Mark Hurley, the mutual fund entrepreneur and irrepressible pundit, is stirring the pot again. Six years ago, when he was running Undiscovered Managers LLC, Hurley said that the advisor industry would split into three tiers–megafirms, mid-sized specialist business, and a host of smaller practices. In this world, the smaller firms would fare especially poorly. Hurley has since sold his business to J.P. Morgan Asset Management, but he remains convinced that his thesis is playing out exactly as he predicted.

Now a Dallas-based senior advisor to Headwaters MB, a merchant banking firm headquartered in Denver, Hurley believes that the smaller RIAs are caught in a squeeze of sharply rising costs and stiffening competition for clients and professional staff. His conclusions are contained in a new white paper from J.P. Morgan and Undiscovered Managers entitled “Back to the Future: The Continuing Evolution of the Financial Advisory Business” (The paper is available at www.jpmorganfunds.com/UndiscoveredManagers/).

In the paper, Hurley and co-author Sharon Weinberg, a J.P. Morgan Asset Management managing director, note that while 1,102 RIA firms generate more than $1 million in annual revenue, more than 16,000, comprising 81% of the industry’s players, claim less than $25 million in assets. Most of these smaller players generate less than $1 million in annual revenue and are “marginalized businesses that are unprofitable after paying their owners a market-level salary and have few, if any, resources to fund their growth and evolution,” the paper contends.

Not only do these players have trouble generating resources to grow. They also face rising spending on compliance and marketing and upward pressure on staff salaries, the result of a shortage of trained professionals in an industry that is rapidly graying. Indeed, the study points out that just 18% of the Financial Planning Association’s members are under 39 and only 3% are under 30. But with banks and trust companies, among others, vying for trained financial planners to work with clients, salaries are rising steeply. Between 2001 and 2003, average financial planner compensation has increased by nearly a third, to $99,000, the study says. These rising costs have pushed the average RIA firm’s operating profit margins fell to 16.6% in 2003 from 21% during the bull market year of 1999.

For advisors hoping to sell out, Hurley identifies three potential classes of buyers: employees, financial buyers including National Financial Partners, and strategic acquirers, such as banks and insurers. Advisors who sell to employees “won’t get a lot of money,” Hurley contends, while sales to financial buyers may provide buyers with liquidity but “really don’t add any value” to a firm. In addition, he says, “two-thirds of the economics” of such a sale “end up in the hands of the buyer.” Sellers looking for strategic buyers, meanwhile, may be disappointed. While these purchasers typically pay high prices, few RIA businesses are big enough to make attractive targets. Indeed, smaller RIAs will fare worst in the mergers-and-acquisition game, Hurley says, noting that few of these practices have been acquired so far.

Hurley suggests that custodial firms may soon enter the marketplace as buyers of RIA practices. As advisors shift their mutual fund business to transfer agents and away from custodians’ profitable fund supermarkets, he believes, the custodians will act in their own interest to keep more assets from departing.