By just about any measure this is a very good time to be an independent advisor. Ironically, however, the latest Moss Adams Study of the profession finds that the success of independent advisory firms contains within itself the seeds of what is one of the greatest challenges faced by the principals of those firms since the profession was founded.
After all, the typical advisory firm owner has built a successful business that has increased many times in value since its founding. Those businesses have demonstrated strong growth in recent years and the prospects for continued growth remain solid. So what’s the big problem? What constitutes this greatest of challenges, even and especially for those firms that are already highly successful? It comes down to this finding: Many firm owners find themselves holding concentrated positions in a valuable asset with no clear option for unwinding these positions and passing on ownership to a new generation of firm leaders.
In this exclusive article based on the 2008 Moss Adams Financial Performance Study of Advisory Firms, we review the industry’s record of success, but we also outline those salient ownership issues in detail and prescribe solutions to the ownership challenge inspired by real-world strategies of the best firms that are building transferable value and thereby creating succession options for the founding owners. Moreover, those successful firms’ best practices when it comes to succession also benefit the next generation of advisor owners, and most important, those firms’ clients. This year’s study, sponsored by Genworth Financial Wealth Management, draws from financial and operating performance data submitted by more than 700 independent advisory firms. The report marks the 14th industry review completed by Moss Adams since publishing its first study in 1992.
The Metrics of Good Times
By every measure, advisory firms experienced healthy business expansion in 2007. The typical firm grew its client base by 9%. Growth in assets under management (AUM) doubled client growth, at 18%, fueled not simply by new clients but by gaining a greater wallet share from existing clients in addition to market appreciation (remember that phenomenon?). Revenue growth topped all measures, jumping 22% during 2007, following an 18% increase reported by these same firms in 2006.
Facing a head wind brought about by slowing equity markets in the latter part of the year, firms continued to increase revenues and owners continued to draw higher levels of income from their firms. Income, as measured by pre-tax income per owner, has climbed steadily among our survey participants since 2001. Last year was no exception. In 2007, the typical firm owner earned $259,500 in total income (job compensation plus returns from ownership). This figure was more than double the pre-tax income per owner for survey participants reported just four years ago.
New clients, new assets from existing clients, and improved retention all helped offset whatever effects market depreciation may have had in 2007. The difference between equity market growth and advisor AUM widened considerably in 2007 and is expected to continue widening in 2008. Chart 1 demonstrates the dynamics of asset growth for the industry, which specifically measures the small contribution of market performance relative to the very impressive gains from simply handling more assets from more clients. Relative to past years, assets lost from distributions and lost clients are declining as well. Not only are more clients forming relationships with independent advisors, but these relationships are increasingly sticky.
More important, as advisory firms continue to grow their client base and manage more client assets, they are also increasing the revenue generated from them. The trends are impressive and provide insight into the continued rise in owner income. Not only were firms able to add clients at impressive growth rates, the growth in assets was even higher and revenue growth higher still. This suggests that advisors continue to serve a bigger market and are improving their productivity in doing so.
Despite a threatening bear market for equities, advisors expect 2008 to be another year of healthy growth. At the time of our survey fielding, during the early months of 2008, firms anticipated client numbers to grow at virtually the same 9% rate they experienced in 2007. Expectations for AUM growth were at 13%, which were tempered somewhat relative to what firms experienced in 2007. Perhaps the strongest sign of confidence in the future, however, is represented by firms’ plans to expand staff–at least one-third of all firms will make some sort of hire. As a result, staff across the industry is expected to increase 16% during 2008. Most hires will be made for professional positions, but technical specialists will see the greatest percentage increase (21%).
No Firm Left Behind
Growth was widespread in 2007, with rates of annual revenue growth safely beyond double digits at every stage of development. As with past years’ studies, we divide and analyze firms according to five stages of evolution defined as follows:
Early Solo. Solo firms have one owner/professional. Our analysis defines any solo practice established since 1999 (approximately the median firm age for solo firms) as an early solo.
Mature Solo. A mature solo differs from an early solo in terms of firm age. Solo practices established in or prior to 1999 are defined as mature.
Early Ensemble. Ensemble firms typically have multiple professionals in addition to administrative and support positions. Our analysis defines early ensemble firms as any ensemble firm with less than $2 million in annual revenue.
Mature Ensemble. Mature ensemble firms have between $2 million and $5 million in annual revenue.
Market Dominator. Market dominator firms are defined as any ensemble firm with more than $5 million in annual revenue.
Firms across all evolutionary stages reported strong growth rates in recent years (see Chart 2). From 2005 to 2007, however, the highest growth rates were experienced by early solos, early ensembles, and market dominators. Early solos, with a growth rate calculated from a smaller denominator, led all firm types in two-year compound annual rates of growth for revenue, AUM, and clients. Because they are newly formed and have not yet reached their capacity in terms of clients and assets managed, they can grow at an exceptionally fast pace. Early ensembles have just gone from a one-professional practice to a two-professional-or-more practice, which enables them to significantly increase the number of clients and assets they are able to take on.
Market dominators are able to take advantage of their economies of scale to maintain their high growth rate. The fact that they are growing more rapidly than most other firms suggests that they have yet to reach optimal size. Recent history demonstrates a trend toward an increasing number of large firms. We categorize multi-professional firms generating $5 million or more in annual revenue as market dominators. Five years ago fewer than 1% of participating firms met these criteria. Today 55 firms, or more than 8% of our sample, are in this size range.
Leverage Yields Greater Income
Perhaps the most obvious performance distinction across the stages of development relates to owner income. Pre-tax income per owner becomes increasingly rewarding as firms increase in size and move up the development path (Chart 3). This is particularly notable in the progression from early ensemble to mature ensemble, in which mature ensemble owners take home more than twice the income of early ensemble owners. Market dominator owners are earning the most, with a median pre-tax income per owner of $936,000.
Driving this trend is leverage that works in favor of the large firm owners. Total owner income makes up just 13% of revenue for market dominator firms compared to 51% of revenue for early solos. Revenue is 33 times greater at the market dominator firm, however, and there are proportionately far fewer owners at each market dominator to share firm income. Chart 4 illustrates the prevalence of owners at each stage. The one owner that is typical of the early solo firm makes up 50% of the firm’s personnel. In contrast, the typical market dominator firm, despite its much greater size, has just two owners that account for 9% of firm personnel. While large firm owners have greater responsibility for managing staff, the staff creates leverage for owners and yields higher income.
As we have seen in previous years’ Studies, the staffing structure of an advisory firm evolves as firms move across the development stages. Professionals at early solo firms are usually performing multiple roles–from client service and business development to administrative tasks and office management. However, in order to stimulate greater growth, these professionals will eventually need to take on more non-professional staff to free their time to focus on the revenue-generating aspects of the business. On average, mature solos have 2.2 non-professionals per professional, compared to only 1.3 non-professionals in early solo firms (see Chart 5).
Similarly, ensembles leverage their professionals to a greater extent as they mature. Early ensembles may not yet have the financial resources to take on an optimal level of non-professional staff. In addition, their size limits the extent to which individuals can specialize full-time in a job, resulting in fractionalized jobs. A given firm may, for example, need only five hours of weekly operations help, five hours of accounting help, and five hours of technology help. Professionals are forced to multi-task.
As a result, early ensembles have the lowest number of non-professionals per professional. However, as these firms generate more revenue and achieve more scale, they invest in additional staff, and more specialization, across all position types. Market dominators lead ensembles with 1.9 non-professionals per professional compared to a low of 0.9 for early ensembles.
The Growing Importance of Ownership