Midsize law firms driving industry growth

As economic uncertainty lingers, law firm clients are showing some sensitivity to rates and appear willing to switch firms for more competitive offerings. In the first quarter of 2023, demand growth continued to decline for Am Law 100 and 200 law firms slightly, while growth increased for midsize firms and alternative law service providers (ALSPs).

The labor market still remains historically tight, but layoff announcements continue for Am Law 100 and 200 firms. Midsize firms have taken a very different strategy when it comes to hiring as compared to their larger counterparts.

Demand

According to the Thompson Reuters Law Firm Financial Index, overall demand growth for law services increased by 0.1% year over year in the first quarter, reversing a six-quarter decline. However, the increase in demand for midsize firms (1.8%) led this growth. The Am Law 100 continued to decline, falling 1.5% year over year.

The decline among the Am Law 100 was primarily in transactional demand practice areas, which include mergers and acquisitions (-7.7%), real estate (-7.6%), tax (-3%) and corporate general (-0.8%). Am Law transactional demand practice areas declined by 4.8% overall, while midsize firms in the same areas only declined by 0.6%.

Growth areas were most prominent in litigation (2.4%) and labor and unemployment (1.1%). But again, this growth was distributed unevenly among firms. The Am Law 100 increased by 1.3% for counter-cyclical demand, while midsize firms increased by 4% for the same practice areas.

Demand for midsize firms may show an increasing sensitivity to rates, which continued to increase by 5.5% year over year. This can be seen in the collection realization versus worked rates, which decreased 2.1% year over year for the Am Law 100, but decreased by only 0.2% for midsize firms.

Headcount

In response to sustained demand, midsize firms have continued to add lawyer headcount at a more rapid rate than the Am Law 100. Midsize firms increased headcount by 4.9% year over year as compared to 2.8% for the Am Law 100.

The labor market is still historically tight, and although the competition for talent may have dimmed slightly this quarter, the challenge of hiring and retaining lawyers will likely continue despite economic uncertainty or temporary labor adjustments.

Although midsize firms are enjoying growth in demand and headcount over their larger counterparts, not all midsize firms will continue to compete by offering lower rates in the long term. As midsize firms add headcount, their direct expenses remain elevated, with 8.3% growth year over year as compared to the Am Law 100, which saw direct expenses grow by only 4.8% year over year. 

Expenses

Overall, expenses remain elevated and continue to grow substantially on a year-over-year basis. However, the rate at which expenses are growing continues to slow, especially for direct expenses, which increased by 6.8% year over year in the first quarter, a welcome drop from the double-digit growth rates of 2022.

Alternative legal service providers

As competition among firms heats up, ALSPs also pose a mounting threat to capturing market share. Their compounded annual growth rate between 2019 and 2021 was a whopping 20%, and the ALPS market size is now $20.6 billion.

ALSPs have attorneys on their payrolls, but they provide support services that don’t require a law degree to complete, such as document review, contract management, e-discovery, due diligence, compliance and other functions. This provides them with a competitive ability to decrease the cost of services to their clients, and in times of economic uncertainty, many clients and general counsels are tightening their budgets.

Driving efficiency and productivity to remain competitive

The Am Law 100 is already showing signs of a shift in strategy to decrease internal costs. A key determinant of success will be how quickly they pass along cost savings to their clients in terms of value for higher rates, in the hopes of driving demand back up.

Although cutting headcount and decreasing hiring velocity is helping dampen direct costs in the short term, a more sustainable strategy to drive cost savings is to utilize technology to drive efficiencies and decrease administrative, nonbillable time among staff.

Utilizing artificial intelligence (AI) to drive efficiencies is a hot topic among law firms, and it can be an effective strategy when implemented and governed correctly so that accuracy and client confidentiality remain a priority. Use cases with the highest feasibility and business value for law firms include e-discovery, contract analysis, regulatory tracking, trademark and patent research, and legal spend analysis. Accelerating common tasks can help provide more value for billable hours and allow firms to remain competitive with ALSPs. However, before embarking on their AI journey, law firms need a solid data foundation.

Additionally, many law firms look to outsource some or all of their back-office functions to drive down indirect expenses. According to Williams Lea’s annual 2022 legal survey, of the 63% of law firm respondents who reported utilizing back-office outsourcing, 66% said they were thinking of expanding into additional areas in the next 12 months. The main driver? Cost savings, with 68% of respondents citing it as the top benefit achieved through outsourcing.

Moving forward

As the Am Law 100 and midsize firms continue down separate paths strategically, key elements to watch are whether productivity improves among the Am Law 100 during a hiatus in hiring, and whether midsize firms will withstand the margin squeeze as they continue to hire valuable staff.

Regardless of firm size, and despite the unknowns regarding economic growth, all firms can benefit from utilizing AI and conducting a cost/benefit analysis of outsourcing to further bring down expenses and prop up profit margins.