I may set a new record for conflicts of interest with this column. It's even hard to know where to start. First, Pershing Advisor Solutions, the newest entry into RIA custody, has been kind enough to ask me to serve as editor of their newsletter (which I'm happy to do for reasons best explored another time). I just finished working on my first issue of their "Practice Point, " and was blown away by one of the articles. It's a groundbreaking paper by Philip Palaveev, senior analyst at, you guessed it, another one of my clients: Moss Adams in Seattle. Despite these connections, I think this is important information that you need to know about. So let me tell you why, and I'll let you be the judge.
In a new analysis of data from the 2005 FPA/Moss Adams Compensation and Staffing Study, Palaveev reminds us that financial planning firms seem to be growing at a surprising rate (25% in 2004, and about 15% per year since 2000). When those numbers first came out, I asked Philip if this growth might be explained as skewing by larger firms participating in the study. He assured me that it wasn't, citing similar growth by firms that participated in all the studies, and confirming data from other sources.
That advisory practices are growing seems clear. Why firms are growing is more problematic. Ask most advisors (and consultants, for that matter) why practices need to get bigger, and they'll tell you it's to leverage their fixed and staffing costs so they'll be more profitable. Yet for the first time I've seen in print, Palaveev suggest these economies may be more myth than reality. "This theoretical proposition does not often manifest itself in the firm's actual financials," he writes. "…economies of scale seem to persist over some range of revenue, and then the next 'growth spurt' kicks in and the overhead percentage actually goes up rather than down."
My, my. Maybe growing your practice isn't the cat's meow after all. But as if that bombshell isn't enough, Palaveev then delivers what may be the Mother of All Revelations: Leverage isn't the real reason it's good to be bigger, anyway.
To help us understand why, he offers some data that demonstrates that bigger practices are indeed doing better than their smaller peers. It seems that while all practices seems to be growing, the biggest firms are growing the fastest: 26% a year from 2001 to 2005 vs. just 20% for average sized firms. Translated into dollars, this means that the largest firms grew their AUM from $785 million to $988 million while the average advisory firm grew from $64 million to $80 million in AUM. Even with some fluctuation in profit margins, this kind of growth translates into a lot more income for the owners of larger firms.
While having a larger practice seems to have substantial benefits, if they don't come from leverage, where do they come from? Palaveev explains it's a matter of market dominance. It seems that once a firm becomes the largest in its local market, it's presented with myriad advantages over its competition, which translate into more opportunities, more and better clients, better advisors, and even better staff. "…larger firms tend to be more formidable competitors…," writes Palaveev. "The cost advantage of scale has proven to be elusive, but the competitive advantage is undeniable."
Dominance, then, is the reason larger firms can grow faster, even though much of our experience tells us that the bigger something gets, the slower it's growth rate (think of the potential for a penny stock vs. say, GE). The list of the advantages of market dominance is hard to argue with. The biggest firms have the opportunity for more strategic referral alliances, and with better partners; they attract smaller merger partners; they have the resources to finance expansions and acquisitions; and they can attract the best rainmakers.
Perhaps most importantly, according to Palaveev, large firms with large client bases get a bigger boost from what he calls "exponential referral networks." We all know that most advisory clients come from referrals. In most communities, even larger cities, the number of prospective advisory clients is relatively small. If you have 100 clients and they each tell two people about you, you're now on 200 radar screens. But if you have 1,000 clients and they each tell two people, your firm will quickly become known to every potential client. (In smaller markets where everyone knows everyone anyway, this is far less of an advantage.)
Thanks to this new data, the race to become the dominant firm in your city or town takes on an added significance. It's not about ego, or even making a few more dollars (or at least, not only about those things). It's more about gaining the clout to determine your own destiny, rather than have some other firm determine it for you. And about attaining the stature to compete for clients of any size and sophistication, with the top shelf private banks and accounting firms.
In fact, it occurs to me Philip's data implies (but he hasn't said directly) dominance of a different kind–the emerging dominance of independent advisory firms over wirehouses, banks, and accounting firms, the traditional places wealthy folks have turned for financial advice. To have growth figures this good, in advisory firms of this size, it seems to me we have to be talking about dominance not only of the local independent market, but of the market for any financial advice in the community. And that represents a quantum leap forward for independent advice.
Sound good? Well, don't dust off your strategic plan just yet. Regular readers of these pages will recognize one of my recurring themes is to caution against blindly growing advisory practices without careful consideration of the aspects of your working life that are most important to you. In the face of this siren song of compelling data, attractive results and urgency, it seems a good time to revisit some of those issues.
To his credit, Palaveev himself acknowledges that growth on such a large scale is not for everyone. For at least some of the principals, building a dominant practice means transitioning from the role of personal advisor to business executive. Your time will be spent managing, recruiting, strategizing, and most importantly motivating. You'll need to share ownership, responsibility, and decision making to a degree that makes many solo practitioners uncomfortable. And you'll need resources to grow, either through financing, additional investment, or reduced compensation.
