Ever wonder why you seem to be working harder for the same or even less money? Why your practice’s revenues are up–maybe way up–but your income isn’t? Why does it also seem that just when you think your firm has finally broken through to better economics and a lighter workload, things get difficult again and those healthy profits start slipping?
If you feel this way, you’re definitely not alone. In fact, according to the 2006 Moss Adams Financial Performance Study of Advisory Firms, your rollercoaster ride is far more the norm for independent advisors than the exception. This year, thanks to our partnership with Investment Advisor, participation in the Study, sponsored by SEI Investments and JPMorgan Asset Management, reached record highs of over 1,000 firms, giving us the high-quality data we needed to confirm what we’ve long suspected: Independent advisory firms grow along a predictable path. In fact, as firms generate ever-larger revenues, they evolve through five distinct stages, each with its own challenges and opportunities–and barriers that shrink profits and boost the workload as firms struggle to break through to the next level.
Like the growth of practices, the independent advisory industry hasn’t matured in a straight line. Rather, its progress has been marked by a series of highs and lows as new challenges–finding people, delivering services, determining the best form of compensation, weathering turbulent markets, staying current with client demands–are met, battled, and overcome.
Data from the 2006 Study shows that for the independent advisory industry as a whole, both assets under management and revenues are up while at the same time, owner income has remained flat. Perhaps even more troubling, firm growth is slowing. Many advisors are thus asking themselves whether they can simply grow their way out of these doldrums or if a more radical solution may be required.
Smartly Growing Toward Prosperity
Managing overhead and maximizing productivity is always a good idea. But a detailed analysis of the evolution of advisory practices shows that advisors can indeed grow their way to greater prosperity. We believe that understanding the evolution of advisory firms is the key to making decisions that will lead you to create the practice that is right for you and to find the strategies you need to substantially improve your firm’s economics.
Advisory practices today are growing at rates not seen since the early 1980s. At the 119 firms that have participated consistently in our annual surveys for the past five years, average revenues nearly doubled from $777,927 in 2000 to $1,356,018 by 2005. During the same period, assets under management showed a similar 20% annual growth rate, jumping to an average of $228 million this year. Yet, while advisory firms were growing at these double-digit rates, their owners saw a negligible rise in income: In 2000, principals in these firms collected on average $253,010 in total pre-tax compensation; by 2005, that number had grown by only 8%, to $272,761.
The group of all participants in this year’s Study show similar results, growing their top line by an average of 20% a year during 2004 and 2005. But as Figure 1 shows, the typical advisory firm is now experiencing slower rates of growth in clients, AUM, and revenue. Moreover, owners face greater challenges of growing their larger and more complex businesses, as well as the income their firms generate.
The problem is that many firms added infrastructure to support their growth, driving up costs and squeezing profit margins. As a result, net “take home” to owners did not grow at the pace of revenue. Firms reporting in both our 2001 and 2006 Studies added, on average, 3.1 full-time employees to their payrolls during that period. Of those new staffers, 1.8 were professional employees, and 1.2 were technical or administrative support.
At the same time, firms also added almost two new advisors per firm. This quickly growing professional headcount largely fueled the impressive revenue growth. But between 2000 and 2005, direct expense (the cost of professional advisors) as a percent of revenue increased on average from 36% to 40%. The successful result of this investment in new professionals can be clearly seen in Figure 2: Firms who drove their gross margins down (revenue minus direct expense) by investing in professionals from 2000 to 2005 had about twice the growth in revenue (104% vs. 58%) over five years, as firms that kept their gross margins above 60%. On the surface it seems that the lower-margin firms are compromising profitability for growth. However, it’s not that simple: The truth is, they are taking the same type of long-term view they encourage their clients to take by investing now to reap greater rewards later.
Consequently, the antidote to lower profits isn’t to cut back on staffing. In fact, as we’ll see, the most profitable firms have more staff, not less. The real problem is poorly managed staff: Badly timed hiring, the wrong people in the wrong jobs, vague job descriptions, no career tracks, and poor motivation. To succeed in this new world of larger firms, solo practices and ensembles alike will have to find solutions for these staffing problems. The independent advisory industry has entered a new phase–one in which future success will be driven by the effective management of a firm’s human capital.
The Five Models
The independent advisory industry is indeed entering a new phase: To grow assets, clients, and revenues, firms need to leverage their senior professionals with increasingly larger numbers of junior professionals and administrative staff. This leveraging presents greater opportunities for long-term growth and viability, but it also presents challenges for protecting profit margins, particularly in the short term.
With the additional data from greater participation this year, combined with historical data from previous studies, we can specifically analyze what happens as firms add people. Advisory firms exhibit five distinct organizational models as they grow along the evolutionary path. Understanding this process of evolution provides a clearer picture of the choices every firm faces to meet the challenges of growth and competition. Each stage is distinct and requires a different approach from firm owners/managers. The boundaries separating them represent key inflection points for an advisory firm: Times when hard choices about investments and organizational changes must be made to progress to the next development stage.
We see five stages of the typical evolutionary course of financial advisory practices, defined as follows:
Early Solos: Solo firms have one owner/professional. These firms are an extension of the personal skills and time of the principal. Our analysis defines any solo practice established since 1997 (approximately the median firm age for solo firms) as an early solo, which comprise 17% of our study participants. Lifestyle preference, strategic focus, or income needs of the firm owner determine whether the firm will aspire to become an ensemble or choose to remain solo.
Mature Solos: A mature solo was established prior to 1997, representing another 17% of the firms in our study. With firms that are at least ten years old, owners of mature solos have usually made a conscious lifestyle choice to remain solo. Mature solos are focused on creating businesses that allow them total control over client service and product recommendations, as well as the lifestyle they desire.
Early Ensembles: Early ensemble firms have multiple professionals in addition to administrative and support positions, with less than $2 million in annual revenue. These firms make up 52% of our survey participants. Their median age is six years younger than other ensembles. Principals of early ensembles typically aspire to grow and direct their firms to higher evolutionary stages.
Mature Ensembles: These are ensemble firms with between $2 million to $5 million in annual revenue. To advance beyond the early ensemble stage, a mature ensemble has developed a clear business strategy and defined most of the business processes and systems it needs. Having grown to a size few advisory firms achieve (10% of firms in our sample are mature ensembles), mature ensembles pursue targeted markets in a systematic fashion.
Market Dominators: Market dominators are any ensemble with greater than $5 million in annual revenue. Accounting for just 4% of our survey sample, market dominators are the elite group of advisory firms. They are sophisticated in management and service capabilities but face issues in terms of organizational structure, professional development, and retention.
Figure 3 compares snapshots of participating practices at each evolutionary stage. Notice the distinct differences between them: Mature solos handle an average 76% more clients–yet post only about 45% more revenues–than early solos; early ensembles average 40% more clients than mature solos, yet generate 120% more revenues. Mature ensembles have three times the number of people in their firms as early ensembles, generating over four times the revenue with only slightly more than double the number of clients. And market dominators average 5 1/2 times the number of clients of mature solos, yet produce more than 25 times the revenue.
How much better off are the owners when their firms grow to the next stage? Quite a bit. As firms evolve, owners are increasingly rewarded from the benefits of scale, especially in the latest stages. The primary measure Moss Adams uses for gauging the financial success of a firm is pre-tax income per owner–the total annual compensation and profits that owners draw from their firms. As firms move up the evolutionary ladder, the income generated by owners grows dramatically.
Owners of early solo firms have a median pretax income of about $100,767 per year–equivalent to what a senior advisor might make as an employee at a larger firm (but with the independence and flexibility of being one’s own boss). Owner income rises rapidly once a firm evolves beyond the early ensemble stage, with median pretax income for mature solo owners at $157,050; for early ensemble owners at $191,429; for mature ensemble owners at $429,842; and peaking for owners of market dominator firms at nearly $850,000. Clearly there are benefits to size.
There is, however, a cost associated with the higher owner incomes. The number of hours worked increases consistently as owners advance up the evolutionary ladder. While the owner of an early solo firm works an average of 46 hours per week, market dominator owners work 10% more, about 51 hours. Rather than viewed as simply a cost, however, this difference may also reflect that large-firm owners are able to earn more income on an hourly basis, and as a result, have a greater incentive to work more.
The Study isolated the top quartile firms (by owners’ income) within each stage of evolution and identified their best practices that others can apply to increase their own success and prepare for the next evolutionary step, if the owners wish to do so. Top quartile firms at every evolutionary stage tend to leverage their professionals with greater non-professional support. Top quartile solos, especially early solos, tend to be even more leveraged with non-professionals than their ensemble counterparts.
Focus on: Early Solos
Our analysis defines early solos as firms with less than the 10-year median age for all solos. We recognize that some of these firms may already be committed to the solo model, while some older firms may still harbor ambitions of becoming ensembles. Overall, however, we feel the age-based distinction, while simplistic, produces a fairly accurate depiction of early solos in aggregate.
Figure 4 details the comparative staffing models of top quartile early solos versus their peers. Top quartile early solos typically consist of one professional, one administrative position, and a support/technical position. That gives them about twice the administrative and technical capacity of their peers. Top quartile early solos also gain leverage by looking to outsource or automate operational tasks wherever possible. As a result, top quartile owners of early solos spend less time on operational issues and more on business development, which pays off in the form of winning more clients that are within the firm’s target market.
There are many positive aspects as well as challenges associated with the solo model, and the relative balance of these will determine which model a solo practitioner will choose down the road. Like the decision to become a solo practitioner, the decision whether to remain a solo practitioner is based on the personal definition of success of the individual advisor. While income potential is one aspect that may be considered, other factors influencing the decision likely center on lifestyle preferences and the desired span of control. No matter which route an advisor ultimately chooses, solo practitioners overall are generating a very healthy $177,00 in average income and have complete control over their firms–which may be the only measuring stick of success and job satisfaction that they need.
Average total revenue for solo firms who anticipated transitioning to an ensemble model by the end of 2006 was $432,000. Additionally, only about one in five solo practitioners in the study were above $500,000 in revenue. These findings suggest that the typical jumping-off point to ensemble is before a firm gets to $500,000 in revenue. This is consistent with what we have observed for early ensembles: They typically have two professionals and generate $750,000 in annual revenue, or approximately $375,000 in revenue for each professional. If growth is the goal, firms should probably start looking to hire new professionals as soon as revenues break $450,000.