The owners of most wealth management businesses sense that the industry is at a crossroads.
On one hand, they are savoring their great success resulting from two decades of hard work. The profession, which finds its roots in the 1980s and grew into a cottage industry by the early 1990s, is now a $5 trillion behemoth. Individual firms with aggregate client assets in excess of $1 billion are commonplace—an outcome few of the industry’s pioneers would have predicted three decades ago. Fewer still would have foreseen how profitable their firms would become. Many founders of wealth management businesses are now multi-millionaires.
On the other hand, most owners recognize that the business is becoming significantly more challenging. New clients are harder to find, operating costs—and employee compensation in particular—are increasing, and regulators are becoming more hostile. Additionally, looming over all of these changes is a much greater, immutable force: old age. The founders of the advisory business, with an average age of 59, are reaching an age at which personal needs and objectives shift in preparation for retirement.
Three business models are emerging.
The business is far from homogeneous and extremely fragmented, but from 30,000 feet, wealth management firms can be largely grouped into one of three general business models:
Evolving Businesses—approximately 200 firms that have taken the messy and difficult steps necessary to evolve into businesses that are both sustainable in the long run (i.e., after the departure of the founders) and have meaningful enterprise value;
Books of Business (“BoBs”)—almost 18,000 wealth managers with low annual revenue, few (if any) capable successor professionals and no obvious strategic plan, firms that are better described as “jobs” rather than “businesses”; and
Tweeners—1,000 to 1,200 firms with greater scale and profitability than BoBs, but, unlike evolving businesses, have been unable and/or unwilling to take the necessary steps to evolve beyond a founder-centric model and effectively are very large proprietorships.
Five forces will drive the next phase of the industry’s evolution.
The profession is about to embark on the next phase of its evolution. Five forces will combine to create an operating environment that is vastly more challenging and competitive than in prior decades.
To be sure, we are not suggesting in any way that it will no longer be attractive to work in wealth management. The demand for independent financial advice is immense and will continue to grow over time, and we believe that few (if any) firms will go out of business. However, we also believe that the days of easy profits are over.
Only those firms that adapt their strategy and business model to the next decade’s realities will prosper. The owners of those that cannot adapt will have to work harder for less money, and their businesses will ultimately have little enterprise value.
Assumes tweener firm has $5M of revenue, $3M of gross profitability, 2% low-risk asset returns, 8% equity returns, 7% operating cost inflation, 3% client turnover, a current client base with a revenue-weighted average age of 68.8, and 10 new clients annually generating an average of $15K per client.
1. Fewer new millionaire households with more firms competing for them.
The supply of millionaire households (the core prospective clients of wealth managers) declined sharply with the 2008-2009 financial correction and, to date, has barely recovered to pre-correction levels. To be sure, at some point it is likely that economic growth will accelerate and more new wealth will be created. However, even when the supply of prospects expands, firms will find heightened competition for new clients because the number of large firms with sophisticated marketing and business development functions has increased dramatically over even the prior decade. Whereas 10 years ago a firm with $300 million was considered large, today firms managing at least $1 billion are relatively commonplace.
2. Aging client bases with higher capital consumption.
The average age of clients serviced by many wealth managers is now much older than only a decade ago. Because most new clients are in their 50s or early 60s when they hire a wealth manager, those who were recruited over the last decade are likely today in their mid- to late 60s and those from the previous decade are in their 70s.
An aging client base creates a drag on wealth manager revenues in two distinct ways. First, whether due to retirement, charitable giving or other age-related reasons, older clients often increase their gross rate of capital consumption. Second, because older clients have a reduced appetite for investment risk, a larger portion of their portfolios are allocated to lower-risk assets that generate lower nominal rates of return. The combination of higher average gross capital consumption and lower investment returns results in greater net capital consumption by clients, reducing the wealth managers’ assets under management and the corresponding fees paid by the clients.
3. Possible prolonged period of low return on lower-risk assets.
The Federal Reserve recently announced that it will continue quantitative easing until unemployment is below 6.5% or inflation exceeds 2.5%. Until then, the Fed intends to keep the yields on fixed income securities at or near their current record lows.
This new policy is very problematic for any business—such as most wealth managers—that receives fees based on a percentage of assets under management. Nearly all wealth management clients allocate a substantial portion of their portfolios to lower-risk asset classes as part of a rational diversification strategy. Because the nominal returns generated by these types of investments—shorter-term fixed-income securities, hedged investments, etc.—typically track to U.S. Treasury securities with a modest premium, wealth managers should expect returns well lower than historical averages. The impact to wealth manager revenues is direct: Slower appreciation in this part of clients’ portfolios will result in slower revenue growth.
Not surprisingly, a prolonged period of very low nominal returns on low-risk assets would compound the issues raised by aging clients (who, over time, invest larger and larger portions of their portfolios in fixed income and lower-risk assets).
4. Operating costs accelerating at a rate higher than inflation in general.
While the three factors described above will negatively impact the rates at which wealth manager revenues grow, wealth managers also will face an expense issue over the next decade: operating costs—and compensation costs in particular—will continue to rise at a faster rate than general inflation.
Nearly every wealth manager that the Fiduciary Network has studied is currently experiencing average annual cost inflation of at least 5% to 7%, largely driven by higher labor costs for qualified professional employees. A shortage of even semi-qualified professional staff (versus the demand for them) is reflected in their salaries: Typical wealth manager non-owner compensation costs are rising about 7% to 10% annually. Other costs will rise as well. An increasingly adversarial regulatory environment will raise compliance costs, newly litigious clients and former employees will bring more legal fees well in excess of past ones, and more competition will require increased marketing and business development budgets.
Source: Fiduciary Network
5. Aging Founders
Overshadowing the four previous forces is the irreversible fact that most of the founders of wealth management firms are approaching that point in their lives when they need to consider doing their own financial planning. More than a few of these founders have built up lavish lifestyles, the maintenance of which requires significant annual expenditures. But for most, their single most valuable financial asset is the equity in their businesses. Consequently, the value they ultimately receive for that equity will be a key determinant of their ability to sustain their current lifestyle in retirement.
Impact of the forces on individual firms will vary based on their current business model.
The first four forces described above will affect the economics of every wealth manager. However, the types of effects and degree of impact will vary based on the organization’s current business model.
The evolving businesses, with younger client bases, institutionalized brands and marketing efforts, diversified ownership and mature governance structures, are in the best position to adapt to, and capitalize upon, the forces. Their challenge, however, is finding a way to maintain their historically high rates of profitability growth, a precondition to attracting and retaining the experienced and talented successor professionals who are essential to their business model. Unfortunately, doing so is going to be far more challenging over the next decade than in the past.
As relatively large organizations, evolving businesses must add increasingly larger volumes of new clients each year in order to maintain revenue growth rates at a time when the supply of prospects has stagnated. Moreover, even if their business development efforts are successful, servicing ever larger volumes of new clients requires substantially increasing their cost structures. The resources required to onboard a new client are 15 to 20 times greater than the resources required to service an established client—a feature of the wealth management model that effectively caps the number of new clients any firm can add at any one time. Thus, every large industry participant faces a “growth conundrum.”
Evolving business firms have four alternatives available to them to overcome these obstacles to profitability: (i) slow the rate of cost inflation by improving operating efficiency, a goal that requires constant review and improvement of internal processes; (ii) redesign compensation systems to increase the amount of variable and equity components and more closely tie salaries to the performance of the firm; (iii) offer more specialized, higher-value-added advice targeted to specific sub-segments of individuals who will pay a premium for customized advice; and (iv) acquire other wealth managers.
The obvious management challenge for the owners of evolving business wealth managers is to determine which of these four alternatives make the most sense for their firms and when to pursue them. We expect that most will pursue a combination of all four alternatives at different points in time over the next five years.
In contrast, firms in the “tweener” category will be the most changed by the forces sweeping through the industry. While the forces place the future operating margins of all firms in peril, the potential strategies available to evolving business firms are largely impractical for tweener firms. The latter already operate at robust margins so they have far less room to improve their efficiency and cut costs. They also lack the depth and breadth of professional staff essential to specializing and/or integrating an acquisition.
Instead, the owners of tweeners will find that the strategy of the past two decades of maximizing near-term profitability at the expense of reinvestment—which for many of their owners has been extraordinarily successful in building personal wealth—soon will be unsustainable. Their only practical alternatives will be to: (i) take the messy and expensive steps necessary to convert into an evolving business, (ii) sell the firm or (iii) slowly devolve into a “BoB.”
Unfortunately, the last group of wealth managers—the 18,000 or so “Books of Business”—have few options available to them. They will be largely at the mercy of the broader forces sweeping through the industry. Their owners will work much harder and get paid much less.
Future Shape Of The Industry
Given these forces and their likely impact on the economics of individual firms, some might expect that we would forecast a wave of consolidation within the industry. However, we think that is an unlikely outcome.
The vast preponderance of the 18,000 participants that today fall in the “Books of Business” category will remain in business. However, owning a BoB will be far less pleasant than in prior decades. As noted earlier, owners will make less and they will receive very little consideration when they sell their firms.
At the other end of the continuum, a relatively small number of evolving business firms currently will capitalize on (as opposed to endure) the forces confronting the industry. Over the next five to 10 years, these firms will become much bigger enterprises, far larger than their founders might have ever imagined when they first launched more than two decades ago.
In reality, this shift is already happening as several firms in the evolving business category today generate more than $50 million of annual revenue and dozens more generate in excess of $20 million. Some of these firms (as well as others that today are much smaller), through a combination of acquisitions and organic client growth, will wind up having as much as $75 million to $150 million of annual revenue 10 years from now.
Still other firms in the evolving business category will either merge with their counterparts or become much more specialized. However, in all cases, the firms that have made the necessary reinvestments to become an evolving business will become significantly larger enterprises.
The tweener category will largely no longer exist a decade from now. Perhaps counterintuitively, we believe only a small percentage of these firms will be acquired. Only about 50 to 70 tweeners will merge with other wealth managers, 10 to 20 will be acquired by banks and perhaps another 30 to 40 will be purchased by roll-ups. In other words, only about 8% to 10% of these firms will wind up consummating some sort of transaction.
Instead, most tweeners will slowly devolve into BoBs. Their assets under management will slowly shrink while their costs continue to rise. Their profitability will begin a long, slow decline that, at some point in the next four to seven years, will accelerate suddenly. Although they will continue in business in some form, most of the enterprise value that they might possess today will disappear.
Three factors lead us to this conclusion: (i) because most of the owners of tweeners are “anchored” to the operating environment of the last 20 years, and thus are unable to fully appreciate how much and how fast their economics will change, they will have unrealistic valuation expectations or they will wait so long to sell that their firms will no longer be attractive to potential acquirers; (ii) the fact that most wealth management firm owners have no experience in mergers and acquisitions complicates negotiations that are challenging and fragile regardless of the industry; and (iii) the inherent complexity of striking an agreement among three parties—buyers, sellers and the sellers’ successor professionals—with unique (and often conflicting) interests, biases and egos, creates enormous obstacles to deal completion.
Near-term choices will determine where firms land in the brave new world of wealth management.
The ultimate shape of this industry a decade from now is one in which 150 or so extremely profitable, large firms will manage the vast preponderance of its assets and 19,000 other small and marginally profitable firms will remain in business indefinitely. The choices that owners make over the next couple of years will largely determine where their firms ultimately land in this Brave New World of wealth management.
Mark Hurley is the CEO of the Fiduciary Network, which provides passive capital to fee-only wealth management firms for business transitions. Benjamin Robins, Steven Cortez, Yvonne Kanner, Minesh Patel and Erich Bao also contributed to this article. A complimentary copy of the paper can be downloaded at
www.fiduciarynetwork.net. Hurley will discuss his findings further with FA Editor-In-Chief Evan Simonoff during a Webinar on May 8. To register or learn more, click here.