It’s a given that registered investment advisors must have “scale” to grow. But how much scale (aka size) is needed to deliver the highest level of value to clients and produce strong returns for RIA owners and team members?
The latest research from Dynasty Financial Partners and Advisor Growth Strategies highlights data that differ from figures often cited by industry consultants, which may surprise some RIAs.
“Based on the results of our analysis, it became clear that optimum scale for RIAs is greater than the $1 billion to $2 billion assets … size that is industry conventional wisdom,” according to Dynasty Chairman Todd Thomson and Advisor Growth Strategies Principal John Furey, in a report released Wednesday.
(Related: Advisors Need Critical Mass to Thrive)
The Dynasty/AGS research compares the results of firms affiliated with Dynasty to several other industry benchmarks, and it looks at the benefits of working on a shared platform.
(Dynasty partner firms have their own registration with the Securities and Exchange Commission, or Form ADV, and ownership group, but they also work together as a buying group that shares the cost of “C-Suite” talent, like a chief marketing officer, and related business consultants.)
The analysis finds that Dynasty member firms gain substantial scale via the firm’s expertise and negotiating power with technology and custodial providers. Plus, those in its RIA cohort are more profitable than firms operating on a stand-alone basis and grow at a faster pace.
The Dynasty/AGS research argues that due to the disparity in business structures across the RIA industry, earnings before owner compensation (or EBOC) is not the most “meaningful measure for larger, more professional RIA firms.” Plus, earnings before interest and taxes, or EBIT, “does not tend to work for smaller, owner-operated firms.”
Thus, the researched developed and examined a new margin performance benchmark: EBAC, for earnings before owner and advisor compensation.
“EBAC allows for an apples-to-apples comparison for the true margin of RIAs before paying advisors and owners, and thus offers a meaningful comparison of margin across all size and types of RIA firms, regardless of how they structure their ownership,” the authors explained.
In their analysis, firms sharing a platform report EBAC of 62% of average revenue on average vs. industry benchmarks of 56-58% EBAC.
“The Shared Platform Cohort pays more for their state-of-the-art platform and consulting services, but these higher costs are outweighed by far lower personnel costs and other expenses,” according to Dynasty/AGS.
The partners completed the analysis in early 2018. AGS looked at 19 RIAs with between $300 million and $2 billion in assets under administration. The 15 Dynasty firms using the shared platform RIAs ranged from $200 million in AUA to over $4.1 billion.
Firms using a shared platform can “leverage the experience and established scale capabilities made possible by the entire network sharing … services,” while stand-alone firms have to hire and manage employees and consultants directly, work directly with technology vendors and regularly upgrade and improve front- and middle-office operations.
Dynasty says, for instance, that it can provide members with the scale of a business with over $30 billion in AUA, though its largest group included in the study had under $5 billion.
“A fundamental hypothesis in our industry is a well-managed RIA will expand margins as they grow. The results demonstrate that individual firm scale remains important even within the context of a shared platform model,” the authors said.
RIA owners, they add, tend to “overestimate their relative scale, underestimate the impact of the direct cost of employees, underestimate the difficulty and time required to hire and manage non-advisory employees effectively, and over-emphasize the relative cost of technology and outsourcing solutions.”
Looking at the potential impact on relative valuation for firms, the researchers calculated cash flow to the buyer or EBITDA (earnings before interest, taxes, depreciation and amortization), assuming a 35% advisor payout. For stand-alone AGS firms it was 21% versus 27% for firms on a shared platform.
Looking in detail at one firm, the researchers concluded that its pre-shared platform EBAC averaged 64% versus the shared platform average of 66%. When it joined the platform, though, the firm’s revenue growth jumped from an average of 9% per year to 18%.
The authors highlight the following implications:
1. Outsourcing and shared services should predominate in the RIA industry, especially in areas that are not central to the core value proposition.
2. The most profitable and fastest-growing RIAs will be the outsize winners during expected consolidation.
3. Even RIAs that don’t plan to grow nationwide can benefit from leveraging shared services.
“The metrics and results of this analysis show that outsourcing activities to shared-platform firms tends to drive improved margins and, likely, faster growth — driving significantly higher firm valuations,” explained Thomson and Furey.