Hildebrandt/ Citi Client Advisory: Slow Growth For Law Firms in 2010

Considering the contraction in 2009, this isn’t as newsworthy as it might appear. In fact, there is little evidence 2010 will be much better than 2009 according to the Advisory:

“However, while the profession is no longer in crisis mode, we recognize that firms will remain under intense pressure to create new models for pricing and delivery of legal services,” DiPietro said in a news release. “The report addresses these issues as well as the industry’s response to the current market environment.”

I suppose this will lead to another in depth discussion of alternative fee arrangements.  How novel.

Some highlights:

• Realization continues to drop in spite of efforts to raise rates to offset drops in demand;
• Pressure for discounting, fee caps, multi-year rate schedules and alternative pricing increases;
• Increases in “negotiated” rates are being offset by drops in “collected rates”, leading to the lower realization;
• Firms chose to cut expenses, especially compensation costs, to offset losses (a typical reaction);
• Biglaw firms fared better than smaller firms, mostly due to dramatic purging of staff and cost controls;
• Significant improvements seen in 2009 in demand for Mergers and Acquisitions, general corporate, tax, capital markets, and real estate practices;
• Expect further cost cutting measures in 2010 (ie, not likely to be a boom year for technology vendors seeking to encourage firm investment in technology).

A look at the effects on key profit drivers:

• Productivity still in negative growth “driven to some extent by associate pushback on the unsustainable billable hour requirements in many firms”;
• Leverage is increasing to make up for declining productivity (which makes no sense as this drives up costs without adding value);
• Realization, as earlier stated, is in steady decline;
• Expenses had been a source of continual growth until 2009;
• Growth prior to 2009 was consistently driven by rate increases between 6 to 8 per cent annually;
• Expectations for future rate increases are low due to increased client resistance.

The Advisory mentions something that I have touted for years:  the need for improved efficiency to maximize profitability.  During the boom years, it enhanced an already profitable model.  Now, it will be a necessity to offset rate stagnation.

Legal Current has more on the advisory.  To read their take and download a copy of the Advisory, click here.

Are Law Firms Ready For Rate Deflation?

After hitting 5% in July of 2008, inflation has dropped rapidly and is now in negative territory (annualized) for the first time in 54 years.  This creates tremendous spending opportunities but there are many risks.  One of the risks to law firms is a deflating billable rate.  With deflation hitting most aspects of the economy (food and energy being notable exceptions that at least in the latter case isn’t expected to deflate for a while and in fact may be the next credit “bubble” if, err, I mean when cap and trade is passed), it is only a matter of time when clients will either request more discounts or a reduced rate – and if clients don’t ask, other attorneys will offer lower rates to lure new clientele.  Many businesses will be working from much tighter margins while the cost of doing business, including defending lawsuits, won’t lower with their margins.  Something will have to give – either longer A/R outstanding or reduced rates.

It may not come.  But there is reason to believe it will.  Attorneys from large law firms who have been laid off are finding themselves entering the mid-firm market and some enterprising ones will start their own firms, determine a model that maximizes profit, and “Wal-Mart” some out of business while still raking in incredible profits.  All it takes is better efficiency in serving clients (and, in my view, an unprofessional but very business-like approach to targeting and accepting clients).  The relationship you have with your clients puts you at an advantage right now.  However, in forecasting models you should prepare for a fight for your business based on  rate.    

If you are faced with reducing rates to keep clients, efficiency is key to making up the lost revenue.    Don’t rely on volume alone as it can fool you into thinking you are in a better financial position than you are.  You may end up hiring excessive numbers of attorneys, especially as the costs of attorneys goes down (another inevitability that is already happening – salary reduction for new associates).  If you are still making minimal margins because you are too busy to implement efficient processes and you get undercut by someone willing to lower their rates, your firm will be in for a rather intense correction.

Even assuming rates don’t increase, there is a high probability that any planned rate increases will be difficult to implement.  Firms have been contracting for several months and most have already cut costs as low as they can.  A reduction in rate is an unplanned occurrence that can place even more pressure on firms to reduce costs.

From the firms I have consulted, most are still unwilling to invest in efficiency – rather, they are placing more emphasis on productivity and staff reductions.  There are a few firms who are changing their model to streamline processes – those who invest in better procedures will not only be in a better position to absorb rate stagnation (or deflation) but will be in a better position to increase profitability later this year when the economic numbers start to improve.  The test will be whether they retain earnings, a concept that is anathema to many firms.

Please note that due to the activism of the Federal Government to re-inflate the credit markets, there are arguably two possible results:  massive inflation or another asset bubble (which will lead to a result similar to what we are experiencing now).  Either way, the pattern of erratic markets is not likely to end anytime soon and with trillions being poured into the economy, money may get loose for a while – smart firms will invest in their firms (take advantage of the deflation) and set aside sufficient amounts to take short hits on revenue rather than make distributions (in case of a rapid spike in inflation or another asset bubble).  We are in for a long period of uncertainty.  Universal health care, carbon emission taxes, and of course the obvious tax increases to pay for the action taken already and to sustain the new entitlements.

Law firms will not be needed less (and in fact in some areas they will be needed more) but they are not immune to shifts to the economy.  There will be areas of rate inflation but your firm may not be one of the beneficiaries.  Some areas of law that have flourished for decades will suffer greatly and some boutique firms will cease to exist entirely.

Prepare for it.  If your firm flourishes and all the doom and gloom above doesn’t come to fruition, great.  Your bottom line thanks me for helping you have such a strong equitable position during your time of saving – go buy a new touch screen whiteboard or make a distribution so you can pay for all those projects at home.  If the firm struggles, however, you may avoid having to make decisions that are not only uncomfortable but can lead to a fracturing of the firm.

Great News: Smoot Hawley II

As if spending 75% of the near trillion dollar “stimulus” package on things such as contraception (ha, nice pun there) wasn’t enough, it appears this great piece of legislation making the rounds of the Senate as I write this is full of incentives to buy American only – another nice legacy of the 1930’s.  Let’s see, to complete the ruin of our economy, all that is needed is a tax increase in a few years.  I am not even close to going out on a limb to predict that once we get any sign of economic improvement, the tax increases are coming.

Add to that a possible re-emergence of trade wars, and you’ve got the perfect re-enactment of the 1930’s without even having to read a history book!

All Bets Off – Massive Deflation And Fed Still Lowers Rates

All the ingredients are coming together for protracted, painful and seriously impaired economic conditions.  As stated in an earlier post,  a deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow.   It appears we are in the midst of one.  Consumer prices, after a record decline in October, set another record in November, pushing inflation down to 1.07%.  After a year that saw inflation hitting almost 6% in July, this is a painful indicator of things to come.  In spite of OPEC’s threat to drastically cut production, oil prices are still relatively low.

Worse, the Federal Reserve appears to be acting counter-intuitively by lowering interest rates to “zero to .25%“, leading to speculation that once our economy does rebound, hyperinflation will be the next crisis.  It doesn’t help that our government continues to spend money it doesn’t have.

On top of all this, President-Elect Obama announced that his “stimulus plan” will be somewhere between $600 billion and $1 trillion.  The spending spree never ends.

The time to voluntarily liquidate assets has passed.  Foreclosures dipped in November, but few expect that trend to be anything but temporary in spite of Fanny Mae’s Christmas gift to renters of homes in foreclosure proceedings.  Best to hold on to assets and try to keep as much cash on hand as possible.

We can hope that the aggressive moves by the Federal Government will prevent another depression, but it sure seems like we are about to embark on the same policies of the Roosevelt administration that arguably kept the country in a depression for an entire decade.  One of the proponents of further governmental intervention is oddly a scholar of the Great Depression.  Fed Chairman Ben Bernanke believes that the cause of the Great Depression was the lack of action by the Hoover administration to stop banks from failing and by keeping interest rates too high.  In Bernanke’s mind, it was Hoover’s inaction that caused the depression, not Roosevelt’s activism.

There are (at least)  two arguments as to what caused the Great Depression.  One argument postulated by Irving Fisher and furthered by Bernanke states that debt deflation caused the Great Depression and, in at least Bernanke’s case, government inaction during the 3 1/2 years between the stock market crash of 1929 and the swearing in of Franklin Roosevelt caused productivity to become depressed and unable to recover in spite of FDR’s programs for an entire decade.

Fisher was not exactly on target with his arguments in his lifetime (from wikipedia):

The stock market crash of 1929 and the subsequent Great Depression cost Fisher much of his personal wealth and academic reputation. He famously predicted, a few days before the Stock Market Crash of 1929, “Stock prices have reached what looks like a permanently high plateau.” Irving Fisher stated on October 21st that the market was “only shaking out of the lunatic fringe” and went on to explain why he felt the prices still had not caught up with their real value and should go much higher. On Wednesday, October 23rd, he announced in a banker’s meeting “security values in most instances were not inflated.” For months after the Crash, he continued to assure investors that a recovery was just around the corner.

Once the Great Depression was unavoidable to notice, he theorized that debt deflation was a major cause – debt deflation that could have been avoided (according to some) had the Hoover administration taken more aggressive steps to intercede.

The other argument is that it wasn’t Hoover’s inaction that led to the Depression but the Smoot-Hawley Act of 1930, which raised tariffs on goods sold to trading partners and led reciprocal action, skyrocketing unemployment and global isolationism.   Those who would argue this would point that both low interest rates and ample liquidity were available in 1930, but that due to economic uncertainty, few wanted to borrow and take risks.  Further, FDR prevented the economy from pulling itself out of the depression by overly taxing the population (specifically the producers) and redistributing wealth using a “trickle-up” philosophy of using government to employ the people.  Even with FDR’s policies, unemployment was still over 19% in 1938.

You can argue both arguments are right and wrong.  It is plausible that at least having a Federal Reserve that would have released funds to troubled banks could have avoided the panic that led to over 9,000 banks failing in the 1930’s.  However, there is ample evidence that government intervention did more to exacerbate the Depression than remedy it.  The primary force that led us back to economic expansion was the Second World War.

Unfortunately for Bernanke, debt deflation is intensifying in spite of his actions to improve liquidity.  What may come from all these measures, however, could spur the same depressed conditions that he is trying so hard to avoid.  If liquidity does improve, even moderately, inflation will be a large concern.  The question will then be whether it would be better to allow inflation to run amok or to raise interest rates and threaten the improving economy.

One thing I feel relatively certain in predicting:  so long as the government intervenes in the economy, there will not be a lot of certainty in the markets, which will result in further volatility.  And, it doesn’t appear the government is planning on taking its hands out of the economy anytime soon.

False Sense Of Security Still Prevalent Among Law Firms

In spite of overwhelming evidence that the booming economy enjoyed practically uninterrupted for the past 20 years has ended, at least for the near term, many law firms are still optimistic of their 2009 prospects.  I beg to differ.  I believe 2009 will start a strong shift in the make-up of many law firms due to the lack of any planning for the economic conditions.

Who can blame attorneys for being optimistic?  Regardless of the economy since at least the early 1980’s, lawyers have enjoyed consistently increased business and profits.  This has led to a complacency and a denial of the economic conditions that are facing the country.

Law firms aren’t alone.  In fact, the “big three” auto makers (Ford perhaps excepted) are acting out of a similar denial as they attempt to scare Congress and the President into paying for their internal problems.  Who didn’t see the failure of GM coming?  Was no one noticing the extravagant pensions being offered to the employees?  Did anyone who dared notice believe the ever slimming margins would cover the ever growing benefits?   Not likely.  As the Legislative and Executive branches delve deeper into the phantom pockets of our tax base, a  nice summary of the fallacy of “avoiding acting like Herbert Hoover” has been inked in an opinion piece by Todd J. Zywicki in the Wall Street Journal.

Law firms, though not nearly in the long-term slide as the domestic auto industry, is more sensitive to this economic downturn than many attorneys would like to admit.  Many firms have been spoiled by margins that exceed 50% without spending more than a passing glance at the indicators that led them to such bounty.  The issue isn’t so much a drop-off in business, though some firms who specialize in areas that are in the midst of collapse will certainly feel the pain.  Rather, the issue is how firms will retain good talent, retain their expected incomes and avoid layoffs of associates.

These are regular issues for most industries but are foreign to the mid-size law firm.  Many firms pride themselves in their “family” atmosphere, which includes the bratty sibling rivalries that are tolerated when times are good.  Salary incongruousness may seem a bothersome itch when profits are high, but once the deadwood becomes heavy the scratching becomes intolerable.  Some may panic to find their balance sheet showing a loss without ever seeing it coming.  Drastic change is put into place – at a time no worse to prepare.  No more is it wise to visit a market when hungry than to suggest change while in the midst of a spiral.

Yet our economy has afforded all of us time to prepare.  It was suggested by many (myself included as far back as March) that our economy was in for some hard times.  Firms with the foresight and gumption to plan and hold timekeepers accountable for providing not only quality service to their clients but ensuring prompt billing and payment for the betterment of the long term financial health of the firm are in a position now to profit over the firms who were complacent.

It’s not too late, however.  Many firms are just now seeing the first bumps in the road.  It is my opinion that the economic downturn is just now really beginning to hit middle America.  The massive layoffs (over 533,000 in November) are an indicator that the many months of body blows caused by the collapse of the credit and housing markets (not so unlike what happened in the late 1920’s, speaking of Herbert Hoover) are finally taking its toll.  The question now is, where is the bottom?

No one knows.  That is a troubling concern that should make you want to hug every dollar your firm receives and not let go of it.  In times such as these, power goes to those who hold cash.  This may change if our government attempts to over-spend its way out of our economic downturn (thereby devaluing the dollar, leading possibly to hyperinflation combined with stagnant productivity – a prescription for the “d” word), but as of right now, many believe that the economy should rebound sometime in 2010.

In my opinion, firms need to pay more attention to the profitability of each fee earner and place more emphasis on marketing activities and their key profit drivers.  Please feel free to email me (by clicking here) if you would like some ideas on how to not only retain your current income, but increase profits during an economic downturn.

Consumer Price Index Plunges In October

The consumer price index plunged “by the largest amount in the past 61 years” in October.  This may be an indicator of a very deep recession, if not a depression.

A depression is characterized in part by a persistent, sustained, deep, general decline in production. They are typically preceded by a deflationary crash.  A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow.

Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans “stimulate production,” but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

Inflation this year has crept up to a peak in July and has stayed at or near 5% ever since, until October, when it plunged to 3.66%. We all know that the oil prices have been deflationary for the past few months and it appears this is the driving factor in the deflationary prices.   I personally haven’t seen prices (other than gas) get lower, especially food.

However, given the above, the question may shift from whether inflation will eat at your bottom line to whether deflation eats away at production and dries up your clients’ ability to pay.  Based on the above, the best bet is to hold on to as much money as possible and to the extent you hold assets that are devaluing, consider liquidating to cash.  Prepare for lower income for the coming years and offset the loss in revenues by keeping your firm in sound financial condition so that you are better able to help serve your clients without the struggle of wondering how you will pay your employees.

The way to do this is to identify areas you believe will affect your income next year.  There are plenty of indicators out there but any prediction is just that.  The lower the expectation, the better opportunity to absorb worse conditions.

After you have identified where you will lose and make money, focus on assigning resources towards strategic targets that you believe will improve revenue.  Although never a fun endevour, it is time for hard decisions related to re-aligning your staff to optimize your ability to serve your clients during a time when cash flow may be strained.

Implementation must be consistent and applied universally.  This of course is the most difficult part of any change, but the future your firm, and/or your best talent, may depend on it.

As always, measure against your forecasts and in this case, worrying about others is irrelevant.  Focus on your own predictions and work towards achieving your own goals.  What happens with other firms can be compared after the economy recovers.

I’ve never lived through  a depression.  I am not sure I can even fathom it.  However, I do recognize the plethora of signs that our economy is not just taking a temporary hit – it is part of a global downturn marked by the largest expansion of credit in history.  Something others have noted invariably lead to deep losses in production.  And there is no denying that there will be massive layoffs in the coming year and our auto industry is facing its own collapse.  Production can’t improve in this environment.

Plan accordingly.

Perfect Pain: Inflation & Deflation

I have spent considerable time discussing the increasing inflationary threat to the economy over the past year. The rapid popping of the asset bubble, however, has worked its way into the rest of the economy and has had an deflationary effect that is beginning to show in core prices.  The most recent Consumer Price Index (for September) has inflation falling under 5% (4.94%) after skyrocketing to 5.6% in in July and 5.37% in August.  The inflation rate for 2008 is still 4.5% – over 1.5% increase over the average rate (3%) since 1992.

The recent “bailout” of $800b of new freshly printed money should serve to increase inflation.  However, according to Tim McMahon on his site Inflationdata.com, the loss of over $7 trillion in value from the NYSE and NASDAQ creates a “net deflationary effect” on the economy:

And that is not counting the value lost in housing prices.  And to make matters worse the mortgage industry took those initial mortgages  and leveraged them using “derivatives” to compound the gains on the upside.  This leverage was by a factor of hundreds of times.  Actually no one even knows the full magnitude of how much compounding went on.  So there could easily be Trillions more of liquidity that evaporated when housing prices stopped going up and began their downward descent.

So how do you reconcile a high inflation rate and net deflation on the economy at the same time?  McMahon explains that the consumer price index considers over 10,000 items that “take into consideration all aspects of the economy.” What is happening in the stock market is based, at least initially, on housing prices.  So, in effect, we get bad news on both fronts:  Our house values are deflating and our cost of living is inflating.

Need it be reiterated the importance of measuring performance?  The boom economy of the past two decades is unfortunately giving way to an as-yet unknown period of economic decline.  We have suffered through two minor recessions during this period, but the extent of this downturn is certain to be more protracted and deeper.  The recession in 1990 was practically non-existent and short and was arguably preventable without the massive tax increases placed on the economy. The recession in 2001 was again short and based primarily on the bust of the tech sector – with not nearly the impact on the majority of Americans as a drop in home values.

The good news for law firms is that regardless of who wins the Presidential election, there will be a rush to enact new reactionary laws to protect consumers that will invariably lead to an increase in lawsuits.  The bad news is that your personal income will be devalued based on the realities of the economy.  Also, those in transactional practices will not be as fortunate, as transactional business typically suffers during recessions.

Next week the government will release 3rd quarter GDP results.  Most expect us to report the first negative growth in seven years. The time to plan for the economic downturn was several months ago – but it is never too late.

Europe Follows US Lead: Eases Mark To Market Accounting Rule

Weeks after the US drops the mark to market accounting rule requirement (and not so coincidentally bank failures ceased), the EU has fallen in line and has backed proposals to ease the rule.

Quote Of The Day

From Democrat strategist Jenny Backus, when discussing Governor Sarah Palin:

“If you want to start throwing fire bombs, you don’t send out the fluffy bunny to do it. I think people don’t take Sarah Palin seriously.”

Panacea Bill Passes; Bush Cautions “It’s No Panacea”

The Emergency Economic Stabilization Act of 2008 is now law.  The markets responded by losing over 350 points (taking into consideration where the DOW was at the time of the vote).

President Bush, after signing the bill, cautioned that it will “‘take some time’ for the measure to have its ‘full impact’ on the economy, and that the task of buying up troubled financial assets in the wake of the mortgage meltdown ‘cannot be accomplished overnight.’”.

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