Many of the UK’s leading law firms need to “radically” restructure this businesses if they are to survive, PwC warned today.
Issuing its annual survey of the top 100 firms, PwC also revealed that almost a quarter of them have reported material rule breaches to the Solicitors Regulation Authority this year.
The poll found that the top 10 firms have increased their dominance of the market; while they increase their average profit margin to 38.5%, for the rest of the top 100, it fell to around 23/24%, with a third of them recording less than 20%.
Similarly the top 10 UK had profit per equity partner (PEP) averaging £1m, up 6.1% from 2012, “as a result of increased focus on cost reduction and tight management of headcount”. However, average UK fee income for the same firms was up by just 0.8%.
By contrast, average UK PEP for the top 11-25 firms fell 7% to £448,000. Fee income rose by almost 10%, which PwC said was “almost entirely driven by consolidation in this segment of the market. Clearly this has yet to translate into improved profitability for these larger mid-tier firms”.
The survey noted that chargeable hours have generally fallen across all grades and all bandings of firms. “This trend is not sustainable, particularly for firms outside the top 10 where focus on increasing utilisation must be a priority.”
Lock-up is improving, but PwC said the average top 10 firm could potentially release £7.6m of working capital through achievement of a 110-day total lock-up benchmark or up to £16.9m through matching the 100 days managed by the top performers.
Linked to this, there has been an increase in the number of law firms making capital calls on their partners.
On the compliance front, the survey found that since the new compliance officer regime had become effective, almost 25% of the top 100 have reported a material breach to the SRA. This has been a standalone incident for almost three-quarters of respondents, and over half of these breaches relate to the accounts rules.
Looking ahead, only a quarter of firms consider an ‘inability to finance growth’ as a key challenge, PwC reported. “However, law firm funding is under pressure and firms should not underestimate the potential impact of this. As firms are required to invest to grow, diversify and/or adapt in order to remain competitive, lenders are becoming more cautious and selective with their funding, no doubt in part due to recent high profile failures in the sector.
“Therefore, we expect lenders to require partners to invest more in the firm if they are going to extend further financing. In addition, balance sheets will come under increasing pressure. For these reasons, law firms will need to review funding strategies and profit distribution policies to ensure adequate cash resources are maintained.”
The majority of firms remain confident of achieving growth over the next three years, with firms in the top 25 more optimistic than the rest. Virtually all see ‘better penetration of existing markets’ as the main opportunity for growth. “As a result, pricing and margins will remain under pressure and clear winners and losers will emerge.”
Lack of stability in the legal market due to general economic conditions and clients’ changing needs/behaviours are seen as the two key threats to business growth, together with over regulation and competition from new entrants to the market. PwC concluded: “New business models are therefore emerging and firms will need a clear strategy to be able to respond to these challenges.”
Most of the top 25 firms believe a merger is very or fairly likely by 2016 and this is increasingly likely to be with a non-UK based firm. There appears to be less appetite for merger among top 26-50 firms, although 42% of these firms still consider a merger to be very or fairly likely.
David Snell, partner and leader of PwC’s law firms advisory group: “The legal sector has come under increased scrutiny from banks and the sector’s regulator following a number of well-publicised law firm insolvencies during the year.
“Worryingly, with almost a third of law firms outside the top 10 recording disappointing net profit margins, our view is that unless these firms can radically restructure their business, their short to medium-term survival must be in doubt.”
He said continued focus on cost reduction and innovative delivery is required across all firms to maintain profitability.