UK legal sector needs to adapt to a ‘new normal’ to thrive as income and profitability falls

The latest annual Legal Benchmarking Report from MHA, the UK-wide group of accountancy and business advisory firms, has revealed law firms saw an overall reversal of income and profitability growth trends experienced over the last three years.

MHA said hanging trends in income and profitability, together with changes in ownership and staffing revealed in the benchmarking report, point to the emergence of a ‘new normal’ for the UK legal sector, where improved financial management is tackling issues such as lock up time, understanding of profit drivers and increased levels of efficiency in billing processes and procedures are needed to ensure future financial stability and profits.

In 2017, law firms of all sizes from sole trader practices to firms with over 25 partners saw their income fall. Mid-tier firms, those with 11 to 25 partners, saw the largest reduction, with a drop of 11 per cent from 2016. Sole trader practices saw the smallest fall of 1 per cent and the other sized firms saw income reduce by 5 per cent in 2017.

Most firms in the survey also saw a reduction in income per fee earner, with only those with 5 to 10 partners experiencing a small increase of 2.4 per cent. With the numbers of fee earners to partners remaining consistent from 2016 to 2017, the overall fall in income is because of fee earners billing less on average in 2017 than 2016. The income position for equity partners revealed a similar picture, with falls for all firms except those with 11 to 25 partners, which saw the level of income to equity partner increase from £591,000 to £746,000.

The profitability gap between the smallest and largest firms continues to grow. For sole practitioners, profits have fallen by 40 per cent to an average of £41,000 in 2017 and nearly 60 per cent lower compared to the levels of profit achieved in 2015. This downward trend is further evidence on the struggle smaller firms face in a marketplace dominated by larger firms. This is further compounded by significant falls in net profit percentage for these firms. The combination of lower levels of fees and increased salary costs of non-equity partner fee earners have led to net profit percentages falling to 12 per cent for sole partner firms and 15 per cent for those with 2 to 4 partners.

Level of profit per equity partner have also seen falls, with firms of 11 to 25 partners dropping 13% and the largest firms falling by 8 per cent. These reductions were not as bad as those for smaller firms, which is in part due to the cultural change in the ownership of law firms, with fewer fee earners and partners moving into equity positions, which gives lower numbers of individual equity partners a bigger share of the profit pool, albeit one which has decreased in quantum.

The research revealed a marked change in the staffing structures of legal practices. There are fewer senior fee earners and increases in paralegal and support staff. The difficulty in recruiting experienced qualified fee earners has not only impacted on income levels but has resulted in the movement of more administrative duties to support staff and paralegals taking on more work from fee earners. This staffing shift is expected to continue and resulting increasing profit levels to follow in future years.

Equity partner numbers have seen a drop and this trend is expected to continue, with fewer high paid fee earners wanting to sacrifice employment security for exposure to the risks of equity and those that are already equity partners are able to access a greater share of the better returns.

In the latest survey, the level of lock up is showing a worrying continuation of an upward trend first identified last year. For most firms, average lock up jumped in 2017 from between 3 to 17 days. Only those firms with 11 to 25 partners saw a reduction from 160 days in 2016 to 133 in 2017, however, this is still higher than average lock up days recorded by these sized firms in 2014 and 2015. The rise in lock up days emphasises the pressure on firms having to fund staff costs and practice overheads against a backdrop of falling income and profitability.

Karen Hain, head of the professional practices sector at MHA, said: “2017 was a year of change for the legal sector and our research paints a challenging picture for many firms. A combination of factors, including fewer mergers and acquisitions, the impact of the fixed fee regime, increased competition from more cost effective and price-driven business models, succession planning issues and the inevitable political and economic uncertainty have created a shift in the operating environment for firms of all sizes. After three years of growth, the drops in income and profitability could lead to criticism that firms took their collective eye off the ball in 2017.

“The UK legal sector needs to adapt to a ‘new normal’ putting a direct emphasis on having a better understanding of profitability and margins on work undertaken and improved financial controls. Efficiency needs to be a key theme for 2018 and beyond. Firm’s that focus on ensuring the right level of work is carried out by appropriately experienced and costed staff will see improved profitable performance. In addition, firms need to ensure they have a full understanding of the value of their services they provide and increase their use of technology to maximise access to financial data, to ensure they are accurately pricing work with appropriate levels of profit built in.

“Achieving profitable performance is also about maximising recoverability of fees. Firms should be adopting practical and more proactive fee billing and collection practices. This can include more active billing strategies with frequent billing rather than event-based on completion of work, agreeing advance billing with clients on complex or larger workload cases and maximising the fee generation opportunities by focusing on cross-selling of services to existing clients.”