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.
Without a clearly understood service process, junior professional positions will struggle to match the expectations of the client or replicate what “Bob” can do. That frustration is usually visible among both the professionals and the clients they service – there is a sense of downgrading if they don’t work with Bob. This becomes a severe capacity limitation (Bob is the scarce resource) and tends to promote a culture of “wanting to be Bob.” Needless to say, when the professionals finally acquire the skills and expertise to be like Bob, they tend to look for a position inside or outside of the firm that gives them the control and power “Bob” had – i.e. they either fracture the firm by building their own little silo or leave to start one of their own.
3. Identify markets and sources of new business that support the institutional value proposition, and find business development processes that are consistent with the strategy. Not every market will support an institutionalized approach. In fact, I would propose that the best markets for an institutionalized firm are at the two extremes of the wealth spectrum – the mass market and the very high-net-worth. The reason is that they have service expectations that are consistent with the idea of a firm-level service. The small, mass market accounts generally are treated as institutional clients in all of their financial needs. They are accustomed to bank and brokerage firms who service them through 1-800 numbers and websites, and they generally do not expect a personal relationship with an advisor. Any personal attention is highly appreciated, but there is less resistance to multiple people being involved. In the other extreme, high-net-worth individuals are accustomed to institutionalized service – their CPA firm, their bank, their trust company have all likely surrounded them with teams of people rather than one key contact. That said, many other markets can be addressed by an institutionalized strategy, as long as it is well-differentiated.
Many firms have a hard time switching from a personalized business development mode to a more institutionalized mode. After all, usually the firm has been built on the strength of the personal network of the founders and it is difficult or counterproductive to replicate that institutionally. For example if the firm has grown through Bob’s network and connections, but wants to now become a large investment manager, it will be very inconsistent to continue relying on Bob or sending Bob-juniors to every country club in town. It might be better to seek sources of new business that lend themselves to an institutional approach. Examples of such sources include CPA firms, banks, direct marketing to consumers, broker-dealers or other networks of advisors, custodial or broker-dealer platforms, etc. Identifying such opportunities is not easy or inexpensive, but relying on personal networks promotes the rent-the-owner model even if we increase the number of people involved.
4. Behave like a large firm. The first step to becoming a large firm is believing that you are one. This means that your firm will have to transform its culture from relying on personal relationships and opportunistic communications to being driven by procedure and structure. This sounds scary to most advisors and they see pending bureaucracy and politics in that transformation. However, nothing is further from the truth – personality and entrepreneurship can exist even in the largest firms, as long as they are directed toward the institutional goal. What has to go, however, is the haphazard approach to service, data gathering and documentation, following of process, the way that decisions are made and the general approach to the business.
It is very common to see advisory firms using their size as an excuse for operational difficulties or mistakes, poor hiring decisions or lack of progress on important initiatives. If a firm wants to grow it really has to shed that mentality and aspire to behave and act like the larger image it wants to grow into.
Essentially this means a shift of focus from relationships to results. Most of the management decisions in smaller firms are driven by relationships – “He is a great guy!” or “He is not very good at that, but he is very loyal.” The reality in a larger firm is that there has to be a focus on results – there really is no way to accommodate the larger number of people in a relationship based management. The statements should turn to “He is great guy, but his performance was below his potential this year,” or “He is not good at this, therefore we need to hire somebody else who can do that job.” Again, this may sound rather cold and impersonal, but in fact it is the only fair way of treating a larger group of employees, so it is either a results-driven approach or a small firm forever.
5. Become CEO and executives, and establish a decision-making infrastructure. Many advisors are uncomfortable with the responsibility of acting like CEOs. In particular, they struggle with managing people and accepting responsibility for the decisions made. The stakes, however, only get higher and the responsibilities get bigger. As a firm grows, the size of budget decisions will increase, the complexity of the operations model will increase and managing the people in the firm will become more difficult.
The burden can be crushing and you hear advisors saying “I don’t want to be the bad guy,” or “I don’t want to be between the two of you.” Unfortunately, that’s what a CEO or an executive does – they make tough decisions under stress and with the potential of upsetting people. As my grandma often said, “You can’t make an omelet without breaking some eggs.”
The decision-making process and interaction of the partner group has to change as well. Most small firms are driven by a consensus process. As the partner group grows, consensus may become impossible or impractical. It is important that the partners are prepared for the transition and have the resolve to carry it through.
6. Invest in people and develop a mentality of investing in people. In any service business, financial advice included, the quality of the professionals involved is a critical factor for the success of the firm. Professionals, however, are rarely available widely in the market and the price of talent is high. This puts an enormous premium on firms that are good at developing people. An advisory firm that does nothing else but creates a reliable process for developing professionals is guaranteed to be successful almost regardless of any other factor discussed here.
It is difficult for the owners of most firms however to shift their focus from clients to people. It is a scandalous but probably true statement in most large firms that the development of professionals is more important than client service. I don’t mean that you should neglect clients, but if you have a chance to provide a young professional with a training opportunity, even if that “displeases” an important client, the scales should perhaps tip in favor of the employee (by no means suggesting risking any damage to the client’s financial interests – just their ego). Unfortunately, too many times firms pull out younger professionals from key assignments at the first sign of trouble.
Budgets should also support hiring, perhaps even ahead of demand, once a firm enters into a stage of trying to institutionalize itself. Recruiting and training is definitely scalable as accounting firms can attest, and that’s why they hire entire classes of new employees.
7. Think in terms of expert jobs and set the foundation for departments. In smaller firms, tasks are simpler, but diverse, and most positions are hybrids in nature – i.e. can easily be split into multiple jobs. Larger firms tend to bring more complex tasks and specialized processes, requiring that the firm retools itself with specialists rather than diverse generalists. This is a painful process since the “Swiss army knife” employees are incredibly valuable in the early stages and tend to have a problem specializing later as the firm needs that. The earlier the owners start thinking about specialization and encouraging employees to focus on fewer but deeper skills, the less painful this process will be.
8. Establish a culture of firm ownership of clients. Finally, for all of this to hold together, everyone should share the deep fundamental belief that the clients are clients of the firm – not just legally, but in terms of who the relationship is with and what the role of the professionals is in this relationship. This is where wirehouses go wrong very often in their efforts to institutionalize their business model – they follow many of the steps we discuss above, but they create a culture of personal ownership of the client promoted by the compensation process and the branch management priorities. If a professional believes that this is “my” client, they will actively undermine every other step taken to institutionalize the relationship – whether they do that consciously or not.
There are many successful firms in the industry today that generate great income for their owners and have wonderful staff and clients. The vast majority of them will be dependent on the owners for the length of the their career and will then dive into a risky process of trying to reinvent themselves around a new generation of owners or under institutional ownership (or both). There were many coffee shops in Seattle before Starbucks and there are still plenty left. Only a couple of them, however, became a nation-wide chain with amazing growth and return to its shareholders. There are many accounting firms in the country, but there are only a few that have the prominence and presence of KMPG, PWC or E&Y. Similarly, there will be only a few firms that cross that bridge between an institutional strategy and a rent-the-owner strategy. For each firm, however, the more of these eight issues it can address, the higher its value will be and the more sustainable its growth and success.