Since 2001, the legal industry has been characterised by double-digit profit growth, strong demand, solid productivity and controlled expense growth. That all started to change in the second half of 2007, and now the first half of 2008 looks very different. In a trend that started last year, expense growth this year has stayed relatively high, driven largely by continued growth in lawyer head count. Demand for legal services was also the weakest seen in the period from 2001 to 2008.

All told, for the first two quarters of 2008, profit margin compression – that is, expenses increasing faster than revenue – was the greatest it has been in the last eight years.

The slowdown is hitting the most profitable firms the hardest. In the first half of 2008, demand dropped off even more dramatically and expenses increased at a more rapid pace at the top firms. The practice areas that normally provide a lift in a downturn – restructuring and litigation – have not helped cushion the drop-off in transactional work.

For 28 years, Citi Private Bank law firm group has confidentially surveyed firms in The Am Law 100 and 200, along with a number of smaller firms. Our report found that, across the industry, revenue growth was a tepid 4.8%, less than half the compound annual growth rate (CAGR) of 10.6% for the previous seven years. That is in sharp contrast to the seven-year demand CAGR of 3.9%.

Despite the fall-off in work, leverage actually increased during the first half of 2008. Total lawyer counts rose by 5.6%, more than three times the rate of equity partner growth. Firms saw profits per equity partner (PEP) drop by 9.1% in the first six months of 2008.

It may seem paradoxical to see an increase in head count while demand drops, but law firms generally set their new associate hiring goals two years in advance. They are also much more reluctant than corporations to resort to mass lay-offs, since they need to keep on enough junior associates to ensure that they will not suffer from a lack of mid-level talent when business picks up again.

When firms are broken down by profitability, our data produced an interesting finding. The firms that soared in 2002 through 2007 were harder hit in the first half of 2008 than their less profitable peers. That changed dramatically in the first half of 2008. Growth in PEP for 51 of the 63 top-tier firms that reported their results to us plummeted from an 11.7% increase in 2007 to an 11.8% drop in the first six months of 2008. In contrast, their less profitable rivals experienced a 5.3% drop in PEP in the first half of 2008.

What is going on? Simply put, top-tier firms tend to rely on certain kinds of transactional work, such as high-end private equity deals and structured finance, and also tend to have a higher percentage of clients in the financial services sector. That client base served top-tier firms well during the prior six years. But since the second half of 2007, the deal environment has languished, and top-tier firms are paying the price.

These firms also have had a tougher time turning off the expense spigot. When times were flush, top-tier firms experienced higher associate attrition rates than average, due to lawyers leaving to work for clients and other opportunities in the financial industry. To make up for this, top-tier firms typically hired more new associates than average, since they expected more to leave. In fact, at top-tier firms, head count grew by 7% in the first half of 2008, versus 4.2% at their rivals.

As I write this, all signs point to the second half of 2008 continuing the trends of the first half. The common wisdom is that this economic slump is more akin to the downturn of 1991 – deeper and more complicated than the downturn of 2001, which was largely limited to the high-tech industry.

Early this year, in a joint advisory issued by Citi and Hildebrandt International, we projected profits would increase by 3%-5%. Based on the six-month results and our sense of the dynamics in the market, we now believe PEP will be flat, or even down by as much as 10%, in 2008.

There is no doubt 2008 will be the most challenging year the legal industry has had since 2001 (and perhaps even earlier). But downturns present opportunities. The dislocation in the market and dissatisfaction among partners offers law firms the chance to gain market share by bringing in select lateral partners.

Law firm management should take heart that the legal industry is, in fact, healthy and resilient. There are a lot of other business sectors that would love to be able to define a bad year as profits that are flat to down by 10%.

Dan DiPietro (pictured) is client head of the law firm group of Citi Private Bank. This is an edited version of an article that appeared in Legal Week's US sister title The American Lawyer.