Things were pretty good for the profession in 2006, but will advisors be hearing the hoofbeats soon?
The end of the advisory industry as we know it has been rescheduled
several times already, and at this point it seems that margin
compression, fee pressure, shortage of clients and industry
consolidation-the four "horsemen" of the advisor apocalypse-are missing
their deadlines again. Last year was very successful for advisory firms
in terms of growth, owner income, new clients and retention of existing
clients. Moss Adams found record-high levels of owner income and
continued prosperity in our annual study of financial performance for
advisory firms published at the end of 2006
Success, however, is a very relative measure, and as a consultant I feel I need to pitch in a few definitions. There is common confusion about what should be an obvious fact-that financial success for a business owner is ultimately measured in dollar terms, not percentage terms. That's where the first "horseman" got delayed. Margin compression may or may not occur; the question is, will lower margins lead to lower income for the owners of advisory firms? In other words, it is always better to earn a 20% profit margin on a $1 million revenue practice (profit of $200,000) than to have a 30% profit margin on a $500,000 practice (profit of $150,000). While margin percentages are helpful for benchmarking and observing trends, the only percentage that really means something is ROI.
Within certain parameters, declining margins are a normal by-product of growth in a service organization, especially if we are looking at a relatively small firm-those who still rely primarily on a small group of founding partners. Very often, this normal growth process for any service organization can get misinterpreted as a sign of impending profitability problems.
We collect a tremendous amount of financial data in our annual survey of the financial advisory industry, and my colleagues and I spend a lot of time pondering the financial performance of firms of various sizes and stages of growth. The 35% to even 50% "profitability" numbers that small practices often record are generally not realistic for large organizations.
The fact that smaller firms do not have a structure or process for defining fair compensation to the owners is one reason their large margins are deceptive. Small firms usually have one or two owners who do not record compensation for themselves (only collecting income after expenses). Obviously, any business would be very profitable if you didn't have to pay the workers. That's just accounting and management misbehavior.
The more interesting reason that large organizations can't see the profitability percentages that so many find impressive is that as firms grow, there is a natural tendency for productivity to actually decline. This process may be surprising to many advisors. The first two or three "employees" of any practice tend to be exceptional-after all, they are the owners. They spend long hours in the office, they are exceptionally motivated (they own it), they are very experienced (12 years or more on average), they know the clients really well (they brought them into the firm). Therefore, they are extremely productive.
It is difficult for the next wave of employees to match the productivity of the founders. First of all, they are not owners; second, they are not as experienced; third, they are not as knowledgeable and won't be for some time. Nonetheless, the second wave of people tends to be pretty extraordinary, too-especially those who stay more than three years with the business. After all, to choose to work for a small practice you have to be quite entrepreneurial, have a lot of initiative and learn fast. Thus, the second wave tends to be quite productive as well, although the firm-wide averages start going down.
The third wave of people usually is different. They are more likely to be treating the firm as mere employment, more likely to be nine-to-five employees, more conservative with their careers and less experienced. I realize that this is somewhat stereotypical, but the process of averages tends to be pretty evident in both the numbers that firms produce financially as well as our experience as consultants. Notice how the professional productivity numbers dip on Figure 1 before they go back up again.
In a letter to Abigail, John Adams once said something to this effect, and I paraphrase, "I study war so that my sons have the freedom to study commerce in order to give their sons the right to study art." A similar process occurs in advisory firms. The founders are entrepreneurs so that the second wave of advisors can be managers and the third wave can be employees. Unfortunately in the evolution of organizations, the "poets" are followed by the bureaucrats.
One of the discoveries we made in our study that I found particularly interesting was how professional expense (measured by direct expense, compensation to professionals who develop business and deliver advice) grew by 94% between 2000 and 2005 for firms who participated in our survey, while professional productivity (measured by revenue per advisor) actually declined by 6%. So advisory firms are hiring more people, paying them more, and seeing less productivity on an individual basis.
Is that a problem? It could be, but I believe that it is explained by growth and by the involvement of junior people in the business. At the end of the day, the typical advisor in a large firm (more than $5 million in revenue) generated close to $1 million in personal income, even if their margins were lower than those of the smaller firms (those with revenue of less than $1 million).
The second horseman-fee compression-didn't keep his appointment either. His cousin, however, did. Our survey does not offer much evidence that in absolute terms, the average fees on a $1 million account changed much between 2001 and 2005, at least not for independent advisors. I have seen some data suggesting that there is in fact intense price competition in the institutional and quasi-institutional (smaller endowments, foundations, large family wealth) markets. While the fee stayed the same for a $1 million account in an independent firm, the number of services provided by advisors for the same fee increased.
The nature of advisory services, as separate from investment management, and the definition of terms such as "investment advice," "wealth management," and "financial planning" are beginning to be better understood by clients. With better understanding comes the increase in expectations. The novelty effect of fee-based pricing as a differentiating factor has gone down substantially. While in 2000 it was very common for independent advisors to lead with the fact that they are fee-based, today this pricing has become an expectation and is offered practically by all types of firms and advisors. As a result, other points of differentiation had to be found, including increasing the level of service.
The third horseman-shortage of clients-must have been delayed in Denver
due to weather conditions. Firms were very successful in growing.
However, the business development responsibility remains largely with
the founding principals, and that is very alarming. That horseman is
not here yet, but we can see the appointment on the calendar. Growth in
advisory firms is coming from a number of sources (see Figure 3).
However, the actual function of business development is not well defined in a lot of businesses, and accountability stops with the original principals. One day, if they retire, this will be a big problem.
Finally, consolidation didn't quite happen. One of our research reports last year was on mergers and acquisitions in the industry. The report, Real Deals: Definitive Information on Mergers and Acquisitions for Advisors, commissioned by Pershing Advisor Solutions LLC found that there were less than 300 transactions among firms with more than $1 million in revenue, compared to a total of 14,000 RIA firms alone and another 35,000 firms affiliated with broker-dealers. Most advisors are still not selling, and the consolidation, at least for now, is not significant.
That said, many of the largest firms in the industry (those with more than $5 million in revenue) now have a corporate parent; they are owned by either a CPA, a bank or a trust. It is too early to speak of consolidation; however, the potential is there, and the process is underway. In fact, the report concluded that many advisors would rather be acquirers than sellers.
So the four horsemen did not arrive, and the financials look great. Still, one trend I believe will shape the future of the industry more than anything else, and that is the future development of human capital. Firms in the industry that can consistently develop and retain high-quality professionals will have a bright future regardless of what happens with fees, demographics, or consolidation. That's why I am looking forward with great anticipation to the results of the 2007 Moss Adams Compensation Study of Advisory Firms, the survey launching this month. This study will allow us to further examine the business development function and understand what firms are doing to perpetuate this skill and responsibility in their organizations. It will also allow us to determine how advisors are building leverage in their teams to create businesses beyond the time of the original founders. Finally, it will allow us to delve into how advisors are relating the compensation they pay (their investment) to the performance they seek (their return on investment). Those who align pay and outcome appropriately may be able to send the horses out to final pasture by building their business around the one resource that can truly differentiate an advisory firm-its people.
Rebecca Pomering is a principal in Moss Adams LLP and consults with financial advisory practices on matters related to strategy, compensation, organizational design and financial management. She is co-author with Mark Tibergien of Practice Made Perfect.