From the December 2005 issue of Investment Advisor • Subscribe!

Why Bigger is Better

The 2005 FPA Compensation and Staffing Study offers the best preview yet of the advisory practice of the future

What will the financial advisory practice of the future look like? No, we're not talking about George Jetson flying to work, and once there, finding all his tasks fully automated. Instead, we're asking how advisory firms will be different five or 10 years from now. Because if you can see the trends developing, and understand why things are moving in that direction, we think you'll have a much better chance of building tomorrow's firm, and reaping tomorrow's benefits, today.

Like any good futuristic model, ours is firmly rooted in the present, and in the past. For five years now, Moss Adams has been working with SEI and the Financial Planning Association to study trends in the development of independent advisory businesses. This year's publication, The 2005 FPA Compensation and Staffing Study, provides the most dramatic picture yet of how the independent advisory world is changing, and what the practices of the future are likely to look like. It's a view that quite possibly will change the way you think about your firm and the business of delivering advice.

The most striking nugget from our data is that in 2004, the advisory business was up--way up. In our 2001 Study, the typical firm had 1.5 employees, including the owner. Today, the average firm surveyed has 4.5 employees and generates over $1 million in annual revenues. That's a revenue increase of 25% over 2003, and it was accompanied by an average of 21 more clients and an additional $30 million in assets under management. On those revenues, the average advisor's total compensation increased 12%, to $133,000. What's more, not only are most firms growing like Tiger Woods's endorsement contracts, there are a lot more firms generating in excess of $2 million a year, finally providing solid data on how and why these larger firms operate with almost irresistible efficiency and productivity--powerfully suggesting that they are, indeed, the future of independent advice.

Consider that the top 14% of firms surveyed (the elite ensembles) average $3.5 million in annual revenues, compared to $1 million for other ensembles. And that these leading firms post profit margins of 21.5%, vs. 11.1% for the rest. Of course, top firms naturally generate more revenue: that's what makes them top firms. But it's the far better profit margins (double the percentage points of profit on far greater revenues) that makes these firms compelling case studies. What's more, $1 million in annual revenues may be the point where a firm's operating margins start to improve (see Breaking the Barrier, IA November 2004), but a quick look at Owner Compensation as Percent of Revenue (see chart below) shows the real Holy Grail: at $5 million in revenues, owners' compensation as a percentage of those revenues finally rebounds, and in a big way--back up to 24.5% from a low of 16% at $2 million to $3 million. The message is hard to miss: principals in bigger firms make more money.

Sure, we hear you say, that's all good for them, but the real questions are how did those large firms get that way, and can other firms use the same strategies to achieve similar success? We're glad you asked. Our 2005 Study shows that successful advisory firms are making dramatic long-term changes that fuel their explosive growth. These strategies fall into three general categories: 1) Redefining the roles of their owners, that is, gaining broader expertise by allowing owners' to focus on specialties rather than overlap as generalists; 2) Adding non-owner professional help in unprecedented numbers; and 3) supercharging their recruiting efforts to find and retain those professionals.

Redefining Owners' Roles

Common wisdom tells us that as firms get larger (that is, add more clients and generate more revenues), they add more professionals. That makes sense, because comprehensive financial advise is what business consultants call "labor intensive:" the more revenues you generate, the more people it takes to do it. And somewhere in that thought is the hazy notion that if you have more professionals, sooner or later, you're going to have to let some of them become owners. This year's data takes that vague career track a quantum leap further--it reveals a surprising relationship between the size of advisory practices and the number of owners (or principals) it has. As the second chart below (Number of Principals by Revenue Size) shows, other professionals and support staff notwithstanding, advisory practices generate a remarkably steady $1 million in revenues for every owner.

Why would this be the case? We think it boils down to span of management control. Only 17% of the owners of the firms we polled said they didn't have any management responsibility. It seems that while an advisor can leverage herself with more staff and more professionals, there is a limit to how many people one owner can supervise and still advise some clients. To grow beyond that point, a firm needs to add owners to share the management burden. In fact, we are starting to see some patterns that suggest that a firm should expect to add another owner for every five professionals. Once those owners are added, the firm can even further increase its leverage--and revenues.

One way this works is that multiple owners are able to diversify their roles to cover all the bases of firm management--strategic planning, business development, compliance, staff management, rain-making, etc.--and still have time to work with clients. This is particularly important as even owners who assume the role of CEO (usually given to the largest shareholder) on average continue to also manage 109 client relationships--more than most other principals. In fact, as the third chart (Number of Functions Performed) on the bottom right demonstrates, larger firms with more owners allow those principals to greatly reduce the number of functions for which they have responsibility. We've identified 17 tasks that professionals in ensemble firms perform, such as new business development, delivering advice to clients in a primary advisor role, preparing financial plans, setting up and maintaining client accounts, and so forth. Firms generating at least $3 million in revenue with an average of three principals reduce those tasks to just over eight for the CEO down to under four for owner/managers.

To manage this growing number of owners, we see leading firms formalizing compensation to drive the behavior of their principals and focus the internal economics of the firm. The first principle of owner compensation in a small business is to separate the rewards an owner receives for his or her ownership from that received as an advisor, manager, compliance officer, or other employee function. Not only does a clear distinction between the two forms of compensation enable a firm to determine its true profitability (and other operating margins), it also allows each partner to be fairly compensated for the role they play in firm operations and in generating revenues. The distinction may seem subtle at first, but with an average of 23% of firm revenues (not counting ownership distributions) going to owner compensation, the impact of properly allocating those costs can be huge.

The return on equity that owners receive for their investment in the firm can vary widely with the profitability of that firm, but compensation for the specific jobs owners also performed inside the firm should be calculated at the going rate for those tasks. It's true that principals in most advisory firms wear multiple hats, and sorting out who does what can be a little complicated. But that sorting-out process itself can reveal inefficiencies in how a firm works and major discrepancies in overworked and under-worked owners. That's why we see a clear distinction between owners' comp and ownership distributions as a key step in the maturation of advisory businesses.

To some advisors, such complications in compensation and organization may seem unnecessary after a decade or more working closely with their partners. There are many firms where the initial arrangement of splitting everything equally and everyone jumping in to help works very well. But consider the impact of the first "stranger" you invite to the ownership table--a person with whom you don't share the long history, who may have different motivations, may be from a different generation, and who, surprisingly, may not think that they can fully rely on the "trust me" system. Owners fully recognize the impact of the first new owner and we believe the fear of the "stranger at the table" is delaying the admission of a whole new generation of principals. The firm of the future will have to deal with that fear today. Remember how and why you started your firm. Chances are you did it because some other organization would not let you take control and ownership of the practice you created. Is it possible that someone in your firm may be feeling the same way?

The Emergence of the Employee Advisor

Perhaps the most important statistic to come out of our 2005 Study is that for the first time, the number of non-owner professionals in independent advisory firms exceeds the total number of firm owners. Put another way, there are more non-owner advisors than there are owner advisors. Sometime during 2004, the advisory business reach a watershed moment: the transition from a profession of predominantly sole proprietors to one of ensemble firms.

As the top chart on the right shows, in firms with under $1 million in revenues, 60% of the advisors are owners; but in practices with revenues from $1 million to $3 million, only 45% of the professionals are owners. In firms with revenues of more than $3 million, only 33% are owners--which means two-thirds of the advisors in the largest firms are employees. The business of ensemble firms is quickly morphing from one of coordinating groups of principals to one of managing teams of non-owner advisors.

The impact of this dramatic shift can be seen in the Median Staffing chart at right. Notice that somewhere around $3 million in revenues, the number of non-owner professionals exceeds the number of principals, and then doubles the number of owners in larger firms. In fact, in today's large firms, the ranks of non-owner advisors comprise one-third of the total staff including owners, and it's fair to say that the success of these firms depends in no small part on them.

Non-owner professionals in advisory firms fall into three categories: support advisors, who write financial plans or track investment portfolios but have little client interaction and no responsibility for recommendations or advice; service advisors, who deliver advice and work with clients but are supervised by principals or lead advisors; and lead advisors, who have ultimate responsibility for all client deliverables and service decisions with no supervision, and who may or may not be principals in the firm. It is the advisors in this last category--the non-owner lead advisors--who comprise the most intriguing trend is this year's Study.

For years, we and other consultants to the advisory community have extolled the advantages of leveraging owner/advisors through hiring support and service advisors to perform more menial professional tasks, thus freeing principals to focus on high-level, revenue-generating client service and marketing. It seems the industry has done us one better, creating a class of non-owner professionals who need little or no supervision or management and therefore can greatly increase the leverage of the firm's owners.

It's not clear how this trend emerged, but it's reasonable to speculate that it happened largely by accident: As more and more owner/advisors have been leveraging themselves with support advisors, and the average number of clients has been climbing steeply, we suspect that out of necessity, those support advisors have assumed bigger roles with the clients they advise. Then one day, they and their principals realized they were handling all the needs of those clients without supervision and with little management.

The impact of non-owner lead advisors on a firm's economics is nothing short of dramatic. The median lead advisor handles 65 clients who generate about $370,000 in revenue. Combined with a median total compensation of $92,200 and little supervision and management by the owner(s), a good chunk of that revenue goes straight to the bottom line. The addition of two or three folks like that can make an impressive impact on a firm's profitability without much additional effort on the part of the principals.

Our study shows that the most successful firms have already figured this out. In the top 25% of ensemble firms, non-owner lead advisors typically handle not 65, but 123 clients, who generate some $579,000 in revenues. For those Herculean efforts that generate 56% more revenues than their average colleagues, they are paid an average of $225,400. That comp package (see chart below, Lead Advisors, Components of Total Compensation) represents a bigger portion of the revenues they generate--39% compared to 25% for the average lead advisor. But the best firms know they are well worth it: these lead advisors generate an additional $220,000 in revenue. Good lead advisors are worth their proverbial weight in gold. So how and where can you find these lead advisors?

Supercharged Recruiting

Therein lies the fly in this gilded ointment: To gain the knowledge that will boost your bottom line (our data shows that with $5,683 per client, non-owner lead advisors generate significantly more revenue than even the $4,519 by owner lead advisors), the average non-owner lead advisor has 15 years of industry experience. That doesn't mean you can't find one or two, but it does mean that as more firms grasp the implications of these economics, there will be more competition for the good ones, who will become more difficult to attract. Again, firms that can promise--and deliver--a career track leading to ownership will have an advantage in recruiting and retaining such advisors.

Today's increasing competition to hire professionals can be seen in the top chart at right. Notice that the portion of firms anticipating new hires in support or administrative staff remain essentially unchanged since 2003 at about 31% and 22%, respectively. But in 2005, fully 46% of all firms were expecting to hire professionals, up from only 28% in 2003, or 64% more demand in just the last two years. This rising demand is even more striking when broken down by firm size: 61% of practices generating between $1 million and $3 million in revenues and a whopping 79% of firms with more than $3 million in revenue are looking to hire more professionals.

This competition is also seen in increasing professional compensation across the board. In 2000, the average total comp for an advisor was $79,000; by 2002 it was $119,000; and in 2004, it was $133,000. That's a 12% increase in the last two years and a 68% jump in four years. In part, this can be attributed to non-owner advisors taking on more complicated work and greater responsibility. But now that the workload adjustment has been made, look for professional compensation to keep rising as more firms clamor for a limited stable of talent.

To attract and retain these high-priced lead advisors while managing their cash outflows, top firms are using three strategies: promoting an attractive balance between work and personal life; variable compensation; and equity in the firm. A look at the Factors in Firm Retention table on the previous page shows that firms retaining more than 90% of their professionals in any given year ranked highest in all three strategies.

The two Types of Incentive pie charts on the previous page show this trend clearly: in 2000, 47% of incentive compensation for lead advisors came from discretionary bonuses, with only 34% from incentive compensation. By 2004, the use of discretionary bonuses fell to 21%, while firms using incentives jumped to 51%. Incentive comp plans that are tied to measurable expectations not only allow total compensation expenditures to rise and fall with the success of the firm, they clearly communicate to employees which activities the firm values most highly, enabling them to maximize their contributions.

Finally, there's ownership. While it's true that firms with the highest retention also offer ownership most often, the average is still only 15% of firms surveyed. We believe that the industry will become increasingly creative in offering ownership or ownership-like packages to lead advisors. Often a firm's majority or sole owner is very willing to share in the financial success of the firm, but more reluctant to give up ownership control. Adding junior partners has historically been the solution, but to maintain voting control, the principal has to restrict either the number of partners the firm can add or the size of their holdings. To get around this issue, some firms have added limited partners, who share in profitability without management or voting control. To date, only about 5% of firms have used this solution (see Non-Traditional Ownership chart above).

A more popular strategy has been the addition of income partners, now used by 18% of planning firms. Income owners have a financial incentive in the form of a stake in the profitability of a firm without control over decision-making or any claim to the equity of the firm. While adding income partners seems to be a trend, firms should be careful not to dilute the value of their equity by giving up some of the benefits of ownership without the risk or responsibility that comes with ownership.

For the majority of firms, current owners are going to have to decide whether they want the benefits of a larger firm--higher income, increased specialization, shared management responsibilities, a more balanced lifestyle, and so forth. If the answer is yes, then they'll have to resign themselves to having a smaller piece of a much larger pie.

This won't be an easy decision. Control of their working environment and how their clients are serviced is one of the primary reasons many independent advisors became independent in the first place. Giving up that level of total control to a committee of partners that decides everything from owners' compensation to what technology the firm will buy is too much for some entrepreneurial advisors.

But the trends are clear: the economics of growth through additional partners and lead advisors is hard to avoid. With greater leverage and productivity, larger firms can offer attractive packages to their owners and non-owner advisors. Along with better economics come increased services and higher-quality client care: something all advisors strive for.

In the future, will all advisory practices be large ensembles? Of course not. But consider this: There are over 200,000 CPA firms in the U.S., but only 500 of those have revenue over $1 million. Many services and markets have become the exclusive territory of the larger firms where solo practices are simply not players (e.g., all audit services). This does not mean that solo CPA practices are not rewarding their owners. After all, the average CPA partner in these firms had $95,000 in total personal income (salary, draw, profit, everything). For comparison, however, the average salary for a manager (two levels below partner) in a Big 4 accounting firm is $120,000. Similar numbers can be found for law firms. Why would the advisory industry be any different?

Money is not everything, but the handwriting is on the wall: The majority of independent advisors today work in ensemble firms. Tomorrow, the majority of independent firms will be ensembles. Before long and at least financially, the most viable, lucrative choice for many advisors may prove to be as an owner of an ensemble firm, or to work for one.

Bob Clark, a former editor-in-chief of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at Philip Palaveev is a senior manager at Moss Adams LLP in charge of advisor market research. E-mail him at philip.palaveev@mossadams.com.

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