Journal of Financial Planning: February 2015
While early adopters of the assets under management (AUM) model appeared in the 1980s or early 1990s, the model became widely adopted in the early 2000s. As the AUM model has become increasingly popular and firms have had time to build, the “typical” advisory firm has grown significantly, from an average of only $25 million of AUM in 2002 to more than $200 million in 2013. And with an average profit margin of about 22 percent, the typical advisory firm owner with an AUM practice is enjoying record take-home pay.
Yet, as advisory firms on the AUM model have grown, their growth rates seem to be slowing—a combination of the ongoing crisis of differentiation for advisory firms, and the simple fact that as the firm gets bigger, the denominator of the growth rate fraction is difficult to overcome. After all, adding “just” $4 million of new assets a decade ago would have been double-digit organic growth, yet the same new asset flows yielded barely a 4 percent growth rate for a typical firm in 2009, and would be less than a 2 percent growth rate for the average firm in 2014.
The significant danger of this situation is that advisory firms with current low growth rates will not be able to grow through the next bear market as they have in the past. And at an average profit margin of “just” 22 percent, and the risk that the next bear market could lop off 25 percent or more from a firm’s assets and revenue, some advisory firms may not survive the next downturn without making significant changes.
These risks mean advisory firms should be focusing now on whether they have sufficient flexibility to their overhead costs, other means to stabilize revenues, or enough profit margins to absorb the next market decline when it comes. Although many have been critical that advisory firms are “too profitable” and are due for some competition in today’s environment, the reality is that judging profit margins after a five-year bull market may not be the best measure, and in fact, the greatest risk for most firms may be that their profit margins are still too small to withstand the next bear market when it comes along.
The Role of Profit Margins
Monitoring profit margins is crucial for an advisory firm. It isn’t just about the amount of profit that the owners can extract from the business; profit margins are also an important line of defense for an advisory firm facing a decline in revenue when a bear market occurs.
Fortunately, maintaining the revenue of an advisory firm through the 2000–2002 bear market wasn’t all that difficult, though. With $25 million of AUM, losing almost 25 percent (in a diversified portfolio) from top to bottom was only a loss of about $6 million of AUM. If the adviser merely added half a dozen clients per year with $500,000 each, AUM and revenue remained stable (assuming existing clients were retained).
By 2008, the stakes were higher. A typical advisory firm had just over $100 million of AUM and had two partners, according to the 2011 InvestmentNews/Moss Adams Advisor Compensation and Staffing Study. Now a 25 percent decline in the diversified portfolios was a $25 million loss, and most of the losses came in the span of less than a year from fall 2008 to spring 2009. This time, advisory firms struggled to keep up; replacing $25 million in a year would require two partners to each bring in $1 million of new assets, per month, all year long, amidst a traumatic bear market.
The result: many advisory firms saw, for the first time, a decline in annual revenue in 2009 (after a tepid 2008), and what amounted to a significant step back in annualized revenue projections from the prior peak in Q3 2007.
Between declining assets from market returns, possible client attrition, pressure on fees, and the fact that there were more retired clients taking withdrawals (rather than accumulators who would keep saving into accounts), it just wasn’t feasible for most advisory firms to grow through the bear market. Growth alone was no longer a sufficient defense to market volatility for firms; profit margins had to play a role, too.
Fortunately though, firms had healthy enough profit margins in 2008 that the decline in revenue simply compressed profits. As a result, 2009 was a record low of 13 percent profit margins for advisory firms, according to the 2011 InvestmentNews/Moss Adams study. But they weathered the storm.
Tyranny of the AUM Denominator
Since the market trough in 2009, the average advisory firm has grown significantly once again. According to the 2013 InvestmentNews/Moss Adams Advisor Compensation and Staffing Study, the average advisory firm had grown to more than $200 million of AUM by the end of 2012, with at least two partners, and a staff of seven. The good news is, this continued to boost the income of advisory firm owners. The bad news, however, is that as the base of assets grows bigger, firms are finding it harder to sustain their growth rates, as the denominator for growth becomes larger and larger.
For instance, the average advisory firm heading into 2003 could achieve 12 percent organic growth by just adding half a dozen clients with $500,000 each, growing by $3 million of new assets on a $25 million base. In 2013, a 12 percent organic growth rate for the now-$200 million firm would require a new millionaire every other week, all year long, in a more competitive environment, as all the other $200 million-plus advisory firms are trying to achieve the same growth rates, even with the number of millionaire households in the U.S. barely larger than where it was in 2007.
Nothwithstanding this challenge, the latest InvestmentNews Financial Performance Study of Advisory Firms shows that advisory firms have enjoyed double-digit AUM growth rates in four of the past five years. However, the market growth of the past five years has also been quite generous, which means a significant portion of AUM growth has actually just been the market tailwind.
In fact, if we do the math assuming advisory firms generate the returns of a diversified portfolio and back those market returns out for the past five years, the reality is that while organic growth rates for the industry were strong in 2010 as a rebound from the bear market, growth rates have been slowing ever since, and by 2013 the average advisory firm had an organic growth rate of no more than about 2 percent.
What Happens When the Next Bear Market Comes?
The reason all this matters is that in today’s environment, advisory firms are now so large that not only is organic growth not realistically capable of sustaining the firm through a bear market, but profit margins aren’t necessarily wide enough to sustain the impact for many advisory firms, either.
In other words, the next bear market may lead to a drastic wave of staffing cuts and layoffs from independent advisory firms, with the possibility that many will shut their doors and go out of business or be sold for a tiny pittance (with negative profit margins in a bear market, the firms would have very limited economic value to a buyer).
To say the least, the next bear market may, unfortunately, be the most traumatic ever for owners of advisory firms managing to the potential volatility of their revenue and profits.
Where Should Firms Go From Here?
Given the challenges to advisory firms that have grown larger than ever, with more overhead than ever, facing a potentially severe business strain in the next recession and bear market, what should be done?
The first option is just to build a larger profit margin buffer into the business to absorb the inevitable market shock, whenever it comes. This means taking a hard look at the expenses of the business now, while the business is not under duress and there is more flexibility to make changes. For many advisers, the viewpoint has been that running smaller profit margins is OK because their goal is not necessarily to maximize personal income, and they want to invest into the business itself and/or the quality of the solutions they provide. Yet, profit margins are about more than just income to owners and reinvestment into the business; an advisory firm’s profit margin is also the buffer to revenue shocks, and running with too small a profit margin can risk the survival of the business.
The second option is to buffer the impact of a market downturn by at least making the expenses and overhead of the business more flexible and variable. For instance, staff compensation (the largest expense for most advisory firms) that is structured as a base salary and a bonus tied to overall firm revenue will naturally reduce staff costs in a market downturn (as bonuses no longer get paid), buffering the need to lay off service staff at the worst possible time.
Some firms have also sought to manage their costs by going through mergers and acquisitions in search of size and scale—and therefore greater profit margins to buffer the business. However, research suggests that firms are not necessarily finding economies of scale, lower overhead costs, and better profit margins by growing larger. According to the 2014 InvestmentNews Financial Performance Study of Advisory Firms, operating profit margins remain remarkably consistent in a range from 23 percent to 27.5 percent for firms with revenue from $250,000 a year to $15 million a year, which means focusing on the profit margin of the firm and how costs are managed, regardless of size, may be a more effective strategy than trying to merge to achieve economies of scale as a way of managing the risk.
For some firms, the conclusion may be to try to reduce the volatility of their revenues in the first place, such as transitioning from AUM to retainer fees. However, the risk of a retainer model is that pricing is much more salient; clients may become more acutely aware of what they’re paying at the exact time when they’re most sensitive to their expenses (during a bear market). As a result, it’s not clear whether retainer fees will be any better at managing revenue volatility when the time comes, especially if the AUM firm down the street can lure the client away by charging less on an AUM basis, in anticipation of revenues rebounding when the market recovers.
Alternatively, clients locked in to a $10,000 fee (originally equivalent to 1 percent of their $1 million portfolio) may decide to leave the adviser altogether when their portfolio declines and they realize they are then paying 1.33 percent (a $10,000 fee on a $750,000 portfolio). For many firms, it may be preferable to hedge the firm’s revenue by buying put options to protect against a market decline, similar to how a farmer might purchase put options (or commodities futures) to ensure future revenues at current prices.
Ironically, the smallest of firms may actually be the best positioned in a market downturn, because with little overhead, they may still see a significant personal impact to income, but would have far more flexibility and far less overhead to cover amidst a market downturn. In fact, the InvestmentNews research found that solo advisory firms have some of the best profit margins, even amongst those that are not “top performers.” Thus, while solo advisory firms are limited in the total size of their income (you can only take on and manage so many clients on your own), they may actually be least exposed to the disruptive impact of a bear market.
The bottom line is: while many have criticized profit margins as being unjustly rich and generous, and therefore prone to disruption (for example, from robo-advisers), for many advisory firms, the profit margins may not be large enough to withstand the next bear market. At best, most firms will likely find the next bear market to be the most traumatic ever as a firm owner, simply given the sheer operational leverage of today’s typical advisory firm. Firms that don’t have the profit margins nor the growth potential may not survive. Is your firm well positioned at its current size to withstand the next market downturn when it comes?
This is an adaptation of an article that originally appeared in Nerd’s Eye View.
Michael E. Kitces, CFP®, CLU®, ChFC®, RHU, REBC, is a partner and the director of research for Pinnacle Advisory Group. He is the publisher of the e-newsletter The Kitces Report and the financial planning industry blog Nerd’s Eye View through his website www.kitces.com. He also serves as practitioner editor of the Journal. Follow him on Twitter at @MichaelKitces.