From the November 2008 issue of Investment Advisor • Subscribe!

November 1, 2008

Creation and Evolution

The 2008 Moss Adams Study reveals some absolute truths

A number of lessons can be learned from the recent calamity in the financial markets: if you don't manage risk, you will likely fail; if you don't manage growth, you may go broke; if you fail to plan for business continuity, fate will be your driver. But as one of my early mentors liked to say, "The end of the world only comes once, and it's not today."

Many independent financial advisors--whose ideas about business growth are more prosaic than those of investment bankers, wirehouse firms, and mortgage lenders--plod forward like the proverbial tortoise while the hares find themselves in foxholes. The recently released 2008 Moss Adams Financial Performance Study of Advisory Firms, sponsored by Genworth Financial, validates many compelling attributes of the independent advisory firm model in the midst of headline risk, bankruptcy, and sinking values.

With a very solid sample of firms reporting (almost 800), the 2008 Moss Adams study showed that revenue for the average participant grew by 22% in 2007 after an 18% increase the previous year. Personal income has more than doubled since 2003, and assets are flooding in from new clients who appear to be leaving their brokers and advisors at other firms as well as creating more new liquid wealth.

Beyond the cold statistics of this study is the observation that the financial advisory profession is going through a structural evolution. This may come as a surprise to the creators of independent financial advisory firms who at one time seemed singularly committed to remaining small as a badge of honor. But the demand for independent, objective advice is growing, putting pressure on the best advisors to invest in their businesses by managing risk, managing growth, and planning for succession.

Like tadpole to toad, many advisory firms have moved from swimming in small ponds to hopping from stool to stool, capturing more flies at every stop. They are doing this through a clearer value proposition: as client advocates rather than product purveyors, as employers of choice for people drawn to the profession, and by investing profits into their businesses to finance their growth.

The Moss Adams studies over the years have coined the descriptions of practice models as Early Solo, Early Ensemble, Mature Ensemble, and Market Dominator. Solo firms containing only one advisor benefit from the high personal touch of the owner and a reputation tied to the principal, while ensembles leverage other professional and administrative staff as they mature.

Solos by definition have to be generalists, because whereas ensembles and market dominators have the luxury of staff specializing in different disciplines.

Getting to the Next Stage

An Early Solo is defined in the study as a practice formed since 1999 and operated by one professional. According to the Moss Adams study, Early Solos are growing fast--which isn't surprising considering their baseline is so small. Between 2005 and 2007, the median compound annual growth rate has been 29% compared to the rest of the survey participants at 20%.

Predictably, most Early Solos hit a wall after a few years when they have no capacity to pursue and take on more clients while managing their practices. They tend to outsource more than their peers in order to gain leverage but because outsourcing is often done on a variable cost basis, it is more difficult to improve profit margins.

If Early Solos want to grow from this model, Moss Adams recommends that they begin accounting for profitability and productivity like more mature businesses. The theory is that with a proper accounting framework, they can better evaluate what's working and what's not, and identify where to invest for future growth. A discipline around financial management and budgeting is the second step in the evolution of entrepreneurship: more closely monitoring and managing the key performance indicators of the enterprise in addition to focusing on innovation and revenue generation.

Early Ensembles are firms with two or more professional staff (non administrative) and that generate less than $2 million in annual revenue. The decision to add a partner or another professional colleague can be difficult for advisors who have enjoyed playing in their own sandbox and not sharing their toys. But as the Moss Adams study numbers suggest, the impact on growth, profits, and value as firms create operating leverage is profound. The added capacity allows the firm to add more clients, and partners to backstop each other's practice, sharing responsibilities as well as overhead.

For an Early Ensemble to progress to a Mature Ensemble, the principals must spend time developing staff and redefining the organizational structure. What got them to this stage won't get them to the next stage. They have to clarify their optimal client, their service model, and what they will be known for in their community. This represents an important shift away from advisor-centric operations, to operations that support efficient processes. In other words, the business at this stage must become more systematic, institutional, and in some cases, more bureaucratic for consistent and profitable delivery of solutions to clients.

Early Ensembles tend to be both too big and too small. Often their costs are growing faster than their revenues while their span of control is stretched as advisors attempt to spend time with clients and run the business. Like an adolescent whose clothes don't fit and whose skin is breaking out, the Early Ensemble is in an awkward phase of waiting to become an adult.

A Mature Ensemble fulfills that aspiration. Mature Ensembles generate between $2 and $5 million of annual revenue and have multiple professional staff. Mature Ensembles have greater scale and can afford to invest in specialties. While it is not necessary for larger, mature firms to focus on upscale clientele, this is often the manifestation of their growth. Clients with more complex financial lives require more attention, more services, and greater expertise and often desire a variety of more sophisticated solutions. While smaller firms may be able to effectively deliver on these client expectations through strategic alliances, the complementary service offering of the Mature Ensemble firm establishes their brand as a true wealth manager, and not a tactical financial planner.

Principals in Mature Ensembles have greater risk in terms of management oversight and quality as they get farther and farther away from the daily operations of the enterprise and client service. In order to move to the next level, they have to invest in more controls and devise consistent means of communication between owners, staff, and clients. They also have a larger economic nut to crack each month, which puts greater pressure on business development from younger associates. Fortunately, their scale and mass also provides the financial resources necessary for the investment in human capital that may not be available to their much smaller counterparts.

Becoming a Market Dominator

The authors of the Moss Adams study introduced the concept of Market Dominators among independent financial firms a few years ago. By their definition, a Market Dominator generates more than $5 million of annual revenue, and is growing faster in profit and assets than all other firms. Clearly, large firms have more opportunities to do business because of the sheer volume of contacts with centers of influence and client referrals.

While becoming large may not be the goal for many independent advisors, it seems a natural stage in the evolution of ensemble firms who want more succession options and greater leverage. Such firms tend to have a clear career path for associates--including the opportunity for partner admission. Of course, these firms are coveted by every buyer, custodian, broker-dealer, and product provider, which enhances their equity value. The Market Dominator's greater leverage in their professional relationships ultimately benefits their clients.

One of the more interesting developments for Market Dominators is their desire to open offices in multiple locations. According to the study, most such practices are registered investment advisors not affiliated with a broker/dealer. They've created their own support structure and do not need to outsource this solution. Instead of paying an override, they can purchase the required services at a negotiated price. But in many respects, their emergence parallels the evolution of independent broker/dealers in the 1970s.

At that time, many financial professionals left wire houses and regional firms to take advantage of the independent contractor model. They created some significant enterprises like LPL and Raymond James, and multi-broker-dealer enterprises like ING and AIG. Now it seems that those with an eye on scale and size are creating super-RIAs with multiple locations and operating leverage that could one day equal the breadth and depth of independent broker/dealers in terms of support of independent advisors. Perhaps more than any trend, this will accelerate the metamorphosis of independent broker-dealers into broad financial service firms that serve both the sell side and the buy side of the business.

Regardless, Market Dominators represent the next stage in the evolution of independent advisory practices, a stage that may have never been predicted and seems to have snuck up on the industry. Firms like Harris/SBSB, Regent Atlantic, Brightworth, and others with well over $1 billion in assets have outside investors favorably viewing the business--in spite of what has happened on Wall Street. In fact, according to the Moss Adams Real Deals 2008 Definitive Information on Mergers and Acquisitions for Advisors study that Pershing Advisor Solutions commissioned early this year, 35% of all advisory firms with over a billion in AUM are now owned by a parent. This is another step closer to ensuring business continuity for the largest of the independents.

The end of the financial services world as we knew it may have occurred, but what is replacing it might make the angels rejoice--and clients sigh "what a relief."

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