Advisors who grow their firms by adding large numbers of clients to increase profitability are working against their own goals, according to Todd Doherty, head of acquisition and legacy planning for Advisor Legacy, a consulting firm for the financial industry in Troy, Mich.

Instead, firm owners should set their sights on limiting their clientele to higher-net-worth people and families if they want to be more profitable, Doherty said in a recent interview.

“It’s a bit surprising and often not well understood by firm owners, but there is no efficiency of scale that leads to more profitability. It is actually the opposite,” he said. As firms grow in size, each step up the ladder results in a higher expense ratio. The expense ratio compares the cost of operating expenses to the amount of assets under management.

Instead of looking at the size of the firm, Advisor Legacy looks at tax returns and profit and loss statements when consulting with firm owners on a growth strategy or a possible sale.

“Advisors often do not know what their real profits are,” he added. “A firm with a high a level of growth measured by the number of clients is actually less efficient than a firm that aims to increase the percentage of clients who are high-net-worth or ultra-high-net worth.”

The usual practice when a firm is increasing the number of clients across the board is to hire assistants to serve the lower-net-worth, or mass affluent, clients. That raises the expense ratio, Doherty said. The firm becomes a “larger pie, but the advisor is taking a smaller slice of that pie.”

Doherty divides clients into three groups: those with under $100,000 in assets, those with $100,000 to $500,000 and those with more than $500,000. On average, firms have 40% of their clients in the lower group when they should aim to only have 25% of clients in that category. In the average firm, the clients who make up the 40% bring in only 7% of the firm’s revenue, he said.

“Client segmentation is the most important factor in practice profitability,” he said. “A firm should have some less affluent clients who are young and growing their wealth,” so the lower income clients should not be eliminated completely. “But having more high income clients is more efficient.

“Firm owners have to change the mindset of the firm to think in terms of bringing in high-net-worth clients and being more exclusive,” Doherty advised. “They should develop a value proposition that is more attractive to high level clients. For instance, raise the minimum assets required for new clients and provide more services, such as assistance with health insurance or even buying a car.”

One medium-sized firm in Washington State that was an Advisor Legacy client improved its client segmentation to focus on higher-net-worth clients and raised the firm’s profits by $1 million in a year, Doherty said,

Having a more exclusive clientele will mean firms gets referrals to other high-net-worth people. Once you have clients with more assets, the advisors time also is worth more to the firm, Doherty explained.

The irony in the financial industry is that firm owners often do not realize their own potential profitability, probably because they are too busy being practitioners, Doherty said. “They need to switch from working in their businesses to working on their businesses.”