How Bleak Is Your Future?

While I personally find it impossible to predict future events with much accuracy, I’m often intrigued by how others see the stars aligning. Should I put the depression prevention hotline or the party store on my speed dial?

A case in point is the reaction to JP Morgan’s redux of the Undiscovered Managers’ paper on the future of the industry. The original lead author on the first paper, Mark Hurley, has the uncanny ability to provoke strong reactions and as a result, his writings and speeches usually create split camps of heated debate.

With this report, however, Sharon Weinberg, managing director of JP Morgan Asset Management, and her team did an impressive job of pulling together data from disparate sources (including Moss Adams LLP) to help the advisory profession better understand the forces of change. Whether their forecasts are right is hard to know, but their assumptions are compelling enough for advisors to take stock of their own situations. Even though her company had acquired Undiscovered Managers from Hurley and other investors a few years back and as a result adopted this report, Weinberg’s team did not register a prediction of Armageddon. They did, however, identify a conspiracy of evils that could turn advisors’ lives into more trying times should they not face these facts. Consequently, firms of all sizes need to consider whether we have entered an era of altered economics, in which client service expectations (driven by the market and by advisors themselves) have and will continue to change and become more costly.

• With an increase in size comes an appetite for more capabilities. Firms start to look for more services to add to their client offerings and invest in systems and people who can execute them. Before these new capabilities are fully utilized and leveraged, the firm goes through a period of higher overhead.
• With an increase in size comes a desire to achieve higher quality. Levels of error or performance that were once admissible become too high for the large firms, and an investment is made to improve operations quality.
• With an increase in size the concept of continuity becomes more important and firms invest in backup staff or systems to ensure they are protected from turnover or operational issues with one system.

Advisory practice operations are the biggest source of inefficiency in the advisory business. Yet, counterintuitively, the most common symptom of inefficient operations is not high overhead–including operations salaries and resources–as much as low advisor productivity and low gross margins (revenue less advisor compensation). Firms are inefficient not because they spend too much money on operations, but rather because their advisors spend too much time on operations. I recommend that financial advisors read the Morgan/Hurley report with an eye toward gaining insights that could cause them to reexamine their current business practices, including whom they serve and what their client service experience should be.

Some of the observations are upsetting precisely because they hit close to home. No one likes to be told that their business model has been marginalized or that things will only get worse. But the report does clearly opine that if you own an advisory business and are experiencing distress related to staff, new client development, competition, keeping up with technology, and declining margins, it might be a good time to identify the reasons behind these problems so you can work to resolve them.

The report restates the premise developed in 2002 that technology, new entrants into the market, the absence of a hidden subsidy caused by a bull market, and repackaging of traditional competitors will make it difficult for advisors in the future. But in my opinion, the real lesson in this report comes from the five forces it identifies that will alter the economic structure of the advisory business over the next five to seven years:

1. The rising expectations of key employees for an equity stake.
2. A growing demand for professional staff by advisory firms.
3. Rising general operating costs.
4. The need to grow to critical mass to offset these three pressures.
5. Average age of the advisory profession and the implications for the business.

The statistics don’t lie. From the year 2001 to 2004, the FPA Study on Financial Performance conducted by Moss Adams observed that average operating costs rose faster than revenues, even at a time that the top line for many firms was growing quite nicely. What was the biggest cost driver? Salaries and employee-related costs. Especially troubling is that as advisory practices get bigger, their overhead as a percentage of revenues increases. Intuition would tell us that overhead percentage should actually decline when revenue is increasing but it is harder for firms in their growth cycle to digest costs. For instance, we found that while practices with under $250,000 of annual revenue pay on average 42% in overhead, firms generating between $500,000 and $1 million per year pay 44%.

In the ideal firm, overhead expense would not exceed 35%, which according to our data does not occur for the average firm until they are generating $5 million of annual revenue. That appears to be the new critical mass from an economic perspective regardless of how many assets one is managing. The implication is that advisors below this level struggle to keep their heads above water from a cost perspective. The problem begins as soon as they add one staff member, which begins the cycle. For each salary they add, the more clients they must add to cover them; the more clients they add, the more staff they must hire to support them.

The challenge with smaller firms is that they do not generate sufficient revenue volume to support their investment in infrastructure, so the burden is more acute. Of course, for RIAs, this is further exacerbated by the need for a dedicated compliance officer, which means either shifting the focus of one of the principals or adding dedicated professionals to deal with this issue. In any case, the reality is that for advisory firms to break through the million-dollar barrier, they need to add more professional staff at a rate even faster than administrative staff to handle the growing list of clients.

In our most recent study for the FPA on Compensation and Staffing (available through www.fpanet.org), we found that the issues related to staff expectations and compensation are also rising. This is a supply- and-demand issue. Advisors are fighting over the good talent and often find that they need to sweeten the pot in terms of cash, incentives, or opportunity for equity to attract and keep the best people. Staffing needs won’t be abating in the near term either, especially for professionals.