This is an extended version of the article that appeared in the June 2011 issue of Investment Advisor.
Large financial advisory firms are more profitable, grow faster and have higher equity value per dollar of profit. The largest firms also have an advantage in attracting talent and have an easier time establishing referral relationships with CPA firms and banks. Yet, very few firms manage to reach the size and scale where they can reach these advantages. While the entire industry continues to grow and the average size of an advisory firm has more than tripled since the year 2000, by our estimate no more than 300 firms have reached over $1 billion in assets under management (AUM) – an arbitrary mark for what we could consider a large firm.
The biggest obstacle to growth that otherwise successful firms face is the ability to define and deliver a value proposition that goes beyond the skills and expertise of the small group of owners. “Trapped” in the physical limitation of time, energy and knowledge that the three or four principals possess, firms struggle to create a business model that can transcend that limitation and allow them to reach the true advantages of size – most of all market dominance, reputation and ability to add talent.
- The 2010 Advisor One Survey of the top wealth managers in the country shows that firms with over $1 billion in AUM had consistently higher growth rates every year since 2005 compared to their smaller competitors. The billion-dollar firms in the survey also showed higher revenue per client and higher productivity ratios.
- The Fusion Challenge Survey shows that the largest firms had close to three times higher income per owner ($935,000), compared to their smaller peers ($338,000).
- The “Real Deals” report published by Pershing LLC and FA Insight shows valuation ratios of 3 x revenue and higher for the largest firms, compared to the ratios reported for smaller practices in the FP Transition reports (ratios range from 2.2 x revenue to 2.5 x revenue).
Growing past the owners, however, is very difficult for most firms – it is counter-intuitive to the owners, often culturally objectionable as it violates the values of the firm, and frequently it is even undesirable to the professionals in the firm as it runs contrary to their personal definition of success. Yet, for firms that aspire to achieve that size and the strategic position that comes with it, there is a reliable path of transformation that can be followed. The path requires emphasis on strategy and process, perhaps at the expense of individualized attention to professional careers.
If we trace the evolution of an advisory firm from origin to the largest size category (let’s assume a large firm is one with over $1 billion in AUM) we can define the growth in these four stages:
Practice Growth One or more owners are trying to grow their practice to critical size. The focus is on acquiring clients. The value proposition focuses on the attention and time the owners will devote to their clients. The acquisition of clients is often unselective and opportunistic. There is little focus on business management as the owners are the business. Revenues can range from $500,000 to $1 million before the practice has to enter into the next stage.
Team Service Having grown to critical mass and met basic income requirements the practice starts to focus on adding staff. Employees are hired for specific functions and they start playing significant roles in client service. Positions such as client service administrator and associate advisor are added. While the value proposition still rests with the skills of the owners, the service delivery is based on a team. The firm starts to consider its strategy and add clients selectively. There is emphasis on employee training, compensation and management. Revenues can range from $1 million to $3 million in this stage, depending on the number of partners.
Partnership The firm starts to use employee professionals – non-owner employees who independently service clients. There are protocols and standards for service that are established and followed throughout the practice. Employee management practices are well-developed and thought out. The strategy of the firm is well-articulated, and there is a systematic business development process. Client selection and risk management are emphasized, and the partners of the firm act as a management team. Revenues range from $3 million to $10 million at this stage.
Past the Owners (Institutionalizing) The firm has developed a value proposition that is “abstract” and institutional in nature. The owners are recognizable, but not essential to the value proposition of the firm or delivery of service. The firm has a strong sense of identity that is shared by the entire professional team. Owners focus their time on strategic level projects. Ownership and firm management become separated – some owners focus on management only – and departments within the firm are clearly defined. The culture of the firm is no longer defined or controlled by the owners. Revenues exceed $10 million.
The fourth phase defies many otherwise successful firms and continues to be a challenge for all successful firms. Even among the top firms in the industry, if we were to interview the clients and the staff of the firm we will find that they think of the firm as “Bob’s firm.” Similarly, the value proposition of the firm boils down to “you get to work with Bob” – Bob being working title for the ownerprincipallead advisor of the firm. It is really Bob’s expertise and knowledge that the client is attracted to and wants to associate with. Bob’s ability to communicate and respond to the client will further become part of the value proposition. You will hear clients and staff describing the firm as “Bob’s firm” and chances are the same description is used by many referral sources. Chances are Bob thinks of the firm in those terms too. I propose we call this value proposition the “rent-the-owner” proposition. Over time, as the firm grows it may become “Bob and Scott’s firm” or even “Bob, Scott and Stu,” but the firm is completely defined by two or three names. This owner-dependent proposition is natural and inevitable in the “Practice Growth” and “Team Service” stage, but starts to get in the way in the “Partnership” stage and becomes a barrier to entering the largest stage of growth.
A firm can grow very large on the strength of the expertise and talents of the owners. The rent-the-owner strategy is very appealing and intuitive, but ultimately flawed. It is easy to deploy and comes to the owners naturally. It is also easy for clients to understand – people easily relate to other people and develop personal relationships. It is much more difficult to win their allegiance to an idea or a concept. The flaw in this approach, though, is that ultimately it relies on “Bob” – when Bob is gone, the firm will have to somehow find “new-Bob” to replace him. It is hard to create high equity value in this model and it is hard to grow the firm past the individual limitations of “Bob and partners.” Those limitations can be simply time available, but they can also be skills, expertise, aptitude to tackle certain kinds of business, etc. Ultimately, “Bob’s firm” will have to reinvent itself as “Your Name’s firm” and is always in risk of entering a cycle of slower growth and declining opportunity – usually as “Bob” chooses to slow down himself.
The rent-the-owner proposition is difficult to change or overcome, but for those firms who aspire to become multi-billion dollar enterprises with lasting presence, changing the model to an institutionalized value proposition is essential. The firms that I have worked with that have been successful in this transition tend to follow these eight steps:
1. Conceptualize an institutional value proposition, and structure your strategy and business plans around it. Before building the institutional firm, you have to be able to draw the blueprint – the conceptual value proposition you are trying to implement. How can you differentiate as a firm, as opposed to individually? What are the components of your personal expertise and experience that are transferable to the firm?
Examples of institutionalized strategies are firms that focus on specific target markets and develop unique tools that service that market – for example Mercer Global Advisors and the way they specialize in servicing dentists. Note the difference here between a strategy that can be institutionalized and a similar strategy that still relies on the owners. There are many firms that have one partner who knows something about dentists – Mercer, however, has built its entire business model and expertise around that market.
In developing the concept, you need to focus on differentiating factors that can be institutionalized. The incomplete list of such factors includes data and the insight from it, in-depth knowledge of a distinct market niche, methods for training and developing staff, unique investment style and models, a service culture that can propagate itself in multiple locations, etc. Just like with a house, if you can’t draw it first, you shouldn’t start building it.
2. Structure client service around repeatable steps that can be accomplished by trained employees with the kind of skills that are widely available in the market. Most institutional strategies require the creating of a repeatable service experience that the firm can train to. While it is certainly possible to become the kind of firm that develops a custom process and hires the brightest people to figure out each individual case (e.g. the consulting firm McKinsey), most firms focus on strategies that favor service standardization. The repeatable process will allow the firm to hire widely available talent and employ them in delivering extraordinary service.