On the slide: profit margins continue to fall for all but the top 10 practices

Profit margins among all but the elite of the top 100 law firms have dropped significantly over the past five years, new research has revealed, with the introduction of alternative business structures (ABSs) set to pressure them even more.

However, Pricewaterhouse-Coopers’ (PwC) annual UK law firm survey also said it is “not hard to see why private equity is showing a keen interest in parts of the legal sector” when annual returns on partner capital are around 130% for the top 25 firms, and 88% for the next 25.

The survey found that while net profit margins at the top 10 firms stayed roughly static at 36% this year – which it attributed to their “economies of scale and relative agility” – those for the rest of the top 50 are now around 26% and for firms 51-100 21%.

In 2007, the second-tier firms (those ranked 11-25) recorded a profit margin of 32%, compared to 29% for 25-50 and 28% for 51-100.

Nearly half of the last group of firms reduced their equity partner numbers this year, and the survey said: “With ABSs likely to impact this size category of firm most significantly through new entrants to the market and new business models backed by private equity, the outlook looks even more challenging.”

PwC said pricing remains a major issue, with firms seeing their turnover increase but having little impact on their PEP (profits per equity partner). Firms are reducing or “flexing” pricing to win work, while more are foregoing limitation of liability clauses.

The survey said: “Despite the difficult operating environment, a majority of top 50 firms increased their fee-earner headcount, but apart from the 11-25, this was matched by either flat or declining chargeable hours. This, combined with the pricing pressure, is placing firms’ operating models under greater stress.”

PwC observed that law firms must make permanent cost savings to stay competitive and bolster margins. The firm suggested that this can only be achieved through standardisation of business processes and systems, the use of alternative delivery models and by placing more emphasis on the strategic element of support roles.

Another option would be a merger: 70% of the top 11-25 firms claimed they are considering such a deal during the next three years.

Even within the top 10 the survey found marked differences, with PEP ranging from £1.36m to £530,000, but the average of £908,000 is more the twice that of the second-tier firms (£443,000).

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