Weaver:
Pressure on margins has become more acute for many SME law firms over the past year but optimism about the future remains high, according to new research.
It found that, for many smaller firms, growth in profits per equity partner (PEP) was driven by increases in interest income, with interest income “often” representing a much larger proportion of PEP than underlying trading profits.
The Solicitors Regulation Authority (SRA) last week expressed concern about firms being financially over-reliant on client account interest.
The NatWest Legal Report, now in its 10th year, said large salary rises in summer 2023, after a period of high inflation, “baked in a requirement for firms to achieve high levels of top-line growth just to stand still”.
Headline inflation then tailed away quickly, “leaving the ability to pass on rate rises to clients harder for firms to achieve”.
But 90% of firms were optimistic about the future, with 36% very optimistic, both a little higher than last year.
Nearly 100 firms with a median turnover of £9m took part in the survey, which was written by Andrew Allen, a partner and head of accountants PKF Francis Clark’s national legal sector team. Small firms were classified as having fee income of less than £5m.
Median fee income growth in 2023/2024 was 10%, with fees per equity partner reaching £1.2m, while fees per fee-earner went up 8% to £161,000. Some 88% of firms expected fee income to increase in the 2024-25 financial year, with two-thirds saying it would be up to 10%.
Private client work again was cited as the most buoyant sector, by 28% of firms, but residential conveyancing tumbled from 21% last year to 8% this. Other areas of challenge this year were family and civil litigation.
Median PEP was up 16% for small firms to £136,000 and 6% for large firms to £309,000. There were extremes – while a quarter of firms reported growth in PEP of 41% or more, another quarter saw declines of at least 10%.
“Overall, the growth in PEP levels in firms in 2024 were better than many firms were budgeting for,” the report said. For some this arose from better absorption of people cost inflation and for others [particularly small firms] it was also assisted by increased interest income.”
Employee costs as a percentage of fees stayed at a median of 46%, or 63% after adding notional salaries for partners. “Crucially, this shows a slight reduction in core profitability/margins in law firms in 2024 – by 1%. In context however, this is much better than many firms were budgeting for,” Mr Allen wrote.
“Many had expected that it would not be possible to grow turnover in line with the people cost increases that accrued from high salary rises in the summer of 2023 and firms were often predicting people costs might rise by up to 3% of earned income.”
Two-thirds of firms reported a decline in their professional indemnity insurance costs in 2024 or premium growth of less than 5%.
At 142 days, lock-up was virtually the same as in 2023, but “given the impact of basis period reforms, the issue of lock up management in firms for 2025 will be a crucial factor in the sector”, Mr Allen warned.
All LLPs and partnerships that were not previously operating on a 31 March financial year-end will have significant income tax payments falling due in January 2025 because of the basis period reforms which impacted the 5 April 2024 tax year.
The report said: “For many firms the extent of those liabilities is higher than they may have originally estimated because more of their profits are arising from interest income than at the time the original estimates were prepared.
“Interest income, unlike trading profits, is not eligible for spreading under the HMRC rules. So, while the total financial impact of the basis period reform may not have increased for firms the timing of its impact has been accelerated to January 2025.”
Around two-thirds of the firms surveyed were affected by the change, with a mix of external debt, partner capital and lock-up reduction the answer most had for it, while 27% were looking to their cash reserves.
For every £1 of members’ funds/net assets in the business, the median level of debt was 17p (upper quartile 38p), which the report described as “comfortable in relation to debt availability to law firms”.
Gearing stayed steady at 7.5 fee-earners per equity earner, with the median ratio of support staff per fee-earner up slightly to 0.78.
Though attracting and retaining talent was by far the key challenge identified by firms (44% said this, followed by 17% nominating margin pressure and 15% improving productivity), 28% anticipated growing headcount between 5% and 10% by 2025, and 12% expected more than 10% growth.
Nearly half of firms (48%) said salary level was the most persuasive factor in recruiting fee-earners, whilst 35% identified values and culture.
More than four in 10 firms cited their practice management systems as the biggest IT investment priority, with cyber security management falling to second at 19% and artificial intelligence going from 2% last year to 15%.
Just over a quarter of firms (26%) said a merger or team acquisition was possible over the next year, while 38% said they had been approached by consolidators, up from 22% a year ago.
Just 7% of firms said they placed a high priority on ESG (environmental, social and governance) in their businesses, although a third have made a net zero or emissions reduction commitment.
Just 12% prioritised diversity, equality and inclusion; while 55% of firms said over 60% of their fee-earners were female, the figure fell to 13% of equity owners.
David Weaver, head of professional and business services at NatWest, said: “An optimistic legal sector is a good barometer of overall business confidence within the UK economy, and it’s great to see this building as demand for legal services remains strong.
“While margins continue to be tight, leaders are focusing on increasing fee income to offset wage inflation while also controlling costs and boosting productivity and recruitment.”
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