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February 02, 2015 at 07:00 PM
Common wisdom holds that the advice business is not scalable. While operating leverage may be easier to attain in other industries, such as manufacturing or software development, advisory firms can achieve scale once they reach a certain level of critical mass.
Investopedia defines a scalable company as one that can “improve profit margins while sales volume increases.” Does that description apply to advisory firms?
The 2014 “Financial Performance Study of Advisory Firms” conducted by InvestmentNews and sponsored by Pershing Advisor Solutions revealed that many growing advisory businesses are seeing margins improve as revenues increase. For example, overhead expenses as a percentage of revenue dropped from a high of 48.1% to 28.9% as advisory firms broke through certain revenue and asset barriers.
The most precipitous decline in the expense ratio was noted when advisory firms became “super ensembles,” defined as an advisory business with at least $10 billion in assets under management and at least $10 million in annual revenue (see chart).
For the average independent firm these numbers may seem daunting, but $10 billion of AUM is not beyond the reach of the next generation of financial advisors. Not only does the expense ratio decline as a firm gets bigger, but revenue growth also accelerates with size. Why? Because a larger market presence creates increased efficiency, stronger discipline around business development and the ability to build a brand.
The number of super ensemble firms today proves that the business of financial advice is going through profound change. When I first started benchmarking the profession in the late 1980s, many advisors hoped to get to $100 million of AUM. At the beginning of this decade, the new Holy Grail was $1 billion. Now the many firms breaking through the $5 billion mark and even the $10 billion mark reveal a transformation that few imagined when the independent advisory movement took root.
Yet most advisory firms are small businesses that suffer the same strains as any closely held enterprise. The Small Business Administration defines a small business operating in the service sector as a company with revenues no greater than $21.5 million.
The consolidators like Focus Financial and United Capital are capitalizing on the travails of running a small business by bringing like-minded firms together under one company, and new model firms such as HighTower are creating national advisory brands using broker-dealer command-and-control structures while delivering an advisory experience. But sizeable owner-operated enterprises like Silvercrest, Aspiriant, Oxford and Tolleson have redefined the way advisory firms look and feel by growing strategically and organically, and not necessarily through aggressive recruitment or acquisition models, though tuck-in mergers may have rounded out some of their growth.
The achievement of scale provides a clear economic advantage to advisory firms. It enables such businesses to be more effective at the recruitment and development of talent without straining the income statement. It helps them create critical redundancies and allows them to compete on price in cases where that is important.
