A majority of UK small and mid-size law firms said they are optimistic about the future despite a raft of headwinds that are impacting their financial outlook, according to a NatWest survey.

The NatWest Legal Report 2023 – the ninth edition of the survey – found that almost nine in 10 firms (87%) had a positive outlook even as low fee income growth and rising costs put pressure on profit margins. More than half of firms said they are expecting charge-out rates to grow by less than 5% this year, while almost half of firms (46%) anticipate payroll costs to grow between 5% and 10%. That suggests firms are finding it hard to pass on higher costs to clients, squeezing margins.

The tight labour market remains a concern, with almost half of the firms surveyed (46%) saying the biggest challenge they face this year is attracting and retaining talent. However, 59% said they expect to increase headcount by up to 10% this year, with only slightly more than a quarter (27%) anticipating headcount to stay the same or decline.

Other key challenges this year include concerns about the economic outlook (21%), cashflow issues (10%) and inflation (9%).

David Weaver, head of professional and business services at NatWest, said: “It’s good to see that, despite various headwinds, law firms are optimistic about their financial performance in the coming year. This optimism reflects the fact that many firms have demonstrated record profitability in recent years, despite the ever-present challenges they face.”

The survey also showed that profit per equity partner (PEP) declined slightly (3%) since the last NatWest report in 2021. Median PEP was £246,000, dropping to £148,00 for small firms and rising to £302,000 for larger firms (firms surveyed report fee income between £1m and £75m). A quarter of firms said PEP had declined by at least a fifth over that period.

Meantime, almost a third of firms (32%) said they were likely or very likely to seek a merger or acquisition as a growth strategy in the short term, while 22% say they have been approached by a potential suitor over the past year.

In terms of digital transformation, 41% of firms said their biggest IT investment priority was their practice management systems, followed by their case management systems (29%). Only 2% of firms said artificial intelligence was a key area of investment.

The report also showed just 19% of firms place a high priority on diversity and inclusion. Almost two thirds of firms (62%) said more than 60% of their fee earners are women, though just 24% of firms said that more than 60% of their equity owners were women.

And despite increased focus around sustainability issues, only 10% of firms said they place a high priority on ESG, though 37% have invested in renewable energy solutions for their business.