Pressure on profit margins has intensified for many small and medium-sized law firms across the UK, yet there remains a strong sense of optimism about the future.
In recent times, the reliance on interest income has increased significantly within smaller law firms, as highlighted by new research. For many of these firms, profit growth per equity partner (PEP) has been primarily driven by interest income, which often constitutes a larger share of profits compared to traditional trading activities. This trend, however, has raised concerns with the Solicitors Regulation Authority (SRA), which cautions against an excessive dependence on client account interest.
The NatWest Legal Report’s recent findings underscore the challenges faced by law firms following substantial salary increases in the summer of 2023. These increases, resulting from a period of high inflation, have necessitated substantial growth in revenue merely to maintain existing financial positions. As inflation rates decreased rapidly, law firms found it more difficult to implement corresponding rate increases for clients, exacerbating the pressure on margins.
Nevertheless, the report reveals that optimism within the sector is undeterred, with 90% of firms expressing positivity about the future and 36% describing themselves as very optimistic, a slight improvement from the previous year. This optimistic outlook is grounded in the impressive fee income growth of 10% in 2023/2024, with income per equity partner reaching £1.2m and per fee-earner climbing 8% to £161,000.
Despite challenges in sectors such as residential conveyancing, small law firms have fared well with a median PEP increase of 16% to £136,000, while larger firms saw a 6% rise to £309,000. The growth in PEP exceeded expectations for many firms, partly due to better handling of rising personnel costs and, for smaller firms, boosted by interest income.
Maintaining profitability, however, remains a concern, as employee costs constitute 46% of fees, rising to 63% when including notional partner salaries. The slight dip in profitability margins, though better than anticipated, reflects the ongoing struggle to align turnover growth with increasing staffing costs.
Two-thirds of surveyed firms reported a decline in their professional indemnity insurance costs or minimal increases below 5%. However, unchanged lock-up periods and basis period reforms pose upcoming financial challenges. The reforms necessitate significant income tax payments in early 2025, a situation further complicated by high interest income that does not qualify for tax spreading under HMRC regulations.
Financial stability is upheld by a balanced mix of external debt and partner contributions, with a median debt level standing at a comfortable 17p for every pound of member funds. The prevailing staffing ratio of 7.5 fee-earners per equity partner and slightly increased support staff ratio indicate steady operational gearing.
Recruitment and retention of talent rank as the primary challenge for 44% of firms, followed by margin pressures and productivity improvements. Most firms believe competitive salaries and a strong workplace culture are pivotal in attracting new talent. Plans to grow the workforce by 5% to 10% by 2025 illustrate the sector’s commitment to future expansion.
While technology investments and potential mergers are on the agenda for many firms, fewer prioritise initiatives for environmental sustainability or diversity. Cybersecurity remains a significant concern, with an increasing emphasis on artificial intelligence investments.
David Weaver, of NatWest, notes, “An optimistic legal sector is a good barometer for business confidence in the UK economy,” reinforcing the strong demand for legal services despite tight margins.
The UK legal sector demonstrates resilience and adaptability amid economic pressures, leveraging interest income to mitigate margin challenges while anticipating future growth.
