With such a subsidy mechanism, advisory firms did not have to worry about things such as cost controls or acquiring new clients. Revenues went up simply by retaining existing clients.
The world has changed considerably over the last three years. The same markets that effectively subsidized inefficient advisory business practices for more than a decade are now causing severe margin compression in many firms. According to Cerulli Associates, the industry's assets have declined by 17% since their peak in 2000. But a more critical problem for advisory firms is that operating margins fell by almost 33% from 1999 to 2001, according to the most recent FPA/Moss Adams study.
And 2002 has only been worse. With the S&P 500 already down more than 25% year-to-date, further reducing advisory revenues, many firms are facing a crisis. Their revenues have declined precipitously, but their costs have remained fixed. As a result, owner compensation is only a fraction of what it used to be.
Many firms, in particular those with strong reputations within their communities, have been able to offset this margin compression by seeking scale. They have replaced their lost revenues by recruiting new clients. The correction in the markets has increased the near-term demand for financial advice and these organizations have benefited. Many now have the same level of revenues but are earning less per client.
In the future, however, advisory firms will face margin compression that will not be so easily remedied. At the point that industry supply and demand eventually meet, advisors will face margin compression from a variety of factors. It will also be much harder-and much more expensive-to replace lost profitability by simply adding clients. Firms will either forego more revenue to referral fees or have to invest in marketing forces in order to attract new clients. And in a more competitive environment, they will be successful less often in winning mandates.
Even at current growth rates, many advisory firms will soon face capacity problems. Most advisory businesses are not structured to handle large volumes of clients, and a program of hyper-client growth is not sustainable. These organizations will have to get much more efficient and recruit additional personnel. In other words, they will need to get a lot bigger if they are going to sustain their profitability.
Conclusion
It is too early to determine if our prognostications are true. Our forecast looked forward a decade, and 2009 is still a long way off.
The events of the last three years, however, have only reinforced our belief that the advisory business is in the process of a major evolution. Competition is clearly increasing and will soon force a vigorous rationalization of the industry. That rationalization will be accelerated by technology and the removal of revenue subsidies generated by a bubble in the equity markets.
Unfortunately, many advisory firms have been lulled into complacency by the ease at which they have been able to withstand the margin compression caused by the drop in the equity markets. They believe that in the future, there will be an inexhaustible supply of potential clients that they can capture at little or no cost to replace lost profitability. Should we publish a similar update to our paper three to four years hence, we expect that these firms will have been rudely shaken by the reality of a much more competitive environment.