Increasing competition from breakaway brokers and robo-advisors will make it harder for firms to grow.

This article appeared in the December 2016 issue of Investment Advisor.

Many industry benchmarking studies are reporting that profitability has been falling in most independent advisory firms over the past two years. While there are a number of possible reasons for this, in my work with independent firms, I’ve found there are really only a few reasons. One is technology. Or perhaps more accurately, it’s the failure of many advisory firm owners to efficiently integrate the flood of new technology into their businesses.

Let me explain. While digital technology has been a growing part of the lives of most Americans since the 1980s, for most of that time, the independent advisory industry has been too small to attract the attention of major tech companies. Consequently, much of the technology that has been available to independents has been cumbersome, limited in functionality and not well integrated.

To their credit, despite these drawbacks, many independent advisors realized both the immediate benefits from and the tremendous potential of adding technology solutions to their businesses. They have persevered with inefficient tech, even though it didn’t live up to many of its promises of increased efficiency and cost savings. Ironically, adopting that technology not only didn’t result in significant reductions in staff, it often required adding more staff to make the tech solutions perform the way they should.

Things have changed significantly from those bad old days. The 10-year boom in the independent advisory business — driven by the tremendous increase in assets under management and the flood of breakaway brokers who want to get in on the action — has forced custodians and broker-dealers to up their technology game. It also has driven the success of the smaller tech companies who were serving the industry, to the point of getting the attention of many larger technology players. The result has been dramatic improvement in the quality and efficiency of technology platforms for advisory firms in recent years.

However, while this improved technology has been a blessing to independent advisors in many ways (ease of use, smoother integration, operational efficiencies), we believe it’s also led to the current declines in profitability. That’s because many firm owners are failing to maximize the benefits of their new technology. While they are spending more on vastly improved platforms, which truly do create operational efficiencies, they are also continuing to operate in their old mode of adding more staff right along with it. The double whammy of increasing tech costs and adding staff is eroding their bottom lines.

Unfortunately, that’s not all the bad news. I suspect that in 2017, the increasing competition from breakaway brokers and robo-advisor platforms will make it harder for independent advisors to keep all of the clients they currently have, and to attract new ones.

To address these problems, I suggest owner-advisors do five things to increase their operational efficiency: stop hiring people before they have to; stop adding technology before they need to; improve their sales efforts to add new clients; strengthen their relationships with existing clients; and track the following five indicators.

Indicator 1: Lead Ratio

Every firm has a list of potential clients who have contacted the firm but haven’t scheduled a meeting. They are a major, often untapped, source of new clients. With increasing competition for clients, these leads are more and more valuable.

We suggest firms track changes in the number of prospects on this list over the past calendar year. You can do this on a quarterly or even monthly basis. Look at how many names were on the list a year ago, and how many are on it now. If the number is increasing, you’re doing well. If it isn’t, it’s time to take steps to increase your referral rate from existing clients or your outside business development efforts.

The number of folks on this list will determine your future growth rate: If it grows, you’ll grow.

Indicator 2: Close Ratio

During the past calendar year, how many of the people who had prospect meetings became clients? If the number is going up, great. If it isn’t, it’s time to rework your sales pitch and process.

It’s also possible that your marketing efforts aren’t attracting the right people. By the time prospects get to this point, they’ve obviously been attracted to something about your firm or the way you describe it. So if they decline to become clients, there’s a disconnect; the reality of your firm and its services don’t match your sales message.

It’s important to figure out what the problem is so you can focus your efforts on attracting the right people, in the right way.

Indicator 3: Client Turnover Ratio

The easiest clients to get are the ones you already have. While all firms have some turnover, in this competitive environment, it’s essential to keep as many clients as you can. To see how you’re doing, track the number of clients you have lost over the past 12 months versus the number you started with. Be careful that you don’t include any new clients: Many advisors do and that gives a falsely positive picture of client retention.

We like to see client retention rates in the 80% to 85% range. (Note: If you have too high of a ratio — 95%–99% — it isn’t a good sign either. You are likely overserving them.)

If you’re losing more clients than that, you need to improve your client relationships, and to take a look at the quality of your services or the way they are delivered.

Indicator 4: Gross Profit Margin

This is the measure of how efficient your business is. It’s your gross revenues minus the cost of all your employees — salaries, bonuses and benefits — divided by gross revenue. Technically, the GPM includes only professionals, but we like to include all employees so we can gauge how efficient all of a firm’s employees are. We think it’s a better measure for small businesses.

If your gross profit margin is falling, you’re probably adding more people than you need. If you’re buying the right technology and using it efficiently, this number should be going up, not down. So-called “human capital” is by far the biggest expense for advisory firms; it’s essential to maximize this investment.

Indicator 5: Technology Ratio

This is the measure of all your tech expenses during the year (software, hardware, connections, data, employees, consultants, etc.) divided by gross revenues. New tech should increase your productivity, but if your technology ratio is falling, you’re behind in efficiency. That means you’re either not investing enough in tech, or the tech solutions that you are buying aren’t helping for one reason or another: They could be poorly designed, the wrong solutions for your firm’s needs or, more likely, your people aren’t sufficiently trained to use them properly.

Technology is quickly becoming the second biggest expense for advisory firms. It’s important to get it right and to keep getting it right. This is an area where an experienced consultant can be a big help.

These five indicators are going to be the key ratios for independent advisory firms in 2017. Increased competition means they will have to operate more efficiently. Unfortunately, most firms will see all or most of these ratios fall. The result will be that their growth will slow and they will lose clients. Because many firms have cash now, they are hiring before they need to; and because they have room to grow, they’re investing in tech before they need to. The combination is killing their profit margins.

To survive and prosper in what looks to be a very tough year for the independent advisory industry, owner-advisors have to determine whether they can solve their business problems with technology or with people. If they continue to try to use both, their businesses will suffer. They have to know the key indicator numbers during the year. If any of them are trending down, they’ll have a problem: Their firm’s profitability will fall. If all of them are trending down, the business is in a perfect storm: It is in serious trouble.

— Read Growing an Advisory Business in a Rapidly Changing Industry on ThinkAdvisor.