From the January 2007 issue of Investment Advisor • Subscribe!

January 1, 2007

Stepping Up

The new Moss Adams Study reveals how the best advisors take their firms to the next level

Ever wonder why you seem to be working harder for the same or even less money? Why your practice's revenues are up--maybe way up--but your income isn't? Why does it also seem that just when you think your firm has finally broken through to better economics and a lighter workload, things get difficult again and those healthy profits start slipping?

If you feel this way, you're definitely not alone. In fact, according to the 2006 Moss Adams Financial Performance Study of Advisory Firms, your rollercoaster ride is far more the norm for independent advisors than the exception. This year, thanks to our partnership with Investment Advisor, participation in the Study, sponsored by SEI Investments and JPMorgan Asset Management, reached record highs of over 1,000 firms, giving us the high-quality data we needed to confirm what we've long suspected: Independent advisory firms grow along a predictable path. In fact, as firms generate ever-larger revenues, they evolve through five distinct stages, each with its own challenges and opportunities--and barriers that shrink profits and boost the workload as firms struggle to break through to the next level.

Like the growth of practices, the independent advisory industry hasn't matured in a straight line. Rather, its progress has been marked by a series of highs and lows as new challenges--finding people, delivering services, determining the best form of compensation, weathering turbulent markets, staying current with client demands--are met, battled, and overcome.

Data from the 2006 Study shows that for the independent advisory industry as a whole, both assets under management and revenues are up while at the same time, owner income has remained flat. Perhaps even more troubling, firm growth is slowing. Many advisors are thus asking themselves whether they can simply grow their way out of these doldrums or if a more radical solution may be required.

Smartly Growing Toward Prosperity

Managing overhead and maximizing productivity is always a good idea. But a detailed analysis of the evolution of advisory practices shows that advisors can indeed grow their way to greater prosperity. We believe that understanding the evolution of advisory firms is the key to making decisions that will lead you to create the practice that is right for you and to find the strategies you need to substantially improve your firm's economics.

Advisory practices today are growing at rates not seen since the early 1980s. At the 119 firms that have participated consistently in our annual surveys for the past five years, average revenues nearly doubled from $777,927 in 2000 to $1,356,018 by 2005. During the same period, assets under management showed a similar 20% annual growth rate, jumping to an average of $228 million this year. Yet, while advisory firms were growing at these double-digit rates, their owners saw a negligible rise in income: In 2000, principals in these firms collected on average $253,010 in total pre-tax compensation; by 2005, that number had grown by only 8%, to $272,761.

The group of all participants in this year's Study show similar results, growing their top line by an average of 20% a year during 2004 and 2005. But as Figure 1 shows, the typical advisory firm is now experiencing slower rates of growth in clients, AUM, and revenue. Moreover, owners face greater challenges of growing their larger and more complex businesses, as well as the income their firms generate.

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The problem is that many firms added infrastructure to support their growth, driving up costs and squeezing profit margins. As a result, net "take home" to owners did not grow at the pace of revenue. Firms reporting in both our 2001 and 2006 Studies added, on average, 3.1 full-time employees to their payrolls during that period. Of those new staffers, 1.8 were professional employees, and 1.2 were technical or administrative support.

At the same time, firms also added almost two new advisors per firm. This quickly growing professional headcount largely fueled the impressive revenue growth. But between 2000 and 2005, direct expense (the cost of professional advisors) as a percent of revenue increased on average from 36% to 40%. The successful result of this investment in new professionals can be clearly seen in Figure 2: Firms who drove their gross margins down (revenue minus direct expense) by investing in professionals from 2000 to 2005 had about twice the growth in revenue (104% vs. 58%) over five years, as firms that kept their gross margins above 60%. On the surface it seems that the lower-margin firms are compromising profitability for growth. However, it's not that simple: The truth is, they are taking the same type of long-term view they encourage their clients to take by investing now to reap greater rewards later.

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Consequently, the antidote to lower profits isn't to cut back on staffing. In fact, as we'll see, the most profitable firms have more staff, not less. The real problem is poorly managed staff: Badly timed hiring, the wrong people in the wrong jobs, vague job descriptions, no career tracks, and poor motivation. To succeed in this new world of larger firms, solo practices and ensembles alike will have to find solutions for these staffing problems. The independent advisory industry has entered a new phase--one in which future success will be driven by the effective management of a firm's human capital.

The Five Models

The independent advisory industry is indeed entering a new phase: To grow assets, clients, and revenues, firms need to leverage their senior professionals with increasingly larger numbers of junior professionals and administrative staff. This leveraging presents greater opportunities for long-term growth and viability, but it also presents challenges for protecting profit margins, particularly in the short term.

With the additional data from greater participation this year, combined with historical data from previous studies, we can specifically analyze what happens as firms add people. Advisory firms exhibit five distinct organizational models as they grow along the evolutionary path. Understanding this process of evolution provides a clearer picture of the choices every firm faces to meet the challenges of growth and competition. Each stage is distinct and requires a different approach from firm owners/managers. The boundaries separating them represent key inflection points for an advisory firm: Times when hard choices about investments and organizational changes must be made to progress to the next development stage.

We see five stages of the typical evolutionary course of financial advisory practices, defined as follows:

Early Solos: Solo firms have one owner/professional. These firms are an extension of the personal skills and time of the principal. Our analysis defines any solo practice established since 1997 (approximately the median firm age for solo firms) as an early solo, which comprise 17% of our study participants. Lifestyle preference, strategic focus, or income needs of the firm owner determine whether the firm will aspire to become an ensemble or choose to remain solo.

Mature Solos: A mature solo was established prior to 1997, representing another 17% of the firms in our study. With firms that are at least ten years old, owners of mature solos have usually made a conscious lifestyle choice to remain solo. Mature solos are focused on creating businesses that allow them total control over client service and product recommendations, as well as the lifestyle they desire.

Early Ensembles: Early ensemble firms have multiple professionals in addition to administrative and support positions, with less than $2 million in annual revenue. These firms make up 52% of our survey participants. Their median age is six years younger than other ensembles. Principals of early ensembles typically aspire to grow and direct their firms to higher evolutionary stages.

Mature Ensembles: These are ensemble firms with between $2 million to $5 million in annual revenue. To advance beyond the early ensemble stage, a mature ensemble has developed a clear business strategy and defined most of the business processes and systems it needs. Having grown to a size few advisory firms achieve (10% of firms in our sample are mature ensembles), mature ensembles pursue targeted markets in a systematic fashion.

Market Dominators: Market dominators are any ensemble with greater than $5 million in annual revenue. Accounting for just 4% of our survey sample, market dominators are the elite group of advisory firms. They are sophisticated in management and service capabilities but face issues in terms of organizational structure, professional development, and retention.

Figure 3 compares snapshots of participating practices at each evolutionary stage. Notice the distinct differences between them: Mature solos handle an average 76% more clients--yet post only about 45% more revenues--than early solos; early ensembles average 40% more clients than mature solos, yet generate 120% more revenues. Mature ensembles have three times the number of people in their firms as early ensembles, generating over four times the revenue with only slightly more than double the number of clients. And market dominators average 5 1/2 times the number of clients of mature solos, yet produce more than 25 times the revenue.

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How much better off are the owners when their firms grow to the next stage? Quite a bit. As firms evolve, owners are increasingly rewarded from the benefits of scale, especially in the latest stages. The primary measure Moss Adams uses for gauging the financial success of a firm is pre-tax income per owner--the total annual compensation and profits that owners draw from their firms. As firms move up the evolutionary ladder, the income generated by owners grows dramatically.

Owners of early solo firms have a median pretax income of about $100,767 per year--equivalent to what a senior advisor might make as an employee at a larger firm (but with the independence and flexibility of being one's own boss). Owner income rises rapidly once a firm evolves beyond the early ensemble stage, with median pretax income for mature solo owners at $157,050; for early ensemble owners at $191,429; for mature ensemble owners at $429,842; and peaking for owners of market dominator firms at nearly $850,000. Clearly there are benefits to size.

There is, however, a cost associated with the higher owner incomes. The number of hours worked increases consistently as owners advance up the evolutionary ladder. While the owner of an early solo firm works an average of 46 hours per week, market dominator owners work 10% more, about 51 hours. Rather than viewed as simply a cost, however, this difference may also reflect that large-firm owners are able to earn more income on an hourly basis, and as a result, have a greater incentive to work more.

The Study isolated the top quartile firms (by owners' income) within each stage of evolution and identified their best practices that others can apply to increase their own success and prepare for the next evolutionary step, if the owners wish to do so. Top quartile firms at every evolutionary stage tend to leverage their professionals with greater non-professional support. Top quartile solos, especially early solos, tend to be even more leveraged with non-professionals than their ensemble counterparts.

Focus on: Early Solos

Our analysis defines early solos as firms with less than the 10-year median age for all solos. We recognize that some of these firms may already be committed to the solo model, while some older firms may still harbor ambitions of becoming ensembles. Overall, however, we feel the age-based distinction, while simplistic, produces a fairly accurate depiction of early solos in aggregate.

Figure 4 details the comparative staffing models of top quartile early solos versus their peers. Top quartile early solos typically consist of one professional, one administrative position, and a support/technical position. That gives them about twice the administrative and technical capacity of their peers. Top quartile early solos also gain leverage by looking to outsource or automate operational tasks wherever possible. As a result, top quartile owners of early solos spend less time on operational issues and more on business development, which pays off in the form of winning more clients that are within the firm's target market.

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There are many positive aspects as well as challenges associated with the solo model, and the relative balance of these will determine which model a solo practitioner will choose down the road. Like the decision to become a solo practitioner, the decision whether to remain a solo practitioner is based on the personal definition of success of the individual advisor. While income potential is one aspect that may be considered, other factors influencing the decision likely center on lifestyle preferences and the desired span of control. No matter which route an advisor ultimately chooses, solo practitioners overall are generating a very healthy $177,00 in average income and have complete control over their firms--which may be the only measuring stick of success and job satisfaction that they need.

Average total revenue for solo firms who anticipated transitioning to an ensemble model by the end of 2006 was $432,000. Additionally, only about one in five solo practitioners in the study were above $500,000 in revenue. These findings suggest that the typical jumping-off point to ensemble is before a firm gets to $500,000 in revenue. This is consistent with what we have observed for early ensembles: They typically have two professionals and generate $750,000 in annual revenue, or approximately $375,000 in revenue for each professional. If growth is the goal, firms should probably start looking to hire new professionals as soon as revenues break $450,000.

Focus on: Mature Solos

Mature solos are those firms formed before 1997, which is a good indication that the principal has committed to the solo model. Top quartile mature solos are succeeding relative to their peers in much the same way that top quartile early solos succeed: with higher non-professional support ratios. Top quartile mature solos typically have one support/technical position, compared to their peers who most often have none. They are also less likely to manually perform operational functions. This translates directly into handling more clients: Top quartile mature solos serve almost twice as many clients as their peers, 174 versus 93.

Another point of distinction at top quartile mature solos is their referral tactics for business development. Top quartile firms are more proactive in seeking referrals (77% vs. 54%) and have a greater tendency to form referrals relationships with other professionals (51% vs. 42%). Top quartile mature solos are more reliant on referrals as a result.

True to the adage, in advisory firms, time is indeed money. Whether the goals of a solo practitioner tilt toward income or quality of life, the key to their success is the efficient use of time: Their capacity is driven by the number of hours the practitioner is able to work and the number of clients they can service.

There are many functions to perform at an advisory firm regardless of the organizational structure--from compliance to relationship management. As the only person developing business and delivering advice, solo practitioners must find the balance between generating revenue, delivering advice, managing their businesses, and living in the manner they desire. To get the most from their time, key lessons for mature solo practitioners include:

Do the things only you can do. Activities that do not generate revenue should be off-loaded or outsourced. Solos with support had higher overhead than unsupported solos, and the investment seems to be paying off--they are taking home $197,822 compared to $142,431 for unsupported solos.

Think strategically. Without a strategy, a firm will make poor decisions about which clients it works with, what services it delivers, and how people and resources are organized. By establishing a target client, a firm can increase productivity and profitability, and likely increase client satisfaction at the same time.

Be consistent. As for most practices, the largest source of new clients for solos is referrals (68.5%), and the largest source of referrals is from existing clients (67.5% of referrals). Consistency is the key to the client referral cycle--clients refer friends and associates, who in turn refer more potential clients. The likelihood that clients will refer someone is closely linked to consistently meeting clients' expectations. Additionally, consistently accepting only targeted clients increased the quality of referrals: Target clients will tend to refer target prospects.

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Focus on: Early Ensembles

To get from solo to early ensemble, firms typically expand to two or three professionals and add their first support/technical position to compliment an existing administrative person. Median total staff for top quartile early ensemble firms is 6.0 compared to 4.2 for others--the difference is typically an additional technical or support position. Like top-quartile solos, owners of top early ensembles spend less time on operations than do their lower-performing peers, allowing a great focus on client service.

While the price is high and productivity may initially decline with an increase in professional staff, failure to recruit or develop professionals will allow a practice to stagnate. This is particularly true in the case of early ensembles. With limited resources to fund a new position and limited experience hiring and orienting new professionals, there is great temptation for these firms to preserve the status quo.

And indeed, nearly half of all firms participating in our survey in 2001 and 2006 did not add a new professional (didn't hire or possibly hired and lost a professional) during the last six years. The effects of the reluctance or inability to hire new people were dramatic--slow growth in revenue (4.5% a year) and a declining income per owner: from $220,000 to $210,000. That is not to say that these are practices that are not enjoying some degree of success--$200,000 in income is still likely a comfortable outcome for many. What's lost is the opportunity cost of future potential that could have been captured.

Focus on: Mature Ensembles

In our study, mature ensembles averaged $2.7 million in revenue, with 332 clients, and owner income of $430,000--but top-quartile firm owners raked in average income of $1 million.

By the time a firm reaches mature ensemble status, total firm personnel averages 15. While most firms are about the same in terms of staffing size, staff composition varies: Top-quartile firms employ an average of one fewer professional, resulting in more support per professional and greater professional leverage. In addition to lower overhead costs, having one fewer professional also enables top quartile firms to benefit from a noticeably smaller share of their revenues going toward direct expenses--an average 38.2% for top quartiles versus 42.8% for others.

Dedicated professional managers, which are prevalent among market dominators, begin to appear noticeably in mature ensembles, as shown in Figure 6.

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To sustain growth, firms eventually need to add someone dedicated to spending the increasing amount of time necessary to manage the firm. The most common management positions are chief executive officer (CEO) and chief operating officer (COO). Despite the different titles, both of these positions are created to provide a leader for the operations of the firm and to free up the time of the professional staff, most typically the owners, to service clients.

We believe the optimal time to add professional management is when a firm exceeds $2 million in revenue. At that size the support and administrative department, with five or more employees, become too big and complex to be managed part-time by the principals. In general, we consider five to seven reporting relationships to be the capacity of a manager. With five people in operations, and other management needs relating to advisors or firm finances, management becomes a full-time job.

Another benchmark for hiring a dedicated manager is through a simple break-even analysis. Based on a typical workweek of 50 hours, and assuming four weeks of vacation, professional-owners are working about 2,400 hours per year. With professionals in the study generating $270,000 in revenue per year and approximately 35% of their time spent delivering services, their estimated hourly rate is just under $325. From there a firm can quantify the hours the professional-owner will need to shift from management to client service for the hiring of a dedicated manager to make financial sense. A COO who costs a firm $200,000 in compensation must free up 615 hours of collective professional-owner time ($200,000/$325 per hour) for the firm to break even on its investment.

Focus on: Market Dominators

Market dominators represent a standard of excellence in their own right. Median income per owner for market dominators, at $843,000, is nearly five times higher than that of all respondents. As the name suggests, market dominators excel by dominating their local markets based on the overall size of the practice, and aided by wealthier clients. The median AUM of $2 million per client for market dominators is nearly four times greater than the median for all firms.

Market dominators have business development tactics that extend far beyond passive reliance on client referrals. Compared to survey participants on the whole, market dominators:

  • Are 60% more likely to have annual sales goals.
  • Are twice as likely to use business development specialists.
  • Are 30% more likely to proactively seek referrals.
  • Secure one-third more clients through professional referrals.
  • Are 30% more likely to maintain referral relationships with professionals and three times more likely to have formal agreements with professionals.
  • Get 75% more of their clients through external business development efforts of firm non-owner professionals.

One final observation on market dominator business development is the age range of the typical targeted client. While the majority of other firms focus on clients in the 55-to-65-year range, market dominators tend to target clients aged 45 to 55. Compared to their peers, market dominators are just as likely to serve older clients, but by marketing to younger clients, they are truly multigenerational, seeding their client bases for constant renewal as existing clients age.

The $5 million annual revenue size of market dominators also gives them an advantage in terms of career development opportunities. Market dominators employ the greatest share of non-owner professionals relative to owners--the only level at which total non-owner professional compensation is more than total owner compensation. The responsibilities of these non-owners can be significant. For example, non-owners account for 40% of all new clients won through external business development.

More so than other firms, market dominators have a stable of staff to draw from for promotion as owners near retirement. Caring for this succeeding generation represents a great challenge for market dominators. They must set clear criteria for admitting new owners that are not so restrictive that young talent is discouraged and becomes vulnerable to defection.

The Importance of Expanding Ownership

Expanding firm ownership is not only a challenge for firms that have reached the final evolutionary stage: It is perhaps the final stage in the overall evolution of the independent advisory industry. Today the industry has an aging group of principals who still carry the burden in the majority of practices. A typical advisory firm has two owners who are 50 years old. The principal with the largest percentage of ownership averages 55 years of age--by no means pressed to retire, but approaching the average age of retirement.

There is a misunderstanding that new owners are only needed as a succession solution. In fact, new owners may also mean longevity and leverage for the firm. Expanding ownership keeps firms vital. While principals may have a desire to remain involved in a practice after the age of 65, this approach may lead to a firm with eroding profitability and deteriorating cost structure. Principals should be very careful to define their roles in the practice if they desire to reduce their workload but continue to be part of the business. The Study found that in practices where the majority owner is over 65 years of age, growth slowed and profitability declined over the last five years as a result of growing professional cost (the combination of younger professionals hired as successors and the aging principal) and high overhead.

There is another economic argument for ownership expansion: Average total compensation per non-owner professional in the larger firms is now exceeding $200,000. At such levels of compensation, it may be desirable for a firm to directly link income of these professionals to the actual profits of the firm rather than risk fixing a very substantial amount of professional compensation on each highly prized non-owner. For some firms, non-owner compensation is now exceeding the compensation package for the minority owners, creating the issue of professionals not interested in becoming owners. To succeed, more than anything else, large and small advisory firms need owners to shoulder the risk of being in business, the burden of management, and make the investment to continue traveling up the evolutionary path.


Bob Clark is Editor-at-Large for Investment Advisor, and a former editor-in-chief of the magazine. He can be reached at rclark70000@aol.com. Philip Palaveev is a senior manager who leads the market research for Moss Adams Financial Serivces Practices and consults with broker/dealers and RIAs on strategy, business planning, and compensation. He can be reached at Philip.Palaveev@mossadams.com. All data is from the 2006 Moss Adams Financial Performance Study of Advisory Firms, sponsored by JPMorgan Asset Management and SEI Advisor Network. Seattle: Moss Adams LLP, 2006.

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