Q1 PMI: The Fear of Realization Erosion Lurks Behind Stronger Rate Growth

Topics: Billing & Pricing, Client Relations, Data Analytics, Law Firm Profitability, Legal Innovation, Peer Monitor, Thomson Reuters

PMI

As we have said, rates have been the driving force behind much of the growth in law firm profitability for most of the past decade.

That was one of the key findings of to the 2017 Report on the State of the Legal Market, produced by The Center for the Study of the Legal Profession at Georgetown University Law Center and Thomson Reuters Legal Executive Institute. With all the other regular factors that influence profitability being neutral to unfavorable, rates were left to stand largely alone as the factor that continues to help push greater profits among law firms.

This finding, though, is tempered by a steady stream of anecdotes about clients continuing to resist rate increases. But how much of that resistance is borne out in the actual data?

According to the recently released Peer Monitor Index report for the first quarter of 2017, pressure on rates may not be as great as some believe. Average worked rates, the negotiated rates clients agree to pay to engage a matter, grew by 3% in the first quarter, their best first quarter performance in three years. The previous two years, worked rates had grown at 2.8% and 2.7%, respectively; so this year is starting off on a stronger note.

This would seem to be encouraging news. Increasing rates can help shelter law firm profits in the face of softening demand and increasing expenses, two other factors present in the market for more than the last two years.

But increased worked rates do not necessarily paint the whole picture of client attitudes towards rates. Increased rates do not automatically translate to increased revenues.

For most of the past several years, increasing worked rates have enjoyed about 89% realization against those rates. That meant for every dollar the average firm was able to raise its worked rates, the firm collected 89 cents of that dollar. This has held steady for most of the current decade.

But the first quarter of this year showed something we haven’t seen before — a worked rate realization that dipped below 89%. In fact, average worked rate realization for Q1 2017 settled in at 88.6%, an all-time low.

Q1 PMI

 

To be sure, there are periodic cycles in realization rates throughout the year. The first quarter of any given year can be a time when worked rate realizations appear to take a bit of a dip because of how realization is calculated. When collected rates are compared to worked rates in the same quarter, there is an inherent (though slight) inconsistency because some of the collections may well be from previous quarters for work done on a different rate schedule. This conundrum raises its head in the first quarter of every year.

But this year was slightly different than years past. Worked rates increased, which is normal for the first quarter, but the actual average collected rate declined relative to what it had been in Q4 2016. To put it another way, even if the some of the collections in Q1 2017 were for work done in Q4 2016, clients actually paid slightly less on an average per-hour basis than they had even under the Q4 rate schedule. These factors combined to lead to an historic low in worked rate realization.

I don’t mean to suggest that firms should be concerned about a nosedive in realizations. Historically, lags in Q1 realization have rebounded in following quarters as the lag between work-in-progress catches up to collections on the same rate schedule.

I would, however, tell law firms that they certainly need to watch these metrics closely. Driving strong rate growth is good only if it does not hurt realization or demand. The laws of economics, particularly price-demand elasticity, only work in your favor if the increase in price does not lead to a great shedding of demand or an increased prevalence of write-downs and write-offs.