Will law firms' financial results for 2017 fall short of 2016? Legal industry results through the first nine months of 2017 suggest that's a real possibility. Revenue growth decelerated from the first half of the year, as demand declined and the collection cycle lengthened. There's some comfort in expense growth also moderating, though margins remained compressed.

The good news is that with an unusually large buildup in accounts receivable at quarter-end, the legal industry is well set up for a strong year-end collections push.

These results are based on a sample of 183 firms (80 Am Law 100 firms, 49 Second Hundred firms and 54 niche/boutique firms). Thirty-three of these firms fit our definition of either “international” (less than 25 percent but more than 10 percent of lawyers based outside the United States), or “global” (at least 25 percent of lawyers based outside the United States). Firms with less than 10 percent of lawyers based outside the U.S. are classified as either “national” (less than 50 percent of total lawyers based in headquarter office), or “regional” (greater than 50 percent of lawyers based in headquarter office). Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and more than 35,000 individual lawyers. Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and the Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey and produce the Law Firm Leaders Confidence Index semiannually. These reports, together with extensive discussions with law firm leaders, provide a comprehensive overview of current financial trends in the industry as well as forward-looking insight.

Revenue grew 3.6 percent through the first nine months of the year compared to 3.7 percent for the comparable period last year. The key driver of revenue growth was billing rate increases of 4 percent, higher than the 3.2 percent we saw last year and higher than the typical 3 to 3.5 percent range we've seen for several years. On the other hand, demand—i.e., total timekeeper hours—declined by 0.2 percent compared to a 0.3 percent increase during the same period last year. And while a shortened collection cycle was a key driver of revenue growth last year and through the first half of this year, we saw it lengthen by 0.9 percent in the nine-month results.

Expenses increased by 3.8 percent, compared to 3.4 percent through the same period last year. Not surprisingly, lawyer compensation expense increases had a proportionately greater impact on expense growth this year than last (7 percent vs. 4.1 percent), as the industry continued to feel the combined effects of an increase in lawyer headcount (1.7 percent) and the salary increases adopted beginning in the middle of last year through the start of this year. But just as revenue growth slowed in the third quarter, so did expense growth, down from 5.1 percent through six months.

A natural first reaction might be to attribute most of the slowdown in expense growth to the fact that we've now entered the second half of the year, when the period-over-period impact from the associate salary increases should be comparatively less than during the first half of the year. While it's true that compensation expense growth did moderate somewhat, a larger contributor to the slowdown in overall expense growth was in fact operating expense growth, which was up only 1.6 percent through nine months, compared to 3.3 percent for the first half of the year.

While total lawyer head count grew 1.7 percent, equity partner headcount declined 0.5 percent, a continuation of the long-term, industry-wide trend of keeping equity partner head count in check. The net effect of total lawyer head count growth together with the reduction in equity partners was higher leverage.

Meanwhile, growth in total lawyer hours lagged head count growth, resulting in a 0.6 percent drop in average hours per lawyer. Both the increase in leverage and the decline in productivity are a continuation of the trends that we saw in 2015 and 2016.

Looking toward full-year revenue results, inventory growth of 4.6 percent at the end of nine months is well ahead of the 3.1 percent increase through the same period last year. More important for near-term results, accounts receivable growth was up 6.7 percent, compared to only 2.6 percent a year ago, setting firms up for strong fourth-quarter results.

A possible longer-term concern, however, is that unbilled time increased only 2.4 percent, compared to 3.6 percent a year ago. This, and continued softness in demand, could result in a relatively weak revenue pipeline entering next year.

Behind these industry averages, we continued to see high levels of dispersion and volatility. Slightly more than half (51 percent) of firms saw a decline in demand during the first nine months of 2017, which is consistent with what we've been seeing for several years. Volatility, defined as alternating periods of demand growth and decline, was also evident. To measure volatility in demand performance, we looked at the 140 firms that reported nine-month results in 2015, 2016 and 2017. Exactly half of these firms either saw demand increase in 2016 and decrease in 2017, or vice versa.

We've also heard anecdotally that many firms are actually seeing greater demand volatility quarter-to-quarter, underscoring the challenges both in growing revenue and efficiently resourcing against current and anticipated demand.

Looking at results by revenue size, we saw that larger firms continued to outperform smaller firms, with the differences most pronounced between Am Law 50 firms and Am Law Second Hundred firms.

Am Law 50 firms saw by far both the greatest revenue growth (4.7 percent) and expense growth (4.9 percent). The drivers of this strong revenue growth were increases in rates (4.5 percent) and demand (0.9 percent), both the highest of any segment. Furthermore, approximately 60 percent of these firms experienced an increase in demand, the highest proportion among the segments. This segment is also best situated for a strong fourth quarter, with a 6.3 percent increase in inventory at quarter-end, including 7.8 percent in accounts receivable.

The growth in expenses at Am Law 50 firms was driven primarily by lawyer compensation expense growth, which was the highest increase of all the segments, at 8.2 percent. That's not surprising given that Am Law 50 firms not only saw the greatest increase in lawyer headcount, but were also generally the earliest adopters of last year's salary increases.

Only Am Law 51-100 firms saw revenue growth (3.5 percent) outpace expense growth (3.1 percent). The key revenue driver for this segment was a shortening of the collection cycle, the only segment to see inventory turnover improve during this period. Underlying demand actually decreased by 1.5 percent, and lawyer rate increases were up only 2.5 percent.

While Am Law 100 firms continued to grow revenue at a relatively solid pace, Second Hundred firms continued to face challenges. Revenue growth was up only 0.6 percent, primarily because of a 2.3 percent decline in demand, while lawyer rate increases were up just 2.1 percent, the lowest of all the segments. The comparatively low rate increase could be due in part to a change in the mix of timekeepers, as Second Hundred firms were the only segment to see a reduction in the head count of their highest billers, equity partners (down 3.2 percent).

Probably most troubling for the Second Hundred segment is that the demand decline is relatively pervasive, with 64 percent of firms experiencing a decline, the highest such proportion in any segment, suggesting that these firms are having a hard time bringing in business, as well as putting through rate increases.

Niche/boutique firms were the only segment to see a decline in revenue, driven by the 6.3 percent lengthening of the collection cycle, which could be due to the comparatively greater amount of contingency work compared to the other segments. Niche/boutique firms were also only one of two segments to report demand growth (albeit only 0.1 percent), and they saw rate increases of 3.7 percent, second only to Am Law 50 firms.

On another positive note, the buildup in inventory at niche/boutique firms includes both a solid increase in accounts receivable (7.3 percent) and unbilled time (3.6 percent), which should bode well for both fourth-quarter collections and beyond.

Looking at the firms by geographic reach, our survey found that international firms—those with between 10 and 25 percent of their lawyers outside the U.S.—had the strongest revenue growth (4.4 percent). Despite having one of the highest expense increases, at 4.0 percent, international firms were the only segment to show margin improvement. Revenue growth was driven primarily by rate increases of 3.9 percent, as demand growth was a modest 0.2 percent and the collection cycle lengthened by 3 percent.

International firms also benefitted from a shift in demand mix toward higher rate billers. This segment is also well positioned for strong fourth-quarter collections, with the strongest increase in inventory at 7.6 percent (with accounts receivable up 9.5 percent).

Global firms, with more than a quarter of their lawyers outside the U.S., saw the second best revenue growth, at 3.5 percent. Demand was up 0.5 percent, and the collection cycle lengthened by 2.5 percent. These firms also had a nice 6.0 percent buildup in inventory (6.7 percent in accounts receivable), which suggests good collections experience ahead.

Despite shortening their collection cycle, the more U.S.-centric firms lagged in revenue growth. National firms, which saw a decrease in demand during the first nine months of in 2016, actually saw the strongest improvement in demand during the comparable period this year. Their rate increases lagged the other segments, however. The reverse was true for regional firms, who had solid rate increases second only to global firms, but were the only segment with a drop in demand.

A challenging third quarter for many has led to lower demand through the first nine months, but the combination of stronger than usual rate growth and a slowing of collections has resulted in decent inventory growth levels. Meanwhile, the moderation in expense growth is welcome news.

Unless firms see a particularly strong bump in fourth-quarter demand, matching last year's performance will depend on further moderation of expense growth and, to a much greater degree, effective collections through year end.

John Wilmouth is a Senior Client Advisor in Citi Private Bank's Law Firm Group, and Gretta Rusanow is Head of Advisory Services. Citi Private Bank is a business of Citigroup Inc., which provides its clients access to products and services through bank and non-bank affiliates of Citigroup. Not all products and services are provided by all affiliates or are available at all locations. The views expressed herein are for informational purposes only and are those of the authors and do not necessarily reflect the views of Citigroup Inc. All opinions are subject to change without notice.