How Will AUM Advisors Weather the Next Market Downturn?

Across the entire industry, the latest Investment News study found that the average operating income of an advisory firm was 24%, which – even at a 0% organic growth rate – would be barely sufficient to handle a 25% decline in AUM due to a bear market. However, within advisory firms, the Investment News study found significant variability; while top performing (top 25%) solo firms had profit margins of 42.8%, the rest (the other 75%) were only 20.6%; among ensemble firms, the top had 44.5% profit margins, but the rest averaged only 16.5%.

Source: 2014 Investment News Study of Financial Performance Of Advisory Firms

The significance of this cannot be overstated – it means that as many of 75% of solo and ensemble firms are approaching 0% organic growth rates with 16%-20% profit margins, in a world where even with a diversified base of client portfolios, a bear market can chop AUM and revenue by 25%.

In other words, the next bear market may lead to a drastic wave of staffing cuts and layoffs from independent advisory firms. The larger the firm, the more the fixed overhead expenses, and the greater the risk. That raises the possibility that many will just go out of business altogether or be sold for a tiny pittance (as with negative profit margins in a bear market, the firms would have very limited economic value to a buyer).

To say the least, the next bear market may be the most traumatic ever for owners of advisory firms managing to the potential volatility of their revenue and profits.

So given these prospective challenges to advisory firms that have grown larger than ever – with more overhead than ever – and face a potentially severe business strain in the next bear market that will eventually come, what should be done?

The first option is just to build a larger profit margin buffer into the business to absorb the inevitable market shock whenever it comes. This means taking a hard look at the expenses of the business now, while the business is not under duress and there is more flexibility to make changes. As the Investment News study clearly shows, firms of a remarkably similar size can be run with remarkably different profit margins. For many advisors, the viewpoint has been that running smaller profit margins is ‘okay’ because their goal is not necessarily to maximize personal income, and they want to invest into the business itself and/or the quality of the solutions they provide clients. Yet as this analysis makes clear, profit margins are about more than just income to owners and reinvestment into the business; an advisory firm’s profit margin is also the buffer to revenue shocks, and running with too small a profit margin can risk the survival of the entire business.

The second option is to buffer the impact of a market downturn by at least making the expenses and overhead of the business more flexible and variable. For instance, staff compensation that is structured as a base salary and a bonus component that is tied to overall firm revenue will naturally reduce staff costs in a market downturn (which is important, as staff compensation is the single largest expense for an advisory firm); even with partial revenue-based compensation, the impact of a downturn will still be more severe to owners than to employees, but a compensation structure that naturally builds in cuts to staff compensation when markets and revenue declines can reduce the need and risk for staff layoffs (or owners being forced to put money into the firm just to keep it afloat). This is especially crucial for the long-term survival of the advisory firm, as client demands tend to spike during market declines, so it is otherwise not a good time to be reducing staff and services! For many advisory firms that already pay employee advisors on a revenue-sharing basis, this structure has already been implemented for their most “expensive” employees (however, for employee advisors with a large book of clients,the firm may have already sacrificed its profit margins putting employee advisors onto revenue-based compensation models in the first place!).

Notably, while some firms have also sought to manage their costs by going through mergers and acquisitions in search of size and scale – and therefore greater profit margins to buffer the business – the Investment News research suggests that firms are not necessarily finding economies of scale, lower overhead costs, and better profit margins, by growing larger.

As the graphic from the latest study below shows, operating profit margins for advisory firms remain remarkably consistent in a range from 23% to 27.5% for firms with revenue all the way from $250k/year to $15M/year (and actually declines for the largest super-RIAs, in part because they appear to be reinvesting heavily back into their businesses for future growth, though they may also have access to outside capital to help weather a market downturn). Which means focusing on the profit margin of the firm and how costs are managed – regardless of size – may be a more effective strategy than trying to merge and get larger to achieve economies of scale as a way of managing the risk.

Source: 2014 Investment News Study of Financial Performance of Advisory Firms

For some firms, the conclusion may be to try to reduce the volatility of their revenues in the first place, such as transitioning from AUM to retainer fees instead. However, the caveat of the retainer model is that the pricing is much more salient – i.e., clients may become more acutely aware of what they’re paying – at the exact time when they’re most sensitive to their expenses (during a bear market).

As a result, it’s not entirely clear whether retainer fees will be any better at managing revenue volatility when the time comes. After all, if a $1M AUM client pays a $10,000 retainer fee (equivalent to 1%) instead, and the market declines by 25%, the next advisory firm up the street that still operates on an AUM basis will be soliciting that client at a 1% x $750k = $7,500 fee If the current advisory firm has to match a competitor’s pricing and the retainer fee falls to $7,500, the revenue decline happened anyway.

A further problem of a retainer fee is that when the market rebound occurs, the AUM fee will bounce back, but the retainer may be ‘stuck’ at $7,500 (e.g., advisory firm revenues are up more than 100% since 2009, while it’s difficult to imagine a retainer firm enjoying similar growth when the bull markets get under way).

Alternatively, the problem with clients paying retainers who are ‘locked in’ to a $10,000 fees when their portfolio declines may realize they are then paying 1.33% (a $10,000 fee on a $750,000 portfolio), and may decide to leave the advisor altogether. For many firms, it may be preferable to hedge the firm’s revenue by buying put options to protect against a market decline, similar to how a farmer might purchase put options (or commodities futures) to ensure their future revenues at current prices (minus a small cut for the cost of protection).

For a few firms, the strategy may simply be to double down on growth, reinvesting into marketing and capacity-building for the firm, in an effort to “grow through” the next market decline, as many/most firms have done in the past. However, most firms spend very little on marketing and business development at all; according to the Investment News research results, it’s an average of only 2.1% of revenues across all firms.

Again, due to the sheer size of the firm as it grows, the marketing and business development strategies that were effective in the past are not likely to deliver enough in the future. That’s especially the case if business development has previously been built around just one or a few partners who bring in new clients, and attempt to do so at a time when clients tend to hunker down and not make changes for a while. As shown earlier, 2010 was the big year for new clients after the market decline, not 2009 when the market bottomed.

Simply put, there may just not be enough partners/advisors doing business development to grow through a market decline given the size of firms today. And that’s before considering the challenge that advisory firms over all seem to be struggling more to grow at all in today’s environment, as it is increasingly difficult for firms to differentiate themselves from the competition at all.

Ironically, the “smallest” of firms may actually be the best positioned, as solo proprietors with little overhead may still see a significant personal impact to income, but have far more flexibility and far less overhead to cover amid a market downturn. In fact, as shown earlier, the Investment News research finds that solo advisory firms have some of the best profit margins, even among those that are not ‘top performers.’ Thus, while solo advisory firms are limited in the total size of their income (solo firms may be profitable, but total profits are limited by the capacity of a single advisor’s ability to manage a limited number of client relationships), they may actually be least exposed to the disruptive impact of a bear market.

The bottom line? Many have criticized the profit margins of advisory firms as being unjustly rich and generous, and therefore prone to disruption, such as from robo-advisors. For a large number of advisory firms, however, profit margins may not be large enough to withstand the next bear market, especially given that firms have become so large that they can no longer just grow their way through with new clients as they have in the past. At best, most firms will likely find the next bear market to be the most traumatic ever as a firm owner, given the sheer operational leverage of today’s typical advisory firm. Those firms that don’t have the profit margins nor the growth potential may not even survive.

Is your firm well positioned at its current size to withstand the next market downturn when it comes?