From Style to Substance

Of all the trends that have influenced the financial advice business, perhaps the most profound is the evolution from lifestyle practices to more enduring business models.

A "lifestyle practice" typically depends on one or two advisors. These advisors do not have a succession plan, human capital plan, definable strategy or means to measure success. They feel content with their existing client base and have no plans to grow.

By contrast, an "enduring advisory firm" is structured to survive the founder. The leaders have a clear vision of why the firm exists, a structure that supports this vision, depth in leadership, a career path for their people and a systematic means for obtaining new clients. An enduring firm actively manages to profitability and has a plan to create an orderly transition of management and ownership.

Evolution and Evaluation

Our business continues to evolve; we have reached an inflection point where advisory firms must assess their chosen model. Six big developments led us to this inflection point in the advisory profession.

In the 1970s, fixed-rate commissions were eliminated amid a loud cry from the large brokerage firms. This change in how revenue was generated led many prominent firms of that era — including Kidder Peabody & Co., Bache Halsey Stuart & Co. and E.F. Hutton — to fail. Diverse reasons precipitated their demise, but the lowering of transaction costs from 80 cents a share certainly uprooted their economic model and opened the door to competitive platforms, most notably discount brokerage firms.

Around the same time, financial planning became a profession with the creation of two meaningful designations: Certified Financial Planner (CFP) and Chartered Financial Consultant (ChFC). The emergence of this field enabled financial professionals to shift from being product advocates to client advocates.

Thus the independent contractor broker-dealer was born. This model allowed financial professionals to leave captive environments that required the sale of proprietary products. These broker-dealers had the freedom to deliver "whole of market" to their clients and, in many cases, to set up hybrid advisory practices wherein registered reps could function dually as brokers and as advisors. These reps operated as independently owned businesses under the supervision of their broker-dealers, rather than as employees of the supervising firms.

The hybrid model triggered the rapid growth of corporate registered investment advisors (RIAs) sponsored by broker-dealers. Evidence of this transformation appears on the books of Pershing LLC, one of the largest securities clearing firms in the U.S., which has seen advisory assets at broker-dealers grow from 5% of the total in 2008 to nearly 50% of the total in 2017.

Then, in the 1990s, another evolution enabled professionals to leave the supervised environment of FINRA-regulated broker-dealers to become RIAs under the purview of either the Securities and Exchange Commission or state regulators. This further propelled the financial advice profession into a cottage industry of small, entrepreneurial advisors, free of ownership by a big bank or brokerage firm.

Now the industry is experiencing a dramatic new trend: industry consolidation. Private-equity-backed firms are acquiring advisory practices in bulk, and growth-oriented advisory firms are strategically merging with other RIAs. While motives vary, the idea of creating scale and critical mass in a people-intensive business makes sense.

There is a certain predictability in this roundabout evolution from large employer-based organizations to a highly fragmented entrepreneurial industry, back to larger employer-based organizations. According to the "2015 InvestmentNews Advisor Compensation & Staffing Study" sponsored by Pershing, independent advisory firms currently include more employees than owners.

Does this mean that small lifestyle practices will disappear? Not likely. The model offers distinct appeal to many: no need to manage people, no pressure to generate year-over-year growth, no need to spend valuable time in non-client meetings. However, lifestyle firm owners should not harbor the mistaken notion that they have created a business with transferable value.

Expectations vs. Reality

I recently read about a head of practice management for an independent broker-dealer who suggested that retiring reps should obtain 2.4 to 2.8 times gross revenue for their fee-generating book of business. While using a multiple of revenue is a terrible way to value businesses in general, I thought it especially odd to assign such a high valuation to a practice comprising an aging client base, slow growth and no continuity. The notion of basing value on what an advisor has done misses the principle that value is a function of the future. Only businesses with enduring components can justify a valuation premium.

Fortunately, acquirers and growth-oriented firm leaders are showing greater discipline in the price they pay and the returns they expect. Many merger deals include terms that put the burden of transferability of assets and income squarely on the shoulders of the seller.

The task of creating an enduring advisory firm is not without challenges:

Up until now, advisors have had little pressure to reduce their fees. The median fee has remained steady at 77 basis points for about a decade. This will change for those who cannot demonstrate value beyond an asset-allocation model.
In addition, established practices have a concentration of clients nearing or in the midst of de-accumulation. This scenario curtails firm growth, especially if assets will be dispersed among many beneficiaries upon the death of the client.
Digital platforms are changing how clients interact with their advisors. Robo is not likely to replace the human advisory model, but forward-thinking advisors should consider investing in technology that enhances the client experience.
People development plans and compensation plans must be relevant to the business structure and compelling to young talent. Many firms are still led by people whose experiences were defined by the old ways of doing business. Clearly, change is happening quickly and they must adapt.

Advisors eager to build an enduring firm need to execute on plans that consider the following conditions:

Margin compression. While price may be a factor, most firms will experience a drag on profitability due to lower productivity, a poor client mix and a higher cost of doing business.

Brand confusion. It is hard to tell the difference between advisory firms today. Effective positioning is further muddled by large retail brands now promoting their own ease of use and range of offerings.

Critical mass. Size does matter when it comes to continuity and business economics, though critical mass varies by market. In its simplest form, when a firm has true redundancy in every position and it can afford to pay for this redundancy while still generating a reasonable return, then it has reached critical mass. In other words, an enduring firm can lose someone performing a key function without missing a beat.

Lack of capacity. The single biggest inhibitor to growth is the lack of capacity to serve optimal clients. For the most part this translates to people, but it also includes effective workflow and technology. An advisor or advisory team can manage a finite number of clients, and it takes 18–24 months for advisors and staff to achieve full productivity and proficiency. Advisory firms should anticipate their capacity needs based on the rate of growth they wish to attain.

Becoming an employer of choice. Enduring advisory firms must attract and pursue employees and potential new partners as persistently as they seek new business. The industry currently suffers from an undersupply of people needed to deliver financial advice. Becoming an employer of choice is the newest frontier in branding.

— Read Aspire to Be the Employer of Choice on ThinkAdvisor.