Endangered Supply

Recovery continues for financial advisory firms. Driven predominantly by sustained appreciation in security markets, virtually all performance indicators for advisory firms trended upward in 2010. As firms grew again, so did their need for people. Always an important part of a firm’s budget, people-related costs increased from 77 cents of every dollar in average expenses in 2008 to 80 cents in 2010. People will continue to be a priority in 2011, with the typical firm projecting to expand from 6.1 to 7.4 full-time equivalents (FTEs) (See Figure 1).

For advisory firms, people represent the critical ingredient for growth as well as building value and effective succession planning. Achieving these objectives, however, will require firms to shore up weaknesses with regard to how they deploy and develop staff. Reflective of growing labor scarcity, compensation levels are on the rise again, retention is at risk and the source of the next generation of firm leaders is unclear.

With The 2011 FA Insight Study of Advisory Firms: People and Pay, FA Insight endeavors to support advisory firms in confronting these challenges. People and Pay, our recently released third annual industry study, is our second study with a special focus on human capital. A primary intention of the 2011 People and Pay study is to assist firms to not only attract and retain the right individuals, but to map a path that progresses people toward ownership and management responsibility.

Upward Trends and New Challenges
While the industry is yet to return to pre-recession growth rates, recovering security markets fueled a healthy rise in advisory firm assets under management (AUM) during 2010, which in turn supported strong revenue growth for the year (See Figure 2, next page). Typical firm revenue jumped 18% in 2010. Despite increasing rates of client growth, the pace of revenue growth is expected to slow to a 13% rate in 2011 as AUM growth cools.

Profit margins expanded in 2010 as revenues outpaced growth in expenses. The median operating profit margin in 2010, at 19%, represented an eight-percentage-point improvement over 2009 (See Figure 3). Owner income, including profits and owner compensation, also showed strong improvement over the year. Median owner income as a share of revenue rose to 50% in 2010 from 44% the previous year. Median income per owner, at $261,000, was up 14% in 2010 relative to 2009.

Improved firm performance has put owners in the mood to hire again, which is beginning to put upward pressure on wages. Firms are most interested in beefing up support personnel, with a 16% average increase expected in 2011. Hiring is also expected to be strong for professional positions. In the past two years, compensation growth for advisor positions has surpassed national all-industry averages as the advisor labor market tightens. Median compensation for associate advisors jumped most sharply in the two years since 2009, increasing 17%. This mid-level advisory position is clearly in demand as firms seek to plug the gap between their most experienced advisors and their support personnel.

While just 45% of firms had an associate advisor on staff in 2009, by 2011, 60% of firms had at least one team member in the position. Despite the growth, roughly two associate advisors exist on average to replace every three lead advisors (See Figure 4, next page). Further, the typical lead advisor has 20 years of experience, more than double that of associate advisors. Their level of seniority is not only difficult to quickly replicate, but a very real reminder that many lead advisors are soon approaching retirement. Firms will need to do more to ensure that a new generation of advisors is in place in order to better build, sustain and transfer firm value over coming years.

Looking to Standout Firms
Despite clear signs of recovery, firm owners cannot afford to relax. Unless the development of personnel can be strengthened, high-quality talent becomes scarcer, firm growth is restrained and succession options for owners narrow.

One source for guidance on these issues is the industry’s best-performing firms, which we designate as Standout firms. Standout firms represent the top 25% of firms at each stage of development in terms of two key performance indicators: revenue growth and owner income as a percentage of revenue. Depending on firm stage, Standouts showed 9% to 33% higher revenue growth than other firms in their stage, and produced 11 cents to 20 cents more owner income per dollar of revenue.

With regard to use of personnel, people-related expenditures tend to account for a greater share of total Standout expenses. This greater allocation pays off for Standouts, whose team members are more productive, managing more clients and more revenue per FTE. Standout pay practices also help to support this productivity advantage. While compensation levels are similar between Standouts and other firms, Standouts more frequently use performance-based incentive programs and use them more effectively than other firms, linking pay to a wider range of individualized objectives.

Providing more team members with further incentive to perform, Standouts show a broader distribution of firm ownership. Owners account for a greater share of total FTEs in Standout firms compared with other firms. A more open approach to ownership, combined with greater internal career opportunities brought about by growth, also contributes to generally better staff retention among Standouts.

Although Standouts clearly outperform other firms in important areas, with certain personnel practices there is no apparent superiority. One area of weakness for Standouts, as well as other firms, is the lack of a clearly defined organizational structure that can support firm growth and progress team members. Standouts are also comparatively lax in offering formal training programs and conducting routine performance evaluations. These deficiencies in developing personnel may be affecting the ability of Standouts to move toward effective succession planning. Despite proportionately more widely spread ownership, only a minority of Standouts feel they are adequately prepared for succession.

The Challenge of Succession Planning
Without a proper succession plan, even Standout firm owners will have only limited success in extracting liquidity from their firms upon exit. Lack of succession planning is of concern across all firms. As the business ages and grows and founding owners prepare to retire, shares become increasingly valuable and less affordable to a new generation of owners, causing ownership to become increasingly concentrated.

In 2010, fewer than one in six staff members were primary owners (holding 5% or more ownership), with the ratio falling to one in 10 for the largest firms. Additionally, nearly half of primary owners (48%) are within 12 years of retirement, and almost 18% expect to retire within seven years. Despite the need for urgency, the level of succession preparedness is largely unchanged in recent years. Two-thirds of firms do not have an adequate succession plan, and more than half of these indicate having no plan at all.

The most effective plans will support the transfer of equity shares as well as a smooth transition of responsibilities for client relationships, business development and management oversight. Striking differences exist between firms that do and do not have an adequate succession plan. It is not surprising that these differences primarily relate to the ability of better-prepared firms to develop and advance people, thereby creating a fertile environment for grooming qualified succession candidates.

Progressing People Is Paramount
Good people practices tightly correlate with succession preparedness, but effective use of people can also be an important solution for controlling costs, improving efficiency, preserving culture and building sustainable value in the firm over the long term. Although expenditure on people dominates a firm’s expenses, even the best firms appear challenged to properly progress their personnel in order to maximize their return on this investment.

Organizational structure can provide a vital road map for a firm in advancing people upward through its ranks of responsibility, but is a relative weakness for firms of all sizes. Although more than two-thirds of firms have documented their current organizational structure, just 14% have a plan for how their structure should change as they grow. A clearly documented organizational structure will also include detailed position descriptions, supporting productivity by clarifying accountability. Despite the benefits, only 38% of firms have documented position descriptions.