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Law Firms 101: Riding the Wave of Economic Headwinds - Timothy Ang

You may have heard about law firms laying off staff in recent months. Just a few days ago, for example, Bryan Cave Leighton Paisner laid off almost 50 business service professionals, joining the likes of Kirkland & Ellis, Dechert, Shearman & Sterling and Cooley to have recently reduced headcount. Could these cuts spread even further? What makes law firms fire people? Beyond the truism that an economic downturn affects law firms negatively, which even then is not always true, it is important to understand the industry-wide challenges that law firms are facing, and how a given firm may or may not be well-positioned to ride out the current downturn. Such is my focus in this article.


Challenges


There are two unique challenges affecting the legal industry at the moment. These are an increase in lawyer salaries, and a reduction in client demand for legal services due to macroeconomic conditions. Each challenge can be categorised into a cost driver, which increases a firm’s expenses, and revenue dampener, which limits the amount of money that a law firm brings in. Together, they weigh on profitability.


(1) Lawyer salaries


First, lawyer salaries, especially those of associates, have been increasing rapidly due to a pay war for talent. This had been ongoing since American firms pursued organic growth in London over the past decade or so, offering salaries much above that of UK firms. For example, the highest salary for a newly-qualified (NQ) lawyer was £100,000 in 2010 (inflation adjusted, £136,100 in 2022 currency) offered by the now-defunct US firm Bingham McCutchen; other top US firms were not far behind. In comparison, Freshfields cut newly-qualified salaries from £66,000 to £59,000 in 2009 (inflation adjusted, £92,800 and £82,900 respectively).


However, the pay war only intensified after the onset of the pandemic. Scott Gibson of the legal recruiting agency Edwards Gibson argues that this was due to high lawyer attrition driven by burnout, along with the parallel boom in work in late 2020 to 2021 and a tight labour market for junior lawyers. As a result, NQ salaries were increased amongst firms that pay the top US market rate three times in 2022 alone. In 2022, the highest NQ salary in the City, notwithstanding some variation due to how firms calculate currency exchange rates, was £179,000 at Akin Gump - a 79% increase over that in 2010, and a 32% premium over inflation. Amid the war for talent, UK-based firms have had to accept higher salary bills to stay competitive. Thus Freshfields, Clifford Chance, and more recently Linklaters and Allen & Overy, have now all raised NQ salaries to £125,000.


(2) Downturn in client demand


Second, client demand for legal services has dropped, for example by 4% in the fourth quarter of 2022. In the field of M&A, an area that many firms are reliant on, deal volume dropped 44% year-on-year in the US and 70% in Europe in that final quarter. Jenny Petch has written about this decline in more detail on this Blog previously. Further, the recent banking crises which took down Credit Suisse and Silicon Valley Bank among others are not helping dealmaking. Businesses are unclear as to whether these collapses were just a transient crisis that has already passed, or are a sign of worse things to come. Hence, businesses are even less confident about investing in expansion, which means fewer deals for law firms to advise on and therefore less revenue.


Together, these two factors have been weighing on law firm profitability. According to a Thomson Reuters and Georgetown University report, average profit per equity partner at large and mid-sized US law firms fell 4.2% in 2022, the first decline since 2009. Nonetheless, this decline is not representative of all firms. Firms can and do utilise different strategies to deal with macroeconomic headwinds, which will now be explored.


Strategies


First, law firms can leverage their countercyclical capabilities, thus protecting themselves against downturns in a particular practice area. Transactional work generally suffers in a downturn, whereas contentious and restructuring work generally increases.


For example, Herbert Smith Freehills adopts a twin enginestrategy and prioritises transactions and disputes, while Weil, Gotshal & Manges is reputed for their restructuring expertise. Notably, Weil advised Lehman Brothers and General Motors on their Chapter 11 bankruptcy filings in the wake of the 2008 financial crisis, generating hundreds of millions of dollars in fees and avoiding laying off lawyers during the crisis. Similarly, Kirkland & Ellis managed to increase revenues by 8% and headcount by 13% last year partly by leveraging its bankruptcy credentials to advising on lucrative crypto bankruptcies like those of Voyager, Celsius Network and BlockFi. Such strategies are not immune to risk, however. In Weil's case, as the crisis-related work dried up and the economy recovered, transactional work did not make up for it and the firm laid off 60 associates in 2013, when many other firms were already rebuilding.


Second, firms can target certain industries. Despite the recent drop in M&A demand, there have still been winners and losers. In particular, the healthcare industry has seen a two-year high in deal volume, constituting nearly a fifth of all M&A deals and benefitting firms that work heavily with healthcare and life sciences clients, such as Wachtell, Lipton, Rose & Katz. On the other hand, the technology sector was badly hit, and the effects on Cooley are emblematic of the risks facing firms who adopt an industry focus. Cooley focuses heavily on the technology and venture capital industries, which meant its fortunes suffered together with those industries as technology stocks took a hammering in the wake of interest rate hikes. In 2022, the firm’s profit per equity partner fell 19.5%, and it laid off 150 lawyers and business professionals (78 lawyers) in late November, after another round of layoffs earlier that month. Nor was this the first time the firm has laid off lawyers, having cut more than 10% of its lawyers after the dotcom bubble burst and others during the financial crisis.


Third, law firms need to consider their expenses. Scott Gibson argues that salary wars are usually a “portent of a market correction”. The last two salary wars in his experience were in the leadup to the dotcom boom and 2008, after which associate compensation fell sharply and hundreds of lawyers were laid off.


There are better and worse approaches to reducing the payroll. In 2009 Skadden offered all its associates the option of taking a year of leave for one third of their base salary, guaranteeing that their jobs would still be there when they returned. On the other hand, in 2023 some firms have been accused of conducting “stealth layoffs”, in which lawyers are told to leave for reasons of poor performance when they would previously have earned stellar reviews, and which coincidentally happen in the midst of the economic downturn.


Conclusion


Law firms are undoubtedly in a tough position whenever the economy faces strong headwinds. However, many of the same factors had been present in past recessions, and law firms should learn their lessons to mitigate the risk of leaving staff out to dry. After all, layoffs hurt a firm’s reputation and ability to attract talent in the future— the example of the verb “Lathamed” being used as a synonym of “laid off” is self-explanatory. Whether they can, however, is a matter easier said than done.

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