Legal spending is up

Early spring is traditionally a time when money is front and centre. The federal and provincial governments release their budgets, companies issue annual reports and prepare first-quarter numbers and law firms pay partners their previous year’s profits.

No doubt, managing partners are crossing their fingers and hoping that 2019 will match or exceed 2018. That’s because industry observers note that last year was a prosperous year for law firms.

Stephen Mabey, an accountant and principal at Applied Strategies, Inc., which provides business advice to law firms, says most Canadian law firms saw a three-to-five-per-cent increase in revenues, and they either made their budget or “were in spitting distance.”

That stacks up with the industry globally, notes law firm strategist Patrick McKenna, of McKenna Associates Inc. He says that 2018 “was a surprisingly good year” and most of the top foreign law firms experienced a five-per-cent increase in revenues, which he calls “pretty damn good.” It also makes 2018 one of the top years in the past half-decade.

However, McKenna notes that the industry is far off its peak of 2007. Billable hours in 2018 averaged 122 per month, below 134 per month prior to the financial crisis. That’s a difference of 144 hours per year, he says, which translates into decreased productivity of $70,000 per lawyer.

While 2018 was a “bang-up year,” McKenna says, “we are nowhere near what we were doing back then,” and whether 2018 reflects a “new normal” remains to be seen.

One of the problems, Mabey says, is that while many Canadian law firms met or exceeded their budgets in 2018, it’s misleading, because they often weren’t “real budgets” in the traditional sense. “A lot of law firms really don’t do budgets,” he says. Rather, they “do an expense budget and don’t budget revenues and then wonder why expectations aren’t satisfied. They never set the expectations.” They can get away with that when the economy is booming, but that can be a disaster when markets turn.

That lack of attention to budgeting details, he predicts, will change as we move into 2019. Not because law firms will take advantage of more sophisticated financial software but because banks will start to ratchet down on credit lines and loan facilities thanks to rising interest rates, growing trade disputes, shaky capital markets and an upward economic cycle that is getting long in the tooth.

Mabey is already seeing it with banks when it comes to law firm budgets. “They want a little more sophistication in the financial reporting, which is causing firms to scramble.”

Credit is getting tighter across the country, he says, and banks are once again demanding that partners provide personal guarantees.

That’s not to say it’s all gloom and doom. There’s a lot from 2018 that suggests 2019 is going to be OK. For example, BTI Consulting Group notes in its Nov. 14, 2018 popular blog The Mad Clientist that “clients are sending substantially more work to outside counsel for the second year in a row. The spending increases are widespread and across the board.”

The BTI Practice Outlook 2019 identified eight trends shaping the legal market, including that outside counsel spending has hit a “new all-time high” and that clients added $US5 billion to outside counsel budgets.

Cybersecurity and mergers and acquisitions are expected to be the benefactors of those increases. It also found that clients expect to pay higher rates for certain popular practice areas.

Legal consulting firm Altman Weil, Inc. has also seen looser purse strings at in-house legal departments, which bodes well for 2019. In its 2018 Chief Legal Officer Survey, released in November, the firm found that more legal departments (42 per cent) increased their outside counsel budget than decreased it (32 per cent) — the first time that’s happened since 2011. Moreover, 41 per cent of chief legal officers expect that their outside spend will rise in 2019.

Also notable is that the total in-house law department budgets are rising, with 53 per cent of companies reporting an increase versus 29 per cent that decreased their overall spend.

However, there is a cautionary note for external law firms, says Rees Morrison, a principal at Altman who works with corporate law departments. He says “inside budgets are increasing relative to the outside counsel spend budgets.”

Legal spend on internal counsel accounted for 48.2 per cent of the total law department budget and exceeded the spend on external counsel, which amounted to 45.3 per cent.

“The two lines crossed over for the first time [in 2018],” he says, providing four possible explanations why internal spend exceeded external spend.

The first is that in-house departments are getting more efficient and effective at cost controls, thereby reducing the amount spent on external firms per file and impacting the ratio between internal and external legal spend.

Second, companies may be adding internal lawyers and in-sourcing more work that was otherwise sourced to law firms. However, Morrison is skeptical that’s the case. The typical ratio at a company is four to five lawyers per billion dollars of revenue, he says. “If there was substantial [in-source] movement, we would see that number ticking up a bit, but it hasn’t.”

Third, it may be that more spending is being treated as an internal expense rather than external. For example, in a big discovery, a company may be increasing its use of contract lawyers, in-house paralegals or internal e-discovery groups, which would fall under internal legal spend, rather than external.

Fourth, as business conditions improve and external spend increases, he says that “almost necessarily increases the ratio of internal spend” to oversee and manage that work.

Morrison says the “biggest wild card” for 2019 remains the U.S. economy. He wonders how much longer the economic tide will rise and notes that the waters are getting choppy. “Sometimes, tides go out,” he says, and the chance of a contraction in 2019 or 2020 is increasing.

Mabey says 2019 is the time for law firms to be cautious and focus their attention on budgets, finances and firms structure, particularly succession planning.

“Firms flounder because they haven’t transitioned management and they haven’t transitioned clients.” He notes that mandatory retirement in partnership agreements is “all over the map” and older lawyers “are working longer.” That is a challenge when it comes to transitioning to the next generation. When you ask a managing partner who is the firm’s next managing partner, he says, often “they look at you with glazed eyes.”

Mabey says, “There is heightened nervousness about 2019-2020. This is the longest bull market we have ever been in. The law of nature says what goes up must come down.”