From the December 2012 issue of Investment Advisor • Subscribe!

Are All Partners Equal?

Pay differentials among owners in an advisory firm can bring angst—or clarity

You have heard the saying that the fastest way to ruin a friendship is to become partners. Unfortunately, many advisors in ensemble practices can relate to this adage.

Advisory firms with multiple owners rarely avoid conflict between partners. The nature of the partnership dynamic often contributes to insecurity, inspires jealousy and exacerbates feelings of unfairness.

Why are these problems so common? Each partner brings an ego to the mix. Rainmakers often believe that they are the most important people in the firm. So too do the senior advisors or portfolio managers who create the value delivered to clients. Key management personnel also feel they hold the enterprise together and drive success. (For the purpose of this discussion, I’ll refer to all multi-owner firms as partnerships though there are different terms based on the entity type.)

When partnerships are formed, all parties enter into the arrangement believing that their special combination of skills, personalities and experience will lead to riches and fame for all. Unfortunately, in many cases, partners invest more in the wedding than in the marriage. After the honeymoon ends, incompatibilities and misunderstandings can arise.

New partners commonly avoid the difficult initial conversations for fear of being perceived as a poor team player. In the early days of a partnership, most advisors choose compromise over confrontation, appeasement over agreement. While attempting to maintain an amiable relationship is noble, ignoring significant issues can lead to resentment. Pent-up emotions explode like cluster bombs at a later point, often when it is too late to have a rational, intelligent discussion about how to resolve the differences. Catalysts for this explosion include major events such as an advisor bringing in a very large client or achieving an extraordinary one-year return with client portfolios, or—on the negative side—spending a disproportionate amount of time entertaining centers of influence with expensive dinners and sporting events.

Many partners find it difficult to accept their responsibility to talk openly with each other, confront bad behavior, encourage good behavior and share openly but calmly how they feel about what’s working and what is not. Adults talk. Children pout. Pouting adults suck the lifeblood out of an organization.

Having been on both sides of this relationship, I can attest to the value of creating a framework for how partners should value each other, especially when it comes to the question of who gets paid what and why.

How to Value Partners’ Contributions

In reality, different partners make different contributions to the value of the business. Firms that allow compensation to float with profits alone are not considering all of the elements that other partners bring to the business, aside from the capital they have invested.

Remember, partners are also employees of the business. Profit distributions reward them for their ownership position. Compensation plans that include base pay plus incentives reward them for the roles they perform. Some partners have management responsibility, some have sales expectations, some are technical specialists and some are solely responsible for working with existing clients. Many do all of these. Compensation models should be created with the idea that different responsibilities carry different rewards but all activities have value.

Many advisory firms have evolved away from the traditional brokerage “eat what you kill” pay model to a reward structure more in harmony with their strategy. True ensemble firms recognize that each person contributes something of value to the success of the enterprise. Business developers need the help of support people and subject matter experts. Portfolio managers need the help of rainmakers to grow their revenues with new assets. Business managers need all elements of the firm to be working efficiently, effectively and in sync with the vision and mission of the enterprise.

The traditional brokerage model rewards a person for new sales. By definition, this is a short-term event that comes with short-term rewards (“short-term” is 12 months or less). Most advisory firms—whether affiliated with a broker-dealer or operating as an independent RIA—tend to generate the vast majority of their revenue from existing clients rather than from new sales. Salespeople tend to be paid more than others, with a highly variable compensation that is tied to results. Their risk of not earning any compensation is also high, another reason for potentially higher rewards. Service people or portfolio managers, on the other hand, have less risk; a higher percentage of their total compensation is fixed as the role requires them to focus on client satisfaction or fulfillment rather than new business development.

This is a comparison only. Obviously, many successful financial services organizations that are sales- or product-driven businesses should continue paying for sales if that is the behavior they seek from their people.

However, assuming that the goals are to execute an agreed-upon strategy, to operate as a team rather than a collection of solo practitioners and to value client service and advice as highly as sales, then partners should implement a logical compensation plan that aligns with these goals. First address these priorities:

  1. Define your strategy and vision, including how you characterize business success.
  2. Decide what kind of behavior you wish to reinforce.
  3. Create a compensation policy statement that spells out what you value and how.
  4. Define the roles of each person, including partners, and include a definition of excellence for all roles.
  5. Benchmark the compensation as a guideline (not an absolute).
  6. Test the maximum potential payout against the economics of your business.
  7. Determine incentives for each role, and identify the triggers for payouts.

Compensation components include base pay, short-term incentives, long-term incentives, perquisites and benefits, retirement and equity. Base compensation is designed to pay a fair wage for a person’s primary role, whether a relationship manager or business manager.

Incentive compensation is often split between short- and long-term rewards, again aligned to the behavior you seek. As an example, you may wish to reward the amount of new business a partner brings into the firm during a quarter or a year. You also may wish to reward how effectively a partner develops his successors over a longer term. Short-term incentives usually are paid in cash (though vested stock could also be part of this). Long-term incentives often are paid in options, phantom or synthetic stock and deferred compensation such as stock issued on a vesting schedule.

If the base is fair for the job a person is doing, and the incentives recognize the individual’s contributions to the business over and above expected performance, then what’s left in terms of profit is distributed to equity holders on a pro rata basis. This design helps to distinguish between rewards for ownership and rewards for individual contributions to the enterprise. In a way, this design represents the classic Adam Smith view of capitalism: a recognition that labor and capital bring different value to a business.

The spirit of partnership includes sharing the risks and the rewards of a business. Practically speaking, however, all partners do not contribute equally to the success of an enterprise. The return for a passive investor in a business is based on a return on capital. As an owner and employee, a partner in an advisory firm must go further, defining expectations, rewarding the behavior and performance that are valued and accepting that certain partners may make more than others if their contributions are exceptional.      

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