From the September 2009 issue of Investment Advisor • Subscribe!

Win-Win

Why a partnership is the best ownership structure for an advisory firm, and for clients

The natural state of a true investment advisory firm is a privately owned partnership that is fully controlled by the professionals who are actively involved in the delivery of advice to clients. Any other form of ownership, whether that's a public company or a corporate ownership by a financial institution, creates potential conflicts of interest, exposes the company to undue risk, dilutes the expertise, diverts the focus of the organizational culture away from the client, and ultimately results in a cycle of crisis events that hurts clients and advisors every few years.

While the preceding may very well sound like something Karl Marx would write, this former Communist is eager to argue that last year clearly illustrated why corporate ownership of investment advisory firms is not optimal for either clients or advisors. By "corporate ownership" I mean any structure that substantially removes the practitioners from the equity, profits, and decision-making in the firm, whether that's a publicly owned broker/dealer, a bank, an insurance company, or any other entity that is not owned and controlled by the advisors themselves.

Each of the largest firms of today was once a privately owned partnership. Charles Merrill established a firm in 1914 with Edmund Lynch that was a private partnership until 1971. Henry Morgan and Harold Stanley founded Morgan Stanley in 1935 after leaving JP Morgan. The firm went public in 1986. Charles Barney merged with Edward Smith in 1938 and was acquired by Primerica in the 1980s. Albert Gellatin Edwards founded AG Edwards in 1887 with his son. The firm went public in the 1970s.

I am not suggesting that firms must be small in order to balance ownership goals with client objectives, nor am I suggesting that all small partnerships are somehow better than public or corporately owned firms at servicing clients. I do believe, however, that the corporate form of ownership of any skilled profession has over time always proven problematic because of the inherent conflict between the abstract "owners" who are not involved in the delivery of the professional service, the "management" which represents the "owners," and the professionals who are representing the interests of the client. Sounds like class struggle, doesn't it? If that's the case, let the revolution begin because if the advisory profession wants to list itself in the lofty list of professions it has to reject corporate control. Ironically, it's just not good for business!

I think most of us will agree that the way in which the advisory profession can protect itself from the reputation collapses that occurred over the past year is by adopting organizational structures that make sure that the fortunes of the firm and those of the clients are aligned, where the firm's long-term history of ethical and prudent behavior is emphasized, where advisors care and are heavily invested in the firm's reputation as much as their individual standing, and where all advisors are long-term players who commit to this industry rather than seek a quick profit.

While this idealistic concept may be difficult to create and no structure may accomplish all of these objectives, it is clear to me that ownership by corporate entities is remote from this "perfect" state while a private partnership model is much closer. The problems with corporate ownership have to do with the natural friction between the "classes"--stockholders, managers, advisors, and clients--the dilution of personal responsibility and therefore lack of "skin in the game," the removal of the best supervisor--your partner--from the compliance process, the difficulty in creating a career path, and last but perhaps most important the nearly inevitable shift in culture from client-centric to more bureaucratic and technocratic variations. Let's look at each of these problems in more depth.

Issue No. 1: Owners vs. Clients, Management vs. Advisors

It is the legal obligation of the officers and board of a corporation to act in the best interests of the shareholders. It is also the legal responsibility of an investment advisory firm to act in the best interests of the client. Assuming the role of advocate for the client is the advisor, who has a very human (rather than contractual) relationship with the client. What is more, for that advisor the client represents his livelihood--future revenue and income. For the passive investor/owner, that link may be much more abstract. As a result, the friction between management and advisors is almost inevitable.

This is not just a philosophical argument. Typical decisions that result in such friction are very common. For instance, does the firm reduce the number of investment managers it works with to only a few? Does the firm use one or multiple custodians? Does the firm streamline all support functions or allow each advisor to customize? In each of those decisions the two sides will carry their bias: management will root for efficiency and advisors will root for giving clients a choice. The friction is natural but the two sides do not balance each other out, since this is not a democracy and advisors will usually lose the debate.

By contrast, the potential for biased decisions will be significantly reduced in a partnership where the "management" are practitioners (or were once) and in this way both sides have a vote. Advisors generally seek to build a lasting, renewable, and stable practice that generates great income over time. Investors would generally prefer a faster growing company with a more immediate upside. In other words, investors would like the company to take on much more risk than what advisors would find comfortable (see Tortoise or Hare sidebar).

Remember that the people who own the stock of a publicly owned broker/dealer already have the ability to invest in the broad market. If the broker/dealer has profits that merely grow at the speed of the market and have variability closely correlated to the market then the investors are not achieving anything by owning that stock that they cannot achieve by simply buying an index fund--same returns and standard deviation. A broker/dealer is only interesting to investors if it has a different risk-return profile than the overall market. For most investors that means higher returns even if it means higher risk. Most clients and advisors would actually prefer the opposite--a company that takes less risk with its own capital and puts more emphasis on stability. The slow and steady approach is OK with advisors because a practice takes a long-time to build. Reputations take decades to establish but corporate investors rarely have this much time.

Issue No. 2: Having "Skin in the Game"

In an ideal world most clients would like to know that their advisor has invested a lot of money in the same strategies and models that she has recommended to them. Reputation is de facto the "skin in the game," the capital that a person or firm invests in the profession. Without reputation a professional has trouble attracting clients. If a firm suffers a decline in reputation it will quickly suffer real declines in revenue and will need plenty of time to repair that reputation. Unfortunately, corporate ownership has no patience for reputation to develop or work its magic. Instead it substitutes "brand" for reputation.

It is interesting to note that in most institutionally owned firms, advisors rely on the corporate "brand" early on in their careers and tend to rely almost entirely on their personal reputation later on. The friction between the corporate "brand" and the personal reputation manifests itself every time the firm experiences negative publicity. Recall how advisors hate how "someone is dragging the firm's brand through the mud." This basically means that those advisors who have not created a strong personal reputation will use the corporate brand the most. Unfortunately, they are also the most likely advisors to get the firm in trouble: a classical case of adverse selection.

Issue No. 3: Your Partners Are Your Best Supervisors

One of the best mechanisms of protection that the general public has when relying on an audit report is the fact that a partner of the CPA firm who has no economic interest in that specific client has reviewed and approved the report. The partner reviewing the work fully understands that every audit can be his own private Enron and that his practice will suffer tremendous damage if the firm is shamed for not exercising proper process and care. There is no better "watchdog" than your partner if she has the right motivation to protect your collective reputation. She will be much better at uncovering any problems: they know the process and the firm. They also know you and know what to look for.

If a firm relies heavily on its collective reputation and all the partners have a vested interest in protecting it, they will "police" each other in some form. In fact, most advisory partnerships have a formal process of some kind that has been created internally precisely to minimize that risk. In a partnership environment everyone is quite interested in sticking their nose into other people's practices. That's good for the client.

In a large corporate firm, that responsibility is delegated to the compliance department, staffed either by non-practitioners who are not very familiar with the advisor, or by a branch manager who is familiar with the advisor but whose bonus is largely based on recruiting and revenue growth.

Issue No. 4: A Long-Term Career or "Hit and Run"

It always amazed me that J?r?me Kerviel, the trader who lost 4.9 billion euros for Soci?t? G?n?rale in early 2008, was born in 1977 and was paid a salary of 60,000 euros in the year of his "trading error." He was, however, hoping for a bonus of 600,000 euros if he had "hit his numbers." Both his relative inexperience (he had become a trader only in 2005) and his compensation model in retrospect seem like a time-bomb that just ticked down to zero. However, chances are that many trading floors and research departments have similar stories to tell.

From a corporate perspective the "result now and only results" mentality makes a lot of sense. After all, why pay "senior" traders with high salaries who may not be generating the desired results? Would it not be better to only pay when they make us money? Unfortunately when they are playing with the firm's capital the risks are disproportionate: if they lose they lose their potential bonus and maybe their job. The losses to clients could be measured in billions of dollars and the massively changed current and future lives of individuals and families and charities (a la Bernie Madoff).

In contrast, the slower career tracks of apprenticeship, study, and a gradual increase in responsibilities tend to ensure that by the time someone gets to a position where he can do significant damage he is also risking years of his own time spent getting there and hundreds of thousands of dollars in student loans for medical school or law school. The result of such a career track is a professional who is much more expensive than the corporation would pay for, but also one that would never take on such risks. This is often seen in practice when a bank acquires an advisory firm. Usually the advisors tend to make more than the bank president, but those advisors all spent a dozen years eating ramen noodles while they were establishing their practices.

Issue No. 5: Client-Focused Culture or Bureaucracy

There are many definitions of organizational culture in sociology and management science, but my favorite is one that I heard somewhere in a conversation: "Culture is what happens when no one is watching." The reality is that when a firm grows past a dozen or so advisors the ability to watch who does what is reduced significantly. That's also when bad things happen.

Culture is influenced by many factors, but the top ones are the examples set by the leaders of the organization, the behavior of peers, and the system of rewards and penalties established by the organization. If the leadership of the firm represents the "management," then the examples will be ones of decisions focused on the bottom line. No doubt the reward system will accordingly do the same. What is worse, the peers will likely have a history of friction and resistance with management creating an environment where "sabotaging" the system is not only tolerated but somewhat even celebrated. That is dangerous for everyone involved.

Better Alignment, Better Focus

If we apply these five criteria to corporate ownership of advisory firms we will find them impossible to meet. The time horizon of reputation development and career creation is typically longer than the decision-making cycle expected from public companies. The culture of necessity will always emphasize the practitioners over the "managers," which is contrary to what passive owners would prefer. Most of all, the resulting firm will overemphasize the advisor over the "brand" and would thus make the brand fragile and less valuable in the eyes of outside investors.

Partnerships and reputations are not a magic solution--Arthur Anderson was a partnership and Madoff had a great reputation. They do, however, create a better alignment and focus than the large, complex, and conflicted corporate structures. They do not offer the same opportunities for the public to invest and they do not grow careers and income as fast, but perhaps in retrospect we can go with a little less return in exchange for a little less drama.

At times, when it is unclear who you can trust, people have traditionally turned to the structures that have persisted over centuries: family, community, and friends. At a time when we see scandals of fraud, crumbling brands, ruinous decisions, and collapsing giants, it is not too far-fetched to assume that the industry may turn back to its roots to reinvent itself. Perhaps the best firms of tomorrow are going to be once again named after people you can talk to, who are active in the business, and who remain close to clients and their own partners who can then balance the risk to clients, the risk to their own reputations, and the desire to build a profitable and enduring business.


Philip Palaveev is president of Fusion Advisor Network. He can be reached at

ppalaveev@fusionadvisornetwork.com.

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