Growth is the lifeblood of the independent advisory industry. In addition to greater rewards to firm owners in the form of increasing returns and higher share value, the potential benefits of growth extend to employees as well as clients. Growth creates career opportunities and greater earning potential for staff. Growth can help broaden a firm’s resources and deepen its technical expertise, resulting in improved quality of client service delivery.
Mismanaged growth can put firms at risk, however, stressing their foundations and threatening profitability. To achieve sustainable growth, firms need to take a deliberate approach, one that FA Insight describes as “growth by design.” With a thoughtful, strategic approach, firms can take advantage of economies of scale, build value and protect profitability.
Because sustainable growth is so important, “The 2012 FA Insight Study of Advisory Firms: Growth by Design” features a detailed examination of how firms grow and how they should grow. Here, in the first of four planned articles over the course of the next 12 months, we provide an overview of study findings.
The 2012 study, with record firm participation, is the fourth in an annual industry benchmarking series begun by FA Insight in 2009. The 2012 study is preceded by “The 2011 FA Insight Study of Advisory Firms: People and Pay,” an effort that focused on assisting firms to attract and retain the right people and map a path that progresses them toward ownership. (See www.AdvisorOne.com/tag/People-and-Pay.)
Impressive Gains Mask Potential Liabilities
Independent advisory firms can point to solid accomplishments in 2011. The typical firm, retaining more than 97% of existing clients, added nearly four new clients for every one client lost. As a result, the median firm expanded its client base by 6.1% in 2011, the best year for adding clients since 2008. Firms are optimistic about surpassing that rate in 2012, expecting to finish the current year with a 6.9% increase in total clients (see Figure 1, left).
While the rate of client growth improved, lackluster performance of securities markets slowed the growth of advisory firm assets under management (AUM). Up just 6.9% for the typical firm in 2011, AUM grew at less than half the rate experienced in 2010, a year when the economy and financial markets rebounded from recession. Advisors are hopeful for another rebound in 2012, however, expecting AUM to grow more than twice as much as last year.
Indeed, in spite of declining appreciation in client investment portfolios, advisory firms maintained slower but still solid revenue growth, largely because of their ability to attract new clients. Revenue for the typical firm rose 14.5% in 2011.
While off three percentage points from 2010, revenue growth in 2011, combined with limited growth in staff, contributed to levels of productivity and income per owner that the industry has not seen since the onset of the recession (see Figure 2, right). After all three measures declined dramatically for the typical firm in 2009, revenue per professional is up 22%, revenue per total staff is up 19% and income per owner is up 32% in the two years since the market bottom.
Expenses Grow Despite Productivity Improvements
The upsurge in productivity, however, has not been accompanied by efficiency gains, and expense management is a growing concern. While firms have added clients to help fuel revenue growth, clients are increasingly more costly to service (see Figure 3, right).
Overhead expenses reflect all advisory firm costs that are not directly related to delivery of advice or revenue generation, including items such as support staff compensation, office rent and technology. Since 2008, median overhead costs per client rose at an average rate of more than 9% per year, outpacing growth in client size as measured by AUM.
In 2011, the rise in indirect costs was particularly steep. Overhead expenses per client rose 17%, contributing to a 10% decline in profit per client. For the typical firm, overhead expenses increased from 38.1% of revenue in 2010 to 39.2% in 2011.
Rising expenses resulted in declining profitability, despite revenue growth. The median operating profit margin fell from 18.9% in 2010 to 14.2% in 2011 (see Figure 4, right). Owners’ overall efficiency in converting income from firm revenue declined as well. Owner income (including owner compensation and profits) as a share of revenue fell to 47% in 2011 compared with 50% in 2010.
Undoubtedly, better times have returned for advisory firms, but the inability of many to grow in a manner that contains expenses and upholds profitably is cause for concern. Without achieving more profitable growth, firm owners will fail to capitalize on the advantages of scale and struggle to build value in the enterprises they have created.
Multiple Benefits of Growth
The importance of growth and the need for advisory firms to make growth a priority cannot be overstated. The most commonly cited benefits of growth are increased efficiency, profitability and productivity. These advantages are typical of firms realizing economies of scale. In addition to better quality client service, firms also report that growth offers a variety of benefits related to personnel. For example, growth often brings:
- Greater career opportunity
- Reduced dependency on key individuals
- Improved management capabilities
- Greater succession choices
- An improved ability to attract talent
Growth Can Also Have Negative Consequences
Growth does not always work in a firm’s favor, however. As Growth by Design and previous FA Insight industry studies have shown, expenses can explode and profit margins can erode if growth is uncontrolled. Firms that rapidly add clients and grow revenue may at the same time experience rising overhead expenses and lower operating profit margins.
Three-quarters of firms achieving significant growth reported at least one negative impact as a result. The most commonly cited negative impacts of growth were:
- More challenges in providing career paths for all staff
- Increased dependency on key personnel
- Management capacity, technology and operating systems that cannot keep pace
Standout Firms: Higher Growth, Revenue and Owner Income
The ability to grow revenue without sacrificing owner income is a distinguishing feature of elite firms, defined here as Standout firms, or those in the top 25% of firms surveyed. By definition, and similar to our studies in past years, Standouts excel when measured by recent growth and current income. In 2011, depending upon the firm stage of development, Standouts relative to their peers achieved:
- Eight to 47 percentage points higher rate of annual revenue growth
- Twelve to 19 cents more in owner income per every dollar of revenue generated
Superior revenue growth stems from Standouts simply being better at growing their client base than their peers. Standouts are more typically motivated to grow in order to better meet the demanding needs of clients and shareholders.
Lower expenses and higher productivity drives the Standout advantage in income generation. Standouts are more careful about how they spend their money than their peers. They focus on how resources are deployed, rather than how much resources are deployed.
Standouts have been able to lower their overhead expenses as a share of revenue, usually by employing efficient and disciplined staffing practices. They also spend significantly less on non-professional staff and somewhat less on total professional compensation as a share of revenue.
Productivity is another area where Standouts shine. Professionals at Standout firms are far less likely to be under capacity than their peers at other firms, and this usually means higher revenue per professional.
Growth: Sustainable or At Risk?
Without question, the 2012 FA Insight study has found that there is a right way and a wrong way to grow. A firm growing the right way takes full advantage of scale and builds value, but value is significantly undermined if a firm grows in an undisciplined way.
To probe further into how firms can grow well, FA Insight divided advisory firms into two groups: ‘”sustainable growth” firms that had no significant problems as they grew and “growth-at-risk” firms, which experienced one or more negative impacts. Findings from this comparison complement and add to insight provided by the Standout firms.
Sustainable growth firms excel at converting revenue to owner income and keeping overhead expenses low. The profit margin for the typical sustainable growth firm, at 23%, is markedly higher than the 14% achieved by growth-at-risk firms. Sustainable growth firms not only achieve better profitability, but have set a course toward a steady build-up in enterprise value. They are enjoying these benefits of scale because of the following practices:
- Market focus. Tailoring the client value proposition and client experience to meet the needs of a clearly defined target market.
- Sound management practices. Managing people, technology and processes in a way that helps to maximize efficiency and productivity.
- Discipline. Consistently implementing and reviewing firm processes.
The market focus of sustainable growth firms is demonstrated through adhering to a target market, developing a clear client value proposition and implementing the value proposition consistently.
Leveraging the Operational Infrastructure
Sustainable growth firms particularly outshine their peers by having a rock-solid operational infrastructure, designed around client needs, that allows them to more consistently deliver value to their clients. Nearly all of them (97%) felt their value proposition was consistently implemented.
Potential performance issues are defused by focusing more on how work gets done than how money might solve a problem. Compared with growth-at-risk firms, sustainable growth firms’ major business-to-client processes are more likely to be well-documented and well-understood by staff members. They are about three times as likely to have a mechanism in place for ongoing process improvement. As a result of these efforts, they are about twice as likely to consistently implement processes.
Additionally, sustainable growth firms are more likely to proactively manage technology by:
- Integrating technology components to fully support business-to-client processes
- Providing staffers with both initial technology training as well as ongoing training resources
- Setting annual budgets for new investments in technology
- Applying a consistent process in evaluating technology investments
Engineering Scale to Realize Economies
Growth is essential for owners who want to build value in their firms. Indeed, advisory firms are positioned well for growth, as they continue to add clients and increase revenues. But growth does not always benefit firms and, if done the wrong way, can be detrimental.
Achieving the full benefits of growth and avoiding negative consequences does not happen by accident. The market focus, management practices and general discipline of sustainable growth firms combine as a formidable defense against growth’s negative impacts.
Creating sustainable growth requires a deliberate approach. It is an approach that stresses foresight, careful planning and thoughtful management that will put firms on the right path for realizing scale economies that translate into shareholder value. Further, in addition to economic and personal rewards for shareholders, growth by design promises career opportunities and job satisfaction for staff and superior service delivery for clients.
More to Come
In the months ahead, Investment Advisor readers can look forward to additional articles that will further explore strategies for achieving sustainable growth. While our current article provides a high-level overview of the 2012 “Growth by Design” findings, future articles will probe more specific best practices related to achieving sustainable growth. For more comprehensive guidance, including benchmarking data, the complete “Growth by Design” study is available for order through FA Insight.