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September 25, 2012 at 08:00 PM
Growth is the lifeblood of the independent advisory industry. In addition to greater rewards to firm owners in the form of increasing returns and higher share value, the potential benefits of growth extend to employees as well as clients. Growth creates career opportunities and greater earning potential for staff. Growth can help broaden a firm’s resources and deepen its technical expertise, resulting in improved quality of client service delivery.
Mismanaged growth can put firms at risk, however, stressing their foundations and threatening profitability. To achieve sustainable growth, firms need to take a deliberate approach, one that FA Insight describes as “growth by design.” With a thoughtful, strategic approach, firms can take advantage of economies of scale, build value and protect profitability.
Because sustainable growth is so important, “The 2012 FA Insight Study of Advisory Firms: Growth by Design” features a detailed examination of how firms grow and how they should grow. Here, in the first of four planned articles over the course of the next 12 months, we provide an overview of study findings.
The 2012 study, with record firm participation, is the fourth in an annual industry benchmarking series begun by FA Insight in 2009. The 2012 study is preceded by “The 2011 FA Insight Study of Advisory Firms: People and Pay,” an effort that focused on assisting firms to attract and retain the right people and map a path that progresses them toward ownership. (See www.AdvisorOne.com/tag/People-and-Pay.)
Impressive Gains Mask Potential Liabilities
Independent advisory firms can point to solid accomplishments in 2011. The typical firm, retaining more than 97% of existing clients, added nearly four new clients for every one client lost. As a result, the median firm expanded its client base by 6.1% in 2011, the best year for adding clients since 2008. Firms are optimistic about surpassing that rate in 2012, expecting to finish the current year with a 6.9% increase in total clients (see Figure 1, left).
While the rate of client growth improved, lackluster performance of securities markets slowed the growth of advisory firm assets under management (AUM). Up just 6.9% for the typical firm in 2011, AUM grew at less than half the rate experienced in 2010, a year when the economy and financial markets rebounded from recession. Advisors are hopeful for another rebound in 2012, however, expecting AUM to grow more than twice as much as last year.
Indeed, in spite of declining appreciation in client investment portfolios, advisory firms maintained slower but still solid revenue growth, largely because of their ability to attract new clients. Revenue for the typical firm rose 14.5% in 2011.
While off three percentage points from 2010, revenue growth in 2011, combined with limited growth in staff, contributed to levels of productivity and income per owner that the industry has not seen since the onset of the recession (see Figure 2, right). After all three measures declined dramatically for the typical firm in 2009, revenue per professional is up 22%, revenue per total staff is up 19% and income per owner is up 32% in the two years since the market bottom.
Expenses Grow Despite Productivity Improvements
The upsurge in productivity, however, has not been accompanied by efficiency gains, and expense management is a growing concern. While firms have added clients to help fuel revenue growth, clients are increasingly more costly to service (see Figure 3, right).
Overhead expenses reflect all advisory firm costs that are not directly related to delivery of advice or revenue generation, including items such as support staff compensation, office rent and technology. Since 2008, median overhead costs per client rose at an average rate of more than 9% per year, outpacing growth in client size as measured by AUM.
In 2011, the rise in indirect costs was particularly steep. Overhead expenses per client rose 17%, contributing to a 10% decline in profit per client. For the typical firm, overhead expenses increased from 38.1% of revenue in 2010 to 39.2% in 2011.
Declining Profitability
Rising expenses resulted in declining profitability, despite revenue growth. The median operating profit margin fell from 18.9% in 2010 to 14.2% in 2011 (see Figure 4, right). Owners’ overall efficiency in converting income from firm revenue declined as well. Owner income (including owner compensation and profits) as a share of revenue fell to 47% in 2011 compared with 50% in 2010.
Undoubtedly, better times have returned for advisory firms, but the inability of many to grow in a manner that contains expenses and upholds profitably is cause for concern. Without achieving more profitable growth, firm owners will fail to capitalize on the advantages of scale and struggle to build value in the enterprises they have created.
Multiple Benefits of Growth
The importance of growth and the need for advisory firms to make growth a priority cannot be overstated. The most commonly cited benefits of growth are increased efficiency, profitability and productivity. These advantages are typical of firms realizing economies of scale. In addition to better quality client service, firms also report that growth offers a variety of benefits related to personnel. For example, growth often brings:
- Greater career opportunity
- Reduced dependency on key individuals
- Improved management capabilities
- Greater succession choices
- An improved ability to attract talent
Growth Can Also Have Negative Consequences
Growth does not always work in a firm’s favor, however. As Growth by Design and previous FA Insight industry studies have shown, expenses can explode and profit margins can erode if growth is uncontrolled. Firms that rapidly add clients and grow revenue may at the same time experience rising overhead expenses and lower operating profit margins.
