From the October 2008 issue of Investment Advisor • Subscribe!

October 1, 2008

The Architects

The best firms focus their business planning on the here and now, which makes their futures much brighter, according to the most authoritative Study on the advisory business.

By just about any measure this is a very good time to be an independent advisor. Ironically, however, the latest Moss Adams Study of the profession finds that the success of independent advisory firms contains within itself the seeds of what is one of the greatest challenges faced by the principals of those firms since the profession was founded.

After all, the typical advisory firm owner has built a successful business that has increased many times in value since its founding. Those businesses have demonstrated strong growth in recent years and the prospects for continued growth remain solid. So what's the big problem? What constitutes this greatest of challenges, even and especially for those firms that are already highly successful? It comes down to this finding: Many firm owners find themselves holding concentrated positions in a valuable asset with no clear option for unwinding these positions and passing on ownership to a new generation of firm leaders.

In this exclusive article based on the 2008 Moss Adams Financial Performance Study of Advisory Firms, we review the industry's record of success, but we also outline those salient ownership issues in detail and prescribe solutions to the ownership challenge inspired by real-world strategies of the best firms that are building transferable value and thereby creating succession options for the founding owners. Moreover, those successful firms' best practices when it comes to succession also benefit the next generation of advisor owners, and most important, those firms' clients. This year's study, sponsored by Genworth Financial Wealth Management, draws from financial and operating performance data submitted by more than 700 independent advisory firms. The report marks the 14th industry review completed by Moss Adams since publishing its first study in 1992.

The Metrics of Good Times

By every measure, advisory firms experienced healthy business expansion in 2007. The typical firm grew its client base by 9%. Growth in assets under management (AUM) doubled client growth, at 18%, fueled not simply by new clients but by gaining a greater wallet share from existing clients in addition to market appreciation (remember that phenomenon?). Revenue growth topped all measures, jumping 22% during 2007, following an 18% increase reported by these same firms in 2006.

Facing a head wind brought about by slowing equity markets in the latter part of the year, firms continued to increase revenues and owners continued to draw higher levels of income from their firms. Income, as measured by pre-tax income per owner, has climbed steadily among our survey participants since 2001. Last year was no exception. In 2007, the typical firm owner earned $259,500 in total income (job compensation plus returns from ownership). This figure was more than double the pre-tax income per owner for survey participants reported just four years ago.

New clients, new assets from existing clients, and improved retention all helped offset whatever effects market depreciation may have had in 2007. The difference between equity market growth and advisor AUM widened considerably in 2007 and is expected to continue widening in 2008. Chart 1 demonstrates the dynamics of asset growth for the industry, which specifically measures the small contribution of market performance relative to the very impressive gains from simply handling more assets from more clients. Relative to past years, assets lost from distributions and lost clients are declining as well. Not only are more clients forming relationships with independent advisors, but these relationships are increasingly sticky.

More important, as advisory firms continue to grow their client base and manage more client assets, they are also increasing the revenue generated from them. The trends are impressive and provide insight into the continued rise in owner income. Not only were firms able to add clients at impressive growth rates, the growth in assets was even higher and revenue growth higher still. This suggests that advisors continue to serve a bigger market and are improving their productivity in doing so.

Despite a threatening bear market for equities, advisors expect 2008 to be another year of healthy growth. At the time of our survey fielding, during the early months of 2008, firms anticipated client numbers to grow at virtually the same 9% rate they experienced in 2007. Expectations for AUM growth were at 13%, which were tempered somewhat relative to what firms experienced in 2007. Perhaps the strongest sign of confidence in the future, however, is represented by firms' plans to expand staff--at least one-third of all firms will make some sort of hire. As a result, staff across the industry is expected to increase 16% during 2008. Most hires will be made for professional positions, but technical specialists will see the greatest percentage increase (21%).

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No Firm Left Behind

Growth was widespread in 2007, with rates of annual revenue growth safely beyond double digits at every stage of development. As with past years' studies, we divide and analyze firms according to five stages of evolution defined as follows:

Early Solo. Solo firms have one owner/professional. Our analysis defines any solo practice established since 1999 (approximately the median firm age for solo firms) as an early solo.

Mature Solo. A mature solo differs from an early solo in terms of firm age. Solo practices established in or prior to 1999 are defined as mature.

Early Ensemble. Ensemble firms typically have multiple professionals in addition to administrative and support positions. Our analysis defines early ensemble firms as any ensemble firm with less than $2 million in annual revenue.

Mature Ensemble. Mature ensemble firms have between $2 million and $5 million in annual revenue.

Market Dominator. Market dominator firms are defined as any ensemble firm with more than $5 million in annual revenue.

Firms across all evolutionary stages reported strong growth rates in recent years (see Chart 2). From 2005 to 2007, however, the highest growth rates were experienced by early solos, early ensembles, and market dominators. Early solos, with a growth rate calculated from a smaller denominator, led all firm types in two-year compound annual rates of growth for revenue, AUM, and clients. Because they are newly formed and have not yet reached their capacity in terms of clients and assets managed, they can grow at an exceptionally fast pace. Early ensembles have just gone from a one-professional practice to a two-professional-or-more practice, which enables them to significantly increase the number of clients and assets they are able to take on.

Market dominators are able to take advantage of their economies of scale to maintain their high growth rate. The fact that they are growing more rapidly than most other firms suggests that they have yet to reach optimal size. Recent history demonstrates a trend toward an increasing number of large firms. We categorize multi-professional firms generating $5 million or more in annual revenue as market dominators. Five years ago fewer than 1% of participating firms met these criteria. Today 55 firms, or more than 8% of our sample, are in this size range.

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Leverage Yields Greater Income

Perhaps the most obvious performance distinction across the stages of development relates to owner income. Pre-tax income per owner becomes increasingly rewarding as firms increase in size and move up the development path (Chart 3). This is particularly notable in the progression from early ensemble to mature ensemble, in which mature ensemble owners take home more than twice the income of early ensemble owners. Market dominator owners are earning the most, with a median pre-tax income per owner of $936,000.

Driving this trend is leverage that works in favor of the large firm owners. Total owner income makes up just 13% of revenue for market dominator firms compared to 51% of revenue for early solos. Revenue is 33 times greater at the market dominator firm, however, and there are proportionately far fewer owners at each market dominator to share firm income. Chart 4 illustrates the prevalence of owners at each stage. The one owner that is typical of the early solo firm makes up 50% of the firm's personnel. In contrast, the typical market dominator firm, despite its much greater size, has just two owners that account for 9% of firm personnel. While large firm owners have greater responsibility for managing staff, the staff creates leverage for owners and yields higher income.

As we have seen in previous years' Studies, the staffing structure of an advisory firm evolves as firms move across the development stages. Professionals at early solo firms are usually performing multiple roles--from client service and business development to administrative tasks and office management. However, in order to stimulate greater growth, these professionals will eventually need to take on more non-professional staff to free their time to focus on the revenue-generating aspects of the business. On average, mature solos have 2.2 non-professionals per professional, compared to only 1.3 non-professionals in early solo firms (see Chart 5).

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Similarly, ensembles leverage their professionals to a greater extent as they mature. Early ensembles may not yet have the financial resources to take on an optimal level of non-professional staff. In addition, their size limits the extent to which individuals can specialize full-time in a job, resulting in fractionalized jobs. A given firm may, for example, need only five hours of weekly operations help, five hours of accounting help, and five hours of technology help. Professionals are forced to multi-task.

As a result, early ensembles have the lowest number of non-professionals per professional. However, as these firms generate more revenue and achieve more scale, they invest in additional staff, and more specialization, across all position types. Market dominators lead ensembles with 1.9 non-professionals per professional compared to a low of 0.9 for early ensembles.

The Growing Importance of Ownership

Many of the challenges currently facing the industry can be characterized as "nice problems to have." That is, they are issues largely resulting from industry development and prosperity. The problem of labor scarcity, for example, is a well-known challenge brought about by extensive industry growth. Shortage of talent is also closely linked to another "nice" problem--transitioning ever-appreciating shares of equity.

Across the industry, firms have grown rapidly in recent years and, as a result, have appreciated rapidly in value. Growth has also served to drive up the demand to recruit and retain experienced personnel. These factors, combined with the demographic fact that a significant segment of the firm owner population is nearing traditional retirement age, have elevated ownership-related issues to a central role in the continued development of an advisory firm.

So now let's focus on this major challenge for even the most successful firms. Many founding owners will soon need an exit solution for extracting liquidity from businesses they have worked hard to develop. The typical firm owner is 49 years of age. More than one-third of owners, 37%, indicate they are within 10 years of retirement (see Chart 6). The result is a tremendous wave of firm owners in the midst of a liquidity crisis. First-generation firm owners, long focused on building business value, are now shifting their focus toward liquidating some, if not all, of this value.

Signs of this shift are present throughout our study results. While just 6% of firms had a partner retire in the last two years, nearly one in four, 24%, of the "market dominator" firms, the largest firms participating in the survey, had an owner retire. Prompted by founding owners' desire to diversify out of their shares, but also by an interest in promoting and retaining the firm's next generation of leaders, 28% of firms admitted a new partner within the last two years. More than half of all market dominators admitted a new partner.

Our study results suggest that many more owners would like to transition their shares to a successor but are challenged to find a solution. Only one in four firms indicates having a well-defined succession plan (see Chart 7). Many firms, 44%, have no plan at all. Aside from the need to have a plan, the bulk of firm owners, 48%, cite identification of the right successor or selling to someone within the firm as the most important factor for them to successfully transition out of their firms. A firm's appreciation in value is creating a double-edged sword. The firm represents tremendous value to founding owners, but lack of a practical plan for succeeding shares to junior partners, who are often ill-equipped to finance their purchase, creates liquidity and next-generation leadership-development issues.

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Owners are often forced to look externally for a succession solution. Within the last two years, 29% of all firms considered a sale, including 1% of all firms that actually completed a transaction (see Chart 8). About 60% of firms that consider a sale do so for reasons related to liquidity. The majority of these directly reference a desire for a succession solution. An even larger portion of firms is interested in buying another firm. More than half, 55%, of firms expressed interest in an acquisition, including 3% who recently completed a transaction. While acquisitions are traditionally motivated by growth goals, owners of mature solo firms in particular are considering acquisitions as a means for transitioning out of their businesses.

Transferable Value Is Crucial

Ultimately every owner will someday need a liquidity solution. Regardless of where their firms are developmentally, owners will be well served to focus on creating the broadest opportunity set of possible liquidity solutions. This will require owners to plan carefully, taking specific measures at each stage of development to build transferable value and avoid a final-hour "fire sale" of the firm. The challenge for a firm owner is to maintain income generation while not losing sight of the need to run the business in a way that builds transferable value.

Firms will occasionally peak in terms of income per owner while operating in a manner detrimental to building and realizing value. While high-income firms are to be congratulated, they have possibly earned just a partial victory. Owners of these firms must vigilantly monitor many other operating factors that introduce risk or dampen growth prospects and ultimately influence value. These include the following:

Concentrated ownership. By definition, firms with concentrated ownership, all else being equal, will yield higher income per owner but will not necessarily yield more value. A firm whose ownership is more broadly distributed may be more sustainable, and hence more valuable, given that more key people and future leaders have a direct and vested interest in the long-term success and viability of the firm.

Over-reliance on key individuals. The most obvious forms of over-reliance occur when an individual dominates the firm in either sales, investment strategy, or service delivery. Over-reliance, especially when coupled with lack of repeatable processes or inadequate succession planning, can severely hamper an owner's prospects for getting sufficient liquidity out of the firm.

Overworked professionals. Sometimes a firm achieves high income driven by productivity of its professionals. While high revenue per professional generally indicates good productivity, it may also be a sign that professionals are simply taking on more than is sustainable in the long run. Under this scenario, business risk increases because of possible employee "burn-out" or deterioration in client service.

Depleted client base. This is occasionally evident in mature firms with owners nearing retirement. The firm's client base, while currently profitable, is aging and in need of replenishment. In addition, the client base may lack focus in terms of a targeted market, which may hinder transferability.

Lack of repeatable standardized processes. Transparent and routine processes are at the heart of a valuable and transferable enterprise. If a firm's processes vary by the client or staff member, this creates business inefficiencies as well as posing significant risks to the smooth transition of responsibility for client relationships.

Lack of scalable organizational structure and operational infrastructure. Just because a firm can efficiently work at capacity at present does not mean this will always be the case. The most valuable firms are set up in such a way that the organization and its support structure grow seamlessly and incrementally with new business.

Our survey data suggests that top-quartile firms in terms of income per owner are largely practicing in a manner consistent with building value. While there are a few areas of concern, what those firms with high income per owner are doing right outweighs what they are doing wrong. Only a tendency toward more concentrated ownership and challenges with succession planning stand out as factors that could significantly weaken firm value.

The Best Yet to Come

One of the most exciting aspects of the independent advisory business is that despite the tremendous success the industry has had to date, plenty of potential exists for further growth and improvement. Firms continue to experience steady client growth. In addition, the gap between the industry's top-performing firms and others demonstrates the potential for improvements in productivity, efficiency, and, ultimately, profitability. The best practices of these elite firms provide invaluable lessons for others to more fully realize this potential.

As our data reveals, in the earlier stages of a firm's development the best firms demonstrate disciplined client selection and a propensity to automate or outsource non-core functions. As these firms progress, they are able to spend more time on client service, business development, and directly generating revenue. Owners of top-performing established solo firms, for example, spend 56% of a typical day on either client service or business development, compared to 46% for other owners.

As firms grow, the service set also evolves, but the number of services offered doesn't necessarily increase. Regardless of their stage of development, firms tend to offer six or seven services to the majority of their clients. The best firms focus on what is core to their firm and their client relationships. Owners ensure that each service is used by a meaningful proportion of their clients, is value added to the relationship, and is something for which they can charge. As a result, top-performing firms, particularly the larger ones, generally price higher and earn greater revenue yield off assets managed. The top 25% of market dominator firms, for example, yield five basis points more revenue per dollar of assets managed compared to their peers.

Year after year, we note that at every development stage the best firms use more non-professional staff to better leverage the time of their professionals. Further, professionals become increasingly leveraged as firms grow in size.

The independent advisory industry continues to develop rapidly but is yet to fully reach maturity. While much progress has been made, many firms have yet to find the optimal solution for operational areas such as human resources, organizational structure, financial management, technology, marketing, and use of strategic partners. The strong growth rates of the industry's largest firms relative to smaller firms illustrate the virtues of economies of scale, suggesting that firms can grow bigger still and promise ever-greater rewards to firm owners.

While the current flux in performance of the financial markets may cause advisors concern, forward-thinking firms will recognize this as a time of opportunity. The demand for objective financial advice is not only not going away, but is likely to increase due to the well-known demographic trends in the United States. The best firms will continue to improve their efficiency and effectiveness in serving this market. Specifically, they will use the months ahead to reinforce the value proposition they offer clients and reinvest in their businesses to best capitalize on the next growth cycle for securities. Truly the best is yet to come. Market tribulations, however, serve as a sobering reminder for firm owners that sound practice management, including prescient succession planning, trumps asset appreciation as the key to prosperity. That's the case both on an operating basis, and at the eventual liquidity event.


Dan Inveen, CFA, is the senior research manager for the Financial Services practice at Moss Adams. Contact him at Dan.Inveen@mossadams.com. Investment Advisor readers can purchase a specially priced copy of the complete study discussed in this article at www.mossadams.com/2008advisorstudyIA.

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