allows clients over three months to pay for its services. The dramatic reduction in debtor days early in the pandemic shows that significant success is possible, but management teams need to keep this under constant focus.
We are undoubtedly entering a different but still difficult time. Law firms and their management teams have shown themselves capable of weathering challenging moments, but they may need to steel themselves for some tough choices ahead.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.