Law firms positive about finances despite rising costs

Allen: Firms will need to work hard to keep profit margins on track

Many SME law firms feel optimistic about their financial performance this year even though staffing costs are set to rise quicker than fee rates, according to new research.

It highlighted the ongoing challenge of the war for talent, with 46% of those surveyed seeing the attraction and retention of lawyers as the key challenge they face in 2023, with the economic outlook (21%), cash flow (10%) and inflation (9%) trailing far behind.

NatWest’s 2023 legal report – written by Andrew Allen, head of accountants PKF Francis Clark’s national legal sector team – look in detail at 29 firms with turnovers of less than £5m and 39 bringing in more than £5m.

Median fee income growth in 2022 was 8%, but median profits per equity partner (PEP) dipped 3% to £246,000 (£148,000 for small firms and £302,000 for large firms).

NatWest said 2021 had been the best year financially in a quarter of a century, while firms faced rising people costs and inflationary pressures in 2022.

The survey said nine in 10 firms expected fee income to increase this year too, with most expecting a rise of up to 10%.

Over half of firms planned to increase their charge-out rates by less than 5%, with only 10% looking at a rise of over 10%.

While all but one of the firms expected payroll costs to go up by less than 10% in 2023/24, PKF estimated that – with inflation and the costs of pensions and National Insurance among other factors – they were more likely to be 10-12%.

And with six in 10 firms expecting their headcounts to increase by up to 10% in 2023, the report said “a growing squeeze” on margins and PEP was likely.

“Considering recent inflation, this suggests firms expect to struggle to achieve growth that covers rising people costs and overheads during the next year,” the report said.

A third of firms reported they were either likely or very likely to seek a merger/acquisition in the short term, and 22% reported that they had been approached by a consolidator in the last year.

Private client work and conveyancing were cited as the most buoyant sectors by law firms, with employment the least. Many employment teams have struggled “since the (short-lived)

high-demand days during the pandemic”, the report said.

“In many teams, for example, we saw 10% to 15% growth in reported income in 2020/21, which was then lost during 2021/22 with similar declines.”

Other findings included:

  • The most common hybrid working arrangement was for fee-earners to work at home for two days per week.
  • Median lock-up days was 136 days in 2022, two days more than in 2021.
  • For every £1 of members’ funds/net assets in the business, the median level of debt was 24p (upper quartile 54p), “appearing to be comfortable in relation to debt availability to law firms”.
  • There was a median of seven fee-earners per equity owner and 0.8 support staff per fee-earner.
  • 61% of firms primarily focused on fees issued as a mechanism to monitor fee-earner performance.

David Weaver, head of professional and business services at NatWest Group, said: “It’s good to see that, despite various headwinds, law firms are optimistic about their financial performance in the coming year. This optimism reflects the fact that many firms have demonstrated record profitability in recent years, despite the ever-present challenges they face.

“Looking ahead, with firms predicting high people costs and overheads for 2023, it’s essential that firms keep a close eye on their margins. No one can predict the future, but firms should be working to forecast the impact that rising interest rates will have and how best to mitigate that and maintain a steady cash flow.”

Mr Allen added: “It is encouraging to see the level of optimism in the legal sector at present despite the pressures on margins that many firms face this year. There are some tidal changes happening currently in the sector; the recruitment market in some areas is slowly easing and the return of interest income from client funds provides some welcome relief.

“Despite the optimism, firms report they will need to work hard to keep profit margins on track. The popular talk at management level in law firms is currently turning more from recruitment to cash collection topics with the cost-of-living pressures in the economy presenting risks to lock up levels.”

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