The Architects

Many of the challenges currently facing the industry can be characterized as “nice problems to have.” That is, they are issues largely resulting from industry development and prosperity. The problem of labor scarcity, for example, is a well-known challenge brought about by extensive industry growth. Shortage of talent is also closely linked to another “nice” problem–transitioning ever-appreciating shares of equity.

Across the industry, firms have grown rapidly in recent years and, as a result, have appreciated rapidly in value. Growth has also served to drive up the demand to recruit and retain experienced personnel. These factors, combined with the demographic fact that a significant segment of the firm owner population is nearing traditional retirement age, have elevated ownership-related issues to a central role in the continued development of an advisory firm.

So now let’s focus on this major challenge for even the most successful firms. Many founding owners will soon need an exit solution for extracting liquidity from businesses they have worked hard to develop. The typical firm owner is 49 years of age. More than one-third of owners, 37%, indicate they are within 10 years of retirement (see Chart 6). The result is a tremendous wave of firm owners in the midst of a liquidity crisis. First-generation firm owners, long focused on building business value, are now shifting their focus toward liquidating some, if not all, of this value.

Signs of this shift are present throughout our study results. While just 6% of firms had a partner retire in the last two years, nearly one in four, 24%, of the “market dominator” firms, the largest firms participating in the survey, had an owner retire. Prompted by founding owners’ desire to diversify out of their shares, but also by an interest in promoting and retaining the firm’s next generation of leaders, 28% of firms admitted a new partner within the last two years. More than half of all market dominators admitted a new partner.

Our study results suggest that many more owners would like to transition their shares to a successor but are challenged to find a solution. Only one in four firms indicates having a well-defined succession plan (see Chart 7). Many firms, 44%, have no plan at all. Aside from the need to have a plan, the bulk of firm owners, 48%, cite identification of the right successor or selling to someone within the firm as the most important factor for them to successfully transition out of their firms. A firm’s appreciation in value is creating a double-edged sword. The firm represents tremendous value to founding owners, but lack of a practical plan for succeeding shares to junior partners, who are often ill-equipped to finance their purchase, creates liquidity and next-generation leadership-development issues.

Owners are often forced to look externally for a succession solution. Within the last two years, 29% of all firms considered a sale, including 1% of all firms that actually completed a transaction (see Chart 8). About 60% of firms that consider a sale do so for reasons related to liquidity. The majority of these directly reference a desire for a succession solution. An even larger portion of firms is interested in buying another firm. More than half, 55%, of firms expressed interest in an acquisition, including 3% who recently completed a transaction. While acquisitions are traditionally motivated by growth goals, owners of mature solo firms in particular are considering acquisitions as a means for transitioning out of their businesses.

Transferable Value Is Crucial

Ultimately every owner will someday need a liquidity solution. Regardless of where their firms are developmentally, owners will be well served to focus on creating the broadest opportunity set of possible liquidity solutions. This will require owners to plan carefully, taking specific measures at each stage of development to build transferable value and avoid a final-hour “fire sale” of the firm. The challenge for a firm owner is to maintain income generation while not losing sight of the need to run the business in a way that builds transferable value.

Firms will occasionally peak in terms of income per owner while operating in a manner detrimental to building and realizing value. While high-income firms are to be congratulated, they have possibly earned just a partial victory. Owners of these firms must vigilantly monitor many other operating factors that introduce risk or dampen growth prospects and ultimately influence value. These include the following:

Concentrated ownership. By definition, firms with concentrated ownership, all else being equal, will yield higher income per owner but will not necessarily yield more value. A firm whose ownership is more broadly distributed may be more sustainable, and hence more valuable, given that more key people and future leaders have a direct and vested interest in the long-term success and viability of the firm.

Over-reliance on key individuals. The most obvious forms of over-reliance occur when an individual dominates the firm in either sales, investment strategy, or service delivery. Over-reliance, especially when coupled with lack of repeatable processes or inadequate succession planning, can severely hamper an owner’s prospects for getting sufficient liquidity out of the firm.

Overworked professionals. Sometimes a firm achieves high income driven by productivity of its professionals. While high revenue per professional generally indicates good productivity, it may also be a sign that professionals are simply taking on more than is sustainable in the long run. Under this scenario, business risk increases because of possible employee “burn-out” or deterioration in client service.

Depleted client base. This is occasionally evident in mature firms with owners nearing retirement. The firm’s client base, while currently profitable, is aging and in need of replenishment. In addition, the client base may lack focus in terms of a targeted market, which may hinder transferability.

Lack of repeatable standardized processes. Transparent and routine processes are at the heart of a valuable and transferable enterprise. If a firm’s processes vary by the client or staff member, this creates business inefficiencies as well as posing significant risks to the smooth transition of responsibility for client relationships.

Lack of scalable organizational structure and operational infrastructure. Just because a firm can efficiently work at capacity at present does not mean this will always be the case. The most valuable firms are set up in such a way that the organization and its support structure grow seamlessly and incrementally with new business.

Our survey data suggests that top-quartile firms in terms of income per owner are largely practicing in a manner consistent with building value. While there are a few areas of concern, what those firms with high income per owner are doing right outweighs what they are doing wrong. Only a tendency toward more concentrated ownership and challenges with succession planning stand out as factors that could significantly weaken firm value.

The Best Yet to Come

One of the most exciting aspects of the independent advisory business is that despite the tremendous success the industry has had to date, plenty of potential exists for further growth and improvement. Firms continue to experience steady client growth. In addition, the gap between the industry’s top-performing firms and others demonstrates the potential for improvements in productivity, efficiency, and, ultimately, profitability. The best practices of these elite firms provide invaluable lessons for others to more fully realize this potential.

As our data reveals, in the earlier stages of a firm’s development the best firms demonstrate disciplined client selection and a propensity to automate or outsource non-core functions. As these firms progress, they are able to spend more time on client service, business development, and directly generating revenue. Owners of top-performing established solo firms, for example, spend 56% of a typical day on either client service or business development, compared to 46% for other owners.

As firms grow, the service set also evolves, but the number of services offered doesn’t necessarily increase. Regardless of their stage of development, firms tend to offer six or seven services to the majority of their clients. The best firms focus on what is core to their firm and their client relationships. Owners ensure that each service is used by a meaningful proportion of their clients, is value added to the relationship, and is something for which they can charge. As a result, top-performing firms, particularly the larger ones, generally price higher and earn greater revenue yield off assets managed. The top 25% of market dominator firms, for example, yield five basis points more revenue per dollar of assets managed compared to their peers.

Year after year, we note that at every development stage the best firms use more non-professional staff to better leverage the time of their professionals. Further, professionals become increasingly leveraged as firms grow in size.

The independent advisory industry continues to develop rapidly but is yet to fully reach maturity. While much progress has been made, many firms have yet to find the optimal solution for operational areas such as human resources, organizational structure, financial management, technology, marketing, and use of strategic partners. The strong growth rates of the industry’s largest firms relative to smaller firms illustrate the virtues of economies of scale, suggesting that firms can grow bigger still and promise ever-greater rewards to firm owners.

While the current flux in performance of the financial markets may cause advisors concern, forward-thinking firms will recognize this as a time of opportunity. The demand for objective financial advice is not only not going away, but is likely to increase due to the well-known demographic trends in the United States. The best firms will continue to improve their efficiency and effectiveness in serving this market. Specifically, they will use the months ahead to reinforce the value proposition they offer clients and reinvest in their businesses to best capitalize on the next growth cycle for securities. Truly the best is yet to come. Market tribulations, however, serve as a sobering reminder for firm owners that sound practice management, including prescient succession planning, trumps asset appreciation as the key to prosperity. That’s the case both on an operating basis, and at the eventual liquidity event.

Dan Inveen, CFA, is the senior research manager for the Financial Services practice at Moss Adams. Contact him at [email protected]. Investment Advisor readers can purchase a specially priced copy of the complete study discussed in this article at www.mossadams.com/2008advisorstudyIA.