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.

Expense ratios fall as firms growThe 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.

There are risks to growth, however. The pursuit of critical mass can also contribute to cultural dysfunction, defection of employees and impairment of quality control. The more the principals in a firm are removed from the daily activities and supervision of specific client engagement, the greater the risk that steps may be neglected, recommendations may be inappropriate and errors may be made.

To protect against self-destruction brought on by growth, advisors must view scale not as a natural byproduct of growth, but as something that occurs only when the leadership is thoughtful about the business they wish to create, systematic in the processes they implement to manage growth and aware of the metrics that indicate when their train is going off the rails.

Advisors must focus on the following key areas if they hope to achieve scale:

  1. Expansion into new locations

  2. Examination of workflow and processes

  3. Recruitment, retention and development of people

  4. Constant monitoring and measuring of critical ratios

I cite expansion into new locations first because this seems to be the way in which advisors believe they can grow quickly—by merging with or acquiring another firm in a different city. The first question one should ask is whether the firm can achieve critical mass in the new location itself. Based on what we see in the benchmark studies, it appears that a reasonable level of operating efficiency occurs when an advisory firm generates between $7 million and $10 million of annual revenue (this represents staffing, assets and clients in most cases). At this level, an advisory firm has sufficient redundancies and capacity to grow. When advisors open an office in a new location with no plans to get it to critical mass, they become vulnerable. The loss of a key client or key employee or partner in the remote location may force them to close up shop as quickly as they opened the doors.

Streamlining workflow and processes probably constitutes the easiest way to manage growth. Most advisory firms have been doing the same thing the same way since they began. When they re-examine their approach, they often discover many functions that are repeated over and over again and therefore could be automated or done by a lower-level associate in the firm. An improved workflow enables advisors to lower their cost of labor and increase their efficiency, both of which help reduce operating expenses within the firm.

Talent retention and development may be the area of greatest risk. All businesses tend to lose some focus as new people join the firm. To counter this, firms must implement a conscious strategy around training and inculcating the values that leadership holds dear. Regular performance evaluations and meetings with new associates help to reinforce expectations. When the advisory firm opens a new location, the ability to transplant cultural values becomes an even greater challenge if a culture carrier is not deployed to the new office. A decision on whether to merge, acquire or open a new location may hinge upon whether the firm has somebody willing to relocate to provide this necessary leadership.

As with any investment, it is important to define success and to measure performance against those metrics. Even more critical is the need to establish leading indicators for the firm in general as well as for all branch offices or divisions. In addition to tracking operating profit margin and gross profit margin, it is helpful to monitor other ratios such as clients-to-staff, revenue-per-staff, revenue-per-client, error rates, growth rates and attrition rates.

It seems likely that the advisory profession will soon resemble the accounting profession, with a small number of national firms, a larger number of regional and local firms, and the smallest number of solo practitioners. While the advisory business in general is profitable, there comes a point in the life cycle of a firm when its owners have to commit to growing or to staying small. Those caught in the middle never achieve scale or operating efficiency because they are too big and too small at the same time.

Fortunately, current models of success demonstrate how larger enterprises not only can grow efficiently, but also serve their clients effectively.