A new study finds a business of haves and have-nots.

    Six years after Undiscovered Managers issued a controversial report predicting sweeping consolidation, intensified competition and margin pressure in the registered investment advisor business, the tiny mutual fund company, now a division of its giant parent, JP Morgan Asset Management, is back with another report.
    Like the 1999 study, the new report, dubbed Back To The Future: The Continuing Evolution Of Financial Advisory Business, paints a bleak future for small advisory firms, while arguing that the larger the firm the greater its number of strategic options over the next decade. Authored by JP Morgan Managing Director Sharon Weinberg, Mark Hurley-who authored the 1999 study and is now a consultant for JP Morgan-and others at the bank, the new report is more far-reaching in its scope and identifies some new trends that have emerged in recent years. Both Weinberg and Hurley spoke to Financial Advisor in early July about the new study.
    First, let's review the 1999 study. Many thought the 1999 study implied a wave of consolidation, although Hurley says it didn't. Nevertheless, there are many signs it is finally underway.
    When client portfolios were climbing 12% to 15% a year, advisors didn't have to add a lot of new clients to achieve 20% top-line growth. That's changed dramatically, and it's restructured the economics of the business. Many financial advisory firms experienced serious margin pressure during the 2001-2004 period, but most of the pressure came from increased demand for financial advice during a bear market, not from an onslaught of new competitors.
    The new report refers to the bull market of the 1990s as a "hidden subsidy" that covered up a lot of mistakes, inefficiencies and unsound economic models at advisory businesses. While the report notes again that rival financial services concerns, from wirehouses to E*Trade to H&R Block, have entered the advice business, they have been subject to the same economic forces as independent advisors, and many of them have higher overhead and consequently suffered even more margin erosion. Hurley also says that no one is predicting that many firms will go out of business, only that they will face more challenges.
    "We're just saying that costs are going up faster than revenues," Weinberg explains. Talents like investment skills are becoming more important in a low-return environment, she adds, prompting more firms to hire chartered financial analysts or invest more in their own educations.
    Six years ago, Hurley predicted that banks' and wirehouses' entry into the business would crowd out marginal advisory firms. Today, he seems to have increased respect for independent firms' staying power, perhaps after watching them continue to gain share during the bear market. 
    The JP Morgan report cites a study from Phoenix Marketing Services, which claims that RIAs' market share of high-net-worth investors rose from 20% in 1999 to 28% in 2004, and predicts it will reach 38% in 2009. Speaking at a JP Morgan meeting for RIAs in May, Hurley commented that "your main competition will be other people in this room."
    One phenomenon the original report failed to anticipate was the way in which a labor market disruption is starting to erode advisory firms' margins. With the demand for advice continuing to climb, many players like regional and community banks looking to get into the business are deciding that the fastest way to provide advice is to poach associate planners from mid-sized firms, often for offers they can't refuse. "There is a major shortage of qualified people, and it takes three years at least to train them," Hurley says.
    He cites the case of three employees at one firm making around $80,000 per year who were offered $140,000 to move to a bank. "Owners of advisory firms will have to give up more equity and pay higher salaries," to keep good employees, he predicts.
    One sign of the changing labor market, Weinberg says, is that large firms now are willing to hire experienced advisors, pay them salaries north of $150,000 and don't expect or even want them to bring existing clients with them. "Big firms just need to handle and expand their capacity," she says.
    Capacity is a major issue with widespread ramifications. "We are not saying that small firms will go out of business," Hurley warns. "They may give great advice. Their clients aren't going anywhere, and some are willing to pay them more and refer new clients. But their problem is they already are operating at full capacity and the owner is, in effect, subsidizing the business, so it has little resources to reinvest." With the average advisor earning $99,000, many may reach the conclusion that if they give up ownership and become an employee, they can practically double their income and say goodbye to numerous headaches.
    Another way to escape from this squeeze from all sides is for advisors to "grow their way out of this dilemma," the report states. Increasing revenues could compensate for diluted equity stakes, after making employees partners, and higher costs of doing business. Unfortunately, these forces will only accelerate competition for both attractive employees and lucrative clients.
    Frequently, the quality of different practices comes down to the quality of their clients. This is one of the attributes that differentiates the "haves" from the "have nots," as the study identifies them.
During the 2000-2002 bear market, firms of all sizes were awash with new prospective clients. But the larger firms with deeper staffs proved much more adept at replacing low-quality clients with more attractive ones. Ultimately, these clients will generate higher profits, allowing the larger firms to reinvest, add capacity and continue to grow. This explains why the report predicts that the gap between elite and ordinary firms may widen.
    Independent advisors have relied primarily on referrals to generate new business while largely ignoring marketing. When it comes to marketing, the latest annual FPA/Moss Adams report notes that just 2% of the average financial planner's expenses are devoted to marketing. Yet firms with more than $1 million in revenues spend 125% more on marketing than those with $250,00 or less in revenues, which may explain the gap in client quality.


Three Alternatives
    Owners of RIA firms face three primary alternatives, according to the report. The first is to reinvest and grow the business, but this requires that firms evolve their operations to a higher level of maturity. "Most large participants are too owner-centric and lack the professional business management to facilitate large-scale growth," the report claims. "They also have a culture that would abhor the inherent bureaucratic nature this type of evolution" requires.
    The second alternative, dubbed the cash cow option, involves maximizing near-term profitability. Currently, this is the default option of choice, since it entails the fewest changes and doesn't require major reinvestment. The only problem is that it effectively "caps" the organization's future growth potential. Over time, a firm that "harvests' its profits may generate retirement funds for its owners but it also can lose its competitive edge.
    The third and final alternative facing advisors is the sale of their firm. For the vast majority of firms, those that lack significant scale, the economics of selling the firm are not enticing. Many advisors have looked at the prices being paid and concluded correctly that the "cash cow" option is preferable from a financial standpoint. The report acknowledges that selling a firm is time-consuming (deals take six to 24 months to complete), emotionally wrenching and "has the potential to alter the selling organization irrevocably regardless of whether a sale is consummated."
    The way many of these transactions are structured typically requires  advisors to stay on for years to ensure a smooth transition. Also, most deals leave the risk of a firm's potential economic shortfall on the shoulders of the seller for several years after control is transferred.
    On the bright side, the report predicts that after more strategic buyers enter the fray, multiples for top-quality firms could soar from the current level of five to six times saleable cash flow (a firm's prior 12 month's earnings before interest and taxes, after paying its owners a market-level salary) to between nine and 11 times cash flow.