Building an independent advisory firm is like running a marathon–it takes a long time, it is painful and it drains you of every resource and ounce of mental energy you had. It is competitive but it’s more of a competition with yourself, a test of your plan and your will, than it is a race against others. It tests your limits but it gives you a sense of achievement like no other. For many owners of advisory firms, surviving the financial crisis has felt like running their first marathon–long, hard and draining, but ultimately rewarding.
It is hard to imagine when you finish your first marathon that you might find yourself at the starting line of another. Unfortunately, that may be what happens to every firm–we (the independent financial advisory industry) may have to go through another test. I have no insight into the market or the economy, but I believe most advisors would agree that the probability of a double-dip recession is higher than 0%. As daunting and scary as it may seem, we may have to prepare for another marathon. Still, this time we have the lessons of the first one and we know how to prepare better. The time to prepare, though, is now–not when we are in the middle of it. If we prove too cautious and the market surges ahead, then the most we risk is spending too much time on improving our business–how can that be bad?
The possibility of a double-dip recession is very frightening because so many of the business plans, so much of the emotional energy, and the credibility of almost every firm in the industry is heavily invested in the notion of recovery and return to prosperity. Another period of defending client relationships, reducing employment and compensation and having low profitability is not just disappointing–it might change the nature of many firms, threaten their existence, cause them to sell, prompt their people to change careers and undermine the credibility of the industry. I am not trying to be alarmist in my prediction but I remember vividly how many of those decisions were on the table in February and March of 2009. And that was just the first one–the easy one.
Running your second marathon is nothing like running the first one. When you run your first one everyone is cheering for you and all your family and friends line up along the course to support you. When you run your second one everyone is just wondering
what is wrong with you–why do you keep doing this? There is no one cheering from the sidelines, but the bar is set higher because now you have to run faster. Worst of all, you know exactly how bad it is going to be.
The 2008 and 2009 crisis was all about survival–just staying in business felt like an achievement; after all, it was the worst crisis since the Great Depression. What is more, the owners of advisory firms had the full support of their staff–employees were very understanding when their compensation had to be reduced and when some of their colleagues had to be let go. Employees not only cooperated with the owners and the measures they had to take to save the firm, but they also put a lot of extra time and effort to cover the shortage of staff and increased workload. In most firms there were no bonuses in 2008 and 2009 and no salary increases; nonetheless the camaraderie and sense of purpose preserved the culture of the firm and the morale of its people.
According to the 2010 Top Wealth Manager Survey published by WealthManagerWeb.com, 28.7% of all firms in the industry cancelled their bonus plans in 2009 and another 38.2% only paid token discretionary amounts. Salaries were similarly frozen throughout the industry, and the typical firm did not hire any new staff—and most likely reduced staff. Still, employees were there on the sidelines cheering for us—the business owners who were trying to survive this ordeal. They bought into the notion of persevering through this together because they believed that the firm will, in return, help them to grow in their career and would not let them go like others were doing. Unfortunately, if we suffer another recession our employees may no longer be as supportive, and we may have to run this marathon alone.
Financial concerns and employee issues are going to be the primary areas that firms have to shore up. Ultimately though, it will come down to being able to preserve a sense of opportunity and purpose in the firm—a reason to run your second marathon:
Stress-test your cash flow and balance sheet—Pretend you are a big bank for a moment (except, no government bailouts) and apply a similar strategy to your finances. First prepare a projection for 2011 where you increase your payroll by 10%, your other expenses by 5% and reduce your revenue by 10%. The result will typically be 40% to 50% reduction in profits. For some firms this may be an acceptable result, but for other this could be the brink of disaster. Firms that have to make payments to acquirers or buyouts of retired partners, or firms where the partners need to draw high levels of income, have to be particularly careful.
As many advisors realized in early 2009, profit and cash flow are not the same. For most firms, the cash arrives once a quarter but bills arrive daily. Creating a cash-flow budget, and looking at significant cash-flow outlays, such as taxes and estimated tax payments, significant purchases and other liabilities, is prudent and highly recommended. The cash-flow budget should be built off the projection above, but detailing the actual timing of payments. This step will either give you peace of mind or a signal that something has to be done. Keep in mind that reserving three to six months of expenses as capital reserve is a good practice. My concern is that many firms have
depleted their reserve down to nothing or may be about to distribute all of the reserve as dividends at the end of the year.
Work individually with each employee—More than 70% of all expenses in an advisory firm are employee related—salaries, bonuses, benefits, etc. The reality is harsh—if revenues go down and expenses have to remain the same and go down, employee compensation will be affected. There is no way of significantly reducing the expenses of an advisory firm outside of changing the number of staff, staff salaries and/or owner compensation. Usually all three, and typically owner compensation goes first. While employees are normally understanding of temporary changes in compensation, ultimately they still expect growth in their careers. At some point “temporary” starts to feel like “long-term” and at that point you as the business owner may find yourself in charge of a ship in mutiny.
If we really have to go through another period of declining market, or even just a flat market, it is important to understand that employees need to reestablish a sense of direction and purpose in their careers. If a firm goes two or three years without promotions and salary increases, employees would want to know what the ultimate prize is; why should they run in this marathon with you? Owners have symmetrical risk—we lose much on the downside but we win a lot on the upside. Employees lack the upside—they can only see the compensation they have lost. It has been my experience that camaraderie and culture can sustain motivation and contribution at least as well, if not better, than compensation. That said, prolonged compensation issues can undermine even the most cohesive culture.
The last recession was a time of panic and massive lay-offs where employees did not see alternatives if they left their advisory firm. Currently, staff counts are relatively low in our industry and throughout the country. While a recession by definition will not present our employees with many alternatives, there might be more than we think. Many of the larger advisory firm are upgrading their staff and continue to cherry-pick employees that they can lure away from competitors. Larger corporate employers, including those outside of the investment industry also continue to selectively add talent even if they are not hiring in large numbers. In other words, employees may have more choice than you realize. When trying to convince employees to stay with you firm, you are also asking them to dedicate their career to this industry—and that may be difficult to do in the middle of a crisis.
You can’t answer the doubts that your staff have about their future and their careers through bonus plans or memos. The best method in my mind is to treat each employee individually. Each person has different expectations of where their career should be and what their goals are. If employees have the sense that the firm is committed to their career, they will make the same commitment back—and the opposite is also true, they will not make a commitment if they sense a lack of commitment from their employer. Now is the time to reinforce or rebuild the trust
between you and your staff; if the time comes to make hard decisions, this investment will pay off. If you start discussing careers at the same time when you have to again defer salary increases you will have little credibility.
Revisit your strategy—If your strategy, your statement about what makes you unique and better than the competition, did not work in 2008 and 2009 you will have a hard time in 2011. That result is almost guaranteed regardless of the market. Firms that struggled the most in 2009 were “generic” firms that had no differentiating factor in their value proposition.
Regardless of the market next year (but especially in anticipation of down markets), you should take the following steps:
Articulate your investment philosophy to your clients and make sure they understand it—Clients who did not understand how their portfolio behaves relative to the market and why the advisor made the recommendations they did were at the most risk in 2008.
Communicate your strategy to your referral sources—They should know and understand what makes you unique and be able to articulate it. Remind them of what you did in the crisis and how you helped clients.
Foster internal referrals—The number-one source of referrals is existing clients. Continuously reinforcing your differentiation with existing clients and making sure they understand what makes your firm unique will help you continue to enjoy referrals even in bad times.
Talk to your clients frequently but avoid “drama”—You can never assume that clients fully understand your investment philosophy and you can always communicate more. At the same time, clients expect their advisor to lead them through the storm and not panic.
Hold your horses—Firms are starved for resources and owners are starved for income. Many firms have delayed hiring decisions, while the workload has steadily increased and help is long overdue. In many firms that I have worked with, employees have patiently waited for better times in order for the firm to hire more staff, but that patience is getting exhausted and can easily turn into frustration. Still, as tempting as it is to jump the gun and hire staff, all owners need to ask themselves: What will happen
to the extra staff if revenues decline again. It is a tough decision to make: Hire help early and risk early lay-offs or delay the hire and risk mutiny. There is no right choice here, but compromises may be possible, including part-time hires, project-based work with independent consultants and outsourcing.
The other temptation is to maximize owner income. Owners have been waiting for larger distributions (or any distributions) for a long time and it is difficult to resist distributing a significant dividend at the end of the year. Nothing is wrong with that as long as the firm passes the stress-test. If the dividend means draining the capital of the firm below the safety level, you may have to delay the distribution even further.
Be realistic—Many firms are relying on the recovery to jump start important plans—partner admissions, capital for major purchases, exit and succession plans and acquisitions. It is clear that growth is necessary for any expansion to be viable. But at the same time, if you are relying on double-digit growth to make or break your plans, there are reasons to be nervous. If your deal structure requires high levels of growth, if your strategy is banking on the market growing by double digits you should be asking yourself: “What happens if?” Don’t paint yourself into a corner by taking on significant steps that essentially “bet” on growth next year.
Seek help and alliances—You don’t have to run a marathon alone. There will always be people helping you along the course, even if they are not relatives. Now is a good time to look around and identify the resources you can count on. Who can help you make critical decisions if the recession returns? Who can advise you on navigating the financial and employee decisions? What can you outsource—and where? Where can you seek more capital if necessary? Who can you talk to when you simply need peer support and advice? In the stress of a tough market, it is difficult to start looking for that support—it is best to figure out where to find it, ahead of time.
Many firms also considered the idea of merging to create a bigger, and hopefully stronger, entity. Now is a good time to consider that merger and make more definitive steps toward it. The deal should not rely on a “growing market” and should consider the pessimistic scenarios. At the same time, it should not be just an “emergency procedure”—it should stand in good times and bad times. After all, if you are going to run a marathon with someone, they had better be a good friend of yours.
Unlike marathons, owning and running an advisory firm is not as simple as just putting one foot in front of the other. It is a constantly changing puzzle consisting of people, processes, systems, strategies and relationships. It is a living, breathing being that requires encouragement, motivation and sense of purpose of its own. Yet, much like a marathon, it requires a strong will and determination to keep going when most would stop. I have no way of predicting the economy or the market, but I believe we can all see the trouble lurking ahead. The advantage we have is that we have done this before. It may be hard to imagine going through a down market again—and so soon—but we would be remiss not to consider that possibility and use the painful lessons we learned the first time.