What the findings of the 2010 Moss Adams/InvestmentNews study mean for advisers

The following is an edited transcript of the webcast “The 2010 Moss Adams/InvestmentNews Financial-Performance Study of Advisory Firms: Putting the Results to Work.” It was moderated by InvestmentNews deputy editor Evan Cooper.

Click here for the audio webcast and slide presentation.

InvestmentNews: Kelli, give us an overview. What are the highlights of the report this year, and what should advisers know?

Ms. Cruz: On an aggregate basis in 2009, the industry showed a slight decline in average firm revenue after peaking the year earlier. When we look back on our previous study, we see that the rapid decline in 2008 took many advisers by surprise. When we look at the data from the last survey, back in June 2008, the market had declined by only 9.4%, and advisers were still predicting a year of asset growth. They were estimating that their growth would be about 15.7%. But by the year’s end, equity markets had plummeted nearly 40%, and average firm assets under management had declined by more than 10%. Obviously, advisers were caught off guard by what happened with the market decline.

Lower asset levels hampered productivity, so the steep overall reductions in AUM eroded the financial foundations of many practices. By the end of 2009, assets under management per client, which is the basis of most firms’ revenue structure, had fallen more than 19% from its 2007 high. As a result, productivity also dropped, as measured by revenue per professional.

But business development provides a good response, and when we look at where new business came from, it was referrals. This is something we’ve seen consistently across our study as well as in other industry studies: The top three sources of new business are referrals, external business and personal contacts with the community, and involvement with the firm’s professionals.

New-client acquisition, therefore, was a real source of strength. One of the questions we asked firms in this survey is what they were looking at in terms of new initiatives to increase growth and operating revenue. More owner time for business development came up consistently, ranking right up there with some of the top answers. Marketing and business development were among the bright spots across all firms that participated.

But profitability continues to be a challenge. The cost picture had actually begun to improve slightly in 2007, with average overhead expenses as a percent of revenue declining to levels we hadn’t seen since 2003. But again, due to rapid decline in revenue per client in 2009, average expense ratios jumped again, hitting a high of 44.9%, which was an increase of 15 percentage points over 2007. The resulting squeeze on margins and profits meant that some owners had to lower their own compensation to finance the operation.

Overall — across all types and sizes of firms in all evolutionary stages, and for all the time periods we covered — four primary performance levers or drivers shape growth and profitability.

The first is staffing initiatives. We found that even at firms that had to lay off staff as a way to deal with operating pressure, there was an expectation that they would be able to rehire.

Second, we saw that refining a firm’s strategic plan continues to be a huge part of the picture.

Allocating more partner time for business development is a third driver.

The fourth is technology — both investing in technology and leveraging existing technology.

Since some firms outperformed by a large margin, our data suggest that top-performing firms must be doing something different in how they are adjusting or moving these levers and how they are using these areas to improve their competitive and financial advantage.

In terms of staffing, top performers generally are leaner and focus on staff additions to drive growth and support their scale.

Top-performing firms also prioritized more partner and adviser time for business development. We find that this top-performing group is winning more clients and higher assets, and they’re meeting their minimums.

Then there’s technology. Top performers emphasize adequate technology over cutting-edge technology. In other words, they try to wring out what they can from their investment in technology and make sure that they’re getting higher productivity as a result. They value training and how to use technology wisely rather than just running out and buying the newest technology out there.

Finally, we did things a bit differently with this year’s study. Instead of looking at firms through their evolutionary stages and reporting results around those stages, we decided to slice the data and look at a top-performing group and compare all other firms against the top performers.

After looking at earnings before owner’s income as a percentage of revenue, the compounded annual growth rate of revenue from 2007 through 2009, and revenue per staff and total head count, we found that the top 25% of firms had higher revenue and AUM, had won more new business, had better client retention, higher margins and, interestingly enough, increased owner income, despite the poor overall climate.

InvestmentNews: These were firms of all different sizes, right? It wasn’t just bigger firms or a particular kind of firm?

Ms. Cruz: That’s right. Top performers were both small and large. In terms of affiliation, they were very similar to the “all other respondent” groups, with the majority being registered investment advisers. In terms of practice models and other characteristics, they also were very similar to the overall population.

One of the interesting things is that this top-performer group has a wider distribution of ownership. They leverage their human capital to increase productivity. They are maximizing their existing technology, and they’re maintaining a focused approach to their service delivery and client acquisition model. So they know who they are and what they’re good at, and they stay focused on that in the way they approach their clients and deliver service.

InvestmentNews: Mark, this study was your creation when you were at Moss Adams LLP. Where does this year’s report fit in an historical context? Are its results different or surprising, and what lessons can we learn?

Mr. Tibergien: This year’s report really reflects the transformation of the industry in many profound ways. The typical firm that participated in the survey was a much larger practice, which, from a management standpoint, gives us more moving parts to look at. So when you’re trying to benchmark, it’s always interesting to look at a business that has multiple disciplines, multiple owners, multiple types of clients, that you can say, “How does that help inform the way in which I make decisions for the business?”

I think the second part that makes it interesting — Kelli pointed this out — is this year’s study was not so much an observation of trends, because that isn’t what’s relevant. Obviously, the last couple of years were an anomaly in the business. One of the things that we’ve often believed is that it is times like this when managers and advisers earn their keep. In an up market, everybody can look good, on a relative basis. It’s when the air is choppy that we want to know how good of a pilot you are, and so in this particular case, we were able to cull out that the top-performing firms were not necessarily the largest firms, but certainly, they were the most disciplined in how they managed [their businesses].

When looked at as a point of comparison, I think that provides the greatest insight and education for the typical adviser running a business today: “How do I manage through uncertainty which will likely continue for some period of time, and how do I position myself for growth when the market does return?”

What this revealed in my mind was that there was a conscious active-management approach to business, versus a passive-management approach. And this is not about the way in which they manage investments but about the way in which they manage their enterprise. An active-management focus and clear positioning — as well as building a process to drive it — really separated the superior firms from the average.

That said, all of the numbers that Kelli referred to in the beginning about the average firm are not a surprise. We knew that the overhead expense ratio would be higher. We knew that margins would be lower, that assets would be lower and that the productivity impact would be lower. But this is not about a score; it’s about how people are performing in the context of the environment they’re in.

InvestmentNews: An attendee has a question about something you mentioned, Mark. What constitutes “overhead expenses”?

Mr. Tibergien: For those taking notes, I would recommend writing down five lines to help reference what I’m suggesting.

The first line is revenue, which is everything that flows into your business.

The second line is something we call “direct expense,” and it’s fair compensation for all professional staff, not the admin staff, but all professional staff, including the owner as adviser.

The third line is gross profit, the fourth is overhead, and the fifth is operating profit.

Overhead expense is that fourth line. It’s everything required to support the business, except for professional compensation. So that’s rent, utilities, marketing, administrative staff, benefits — all of those things are rolled into overhead expense.

Over the history of looking at the study, what we found is that the top-performing firms had an overhead expense ratio — meaning expenses as a percentage of revenue — of somewhere between 30% and 35%. For smaller firms, just by virtue of scale, it’s not uncommon to see that overhead expense at 40%, but obviously, that creates a struggle. What it implies is that the owner has to continue investing in the business in order to produce an adequate return over and above the reward for labor. But as we look at that overhead expense, it reveals a couple of things. One is, are you lacking cost discipline? Or, two, are you not generating enough volume to support your infrastructure? Whenever you evaluate that box, that’s what you’re trying to conclude.

InvestmentNews: Mark, is there an issue about how you determine the principal’s income? Is it salary alone or is it profit, too?

Mr. Tibergien: That’s been a debate for as long as I’ve been in the business, but from my standpoint, it shouldn’t be one or the other. What you’re trying to conclude is the cost of doing business so that you can manage to that. There are several benchmarks. As an owner of the business, you should be getting paid fairly for what you do, that is, for your job. Then, if there’s anything left over, you get a return from the profitability of the enterprise. That means there’s a reward for labor as well as a reward for ownership.

So how does the principal determine what that compensation is? Our study last year focused on compensation, and there are data in that study from which you can draw a reasonable benchmark. There also are other comparisons that you can look at to ask yourself: “If I had the choice of replacing me in the jobs that I’m doing within this business, how much would that cost?” That is a way to determine a good benchmark for what principal compensation should be, separate from the profit distribution.

InvestmentNews: Does the study address the actions that the top performers took to achieve their superior results? What did they do, specifically, that worked?

Mr. Tibergien: We’ve known for a long time that advisory firms, when they get to a certain point in their life cycle, tend to be much more passive about business development. Their marketing and sales muscle tends to atrophy. One of the things that we found in the top-performing firms is that they actually developed a disciplined approach around developing business from their referral resources — their clients and their centers of influence.

That may seem intuitively obvious, but it’s not something that every firm executes on. It means there should be a program for how you approach it. It may mean eliciting advice through client surveys that may help you position your firm differently. It may mean being more active in working with your clients to have them identify friends of theirs or colleagues of theirs who are in similar circumstances and who may need help.

Ms. Cruz: In terms of business development, lots of numbers in the study support what the top-performing firms are doing. They’ve created the infrastructure so they have the time to tackle business development. They’ve also got advisers who support them in their goal of dedicating more time to business development.

InvestmentNews: So you are saying that top performers actually program in time to devote to business development?

Ms. Cruz: Yes. The principal or the lead adviser of the firm must be able to dedicate the time necessary to do what they do best if they are the rainmaker or the key business development person. And they have to have an infrastructure that supports their being able to do that.

Mr. Tibergien: This is an industry that traditionally was built on the producer model, where the solo practitioner would be the solo rainmaker and hunt for the mastodon and bring it in. The rest would skin it.

Now we have a different situation. It’s much more synchronized, and advisory firms typically have career paths. So when you look at advisory firms that are very clear about the types of clients they’re interested in, the question is how you build a systematic approach to getting those clients and serving them well, in a way that does not constrain the time of the key people so they can continue to make their greatest impact.

For example, if your target market is business owners, you can’t have a 22-year-old fresh out of school doing the prospecting. They’d get laughed out of the office. But you can have that person doing much of the technical work that’s required in order to deliver the experience to clients and support the primary rainmaker. One of the transformations that’s occurring, therefore, is a specialization of roles in practices; it’s the infrastructure of staff that Kelli is referring to.

As people evolve in their career, when they get to their second or third or fourth or fifth year of experience and they’re progressing up the rungs of the ladder, then what one has to do is create a series of expectations for those individuals to be more responsible for business development. After the fourth year, for example, you might say that 25% of an employee’s time be focused on developing centers of influence and their own client base. Then, as they have more experience and more responsibility, you’re able to delegate down the details of the advice work and focus more on revenue creation.

InvestmentNews: Both of you have mentioned the words “process,” “structure” and “systems.” These seem to be characteristics of the top-performing firms. How hard is it for a firm that doesn’t have these words in its DNA to start adopting processes and structures and systems, especially if that way of thinking doesn’t come naturally to the principals?

Mr. Tibergien: Well, it’s intellectually obvious, but it’s not emotionally obvious to many. The best examples I can refer to probably are not in financial services at all but in manufacturing, technology and retail. For example, think of a company that’s publicly traded and highly regarded, perhaps because of a product that you purchase. That product was invented by somebody.

If it’s a retail shoe company, for example, it may have been started by a shoeshiner or a salesperson within a shoe store. Eventually, they created something because they surrounded themselves with the right people to do the right things. If it’s manufacturing, the business could have been a job shop that evolved. In the case of the advice business, one of the critical evolutions that the study reveals is that we are moving out of the job shop mode and into the business mode.

Now, if the principals personally do not have a disposition towards managing people, then what they should be doing is hiring professional managers to help them. One of the things that became clear in this study is that those firms that have committed to professional management were growing better than those firms who weren’t. Is there a cost? Yes. But is there also a return? Obviously.

InvestmentNews: Kelli, isn’t hard for a firm to change its DNA?

Ms. Cruz: In my talking to firms and advisers who have done this, I found that it’s really about deciding what you do well, identifying your strengths and how you want to be spending your time. As Mark was saying, you build an organizational structure around you, which means that you don’t recruit people exactly like you, but rather you recruit for a complementary skill set to help build the team.

Among top performers, one of the things that we found is that top-performing firms had more owners. These people are paid better, and their firms seem to be getting more out of them in terms of management and engagement. So ownership is definitely one of the keys to overall success. And its importance goes beyond just the owners. There’s an ownership mentality that everyone in the firm gets; they roll up their sleeves and sort of slug it out together, versus there being individuals who don’t really come together as a team.

Frankly, some owners have difficulty getting over the attitude that, “Gee, I don’t know if I want to increase ownership, because it’s just going to dilute the value I’ve already created.” In actuality, we’re finding that not having a lot of owners, and not sharing ownership, can actually be having a negative effect on a firm’s growth.

Mr. Tibergien: To that point, I’m going to make an assumption: that anybody who participated in this survey, took part in the webcast or reads the report is interested in building their business beyond where it is. Clearly, business ownership is not easy. It has a series of hurdles. And there are things that people may not want to do, but it’s really a question of defining success.

If you define success as working with a hundred clients, making a good income and not having to manage people, then that pretty much defines the investment that you’re going to make in the business. That choice is perfectly acceptable, and nobody should make a judgment about it.

But if you define success as creating an enterprise with transferable value that will live on after you in order to serve your existing clients and new clients, and that will provide a vehicle for your employees to grow, then you have to begin thinking about these changes, like multiple ownership and professional management. It’s when you resist that natural transition that it be-comes difficult.

So it’s a question of which pain you want: being alone without the resources and ability to grow, and having less income or living with the cost of investing in the business in a different way? Which medicine do you want to take? That’s really the question.

InvestmentNews: Let’s get back to the ownership issue. Are there any guidelines about wider ownership? In essence, how wide is wide?

Mr. Tibergien: It’s three or more owners. Think of it in its most natural terms. If you have a practice in a community with one principal, then by sheer virtue of time and contacts, that person will have only a limited network of who they know and how they can develop the business. If you multiply that person by three, four or five, you now have expanded the circle of opportunity within your community and your market by orders of magnitude. That’s part of the power of having multiple owners — they take on responsibilities that are within their wheelhouse and in their interests. You simply multiply your brand by orders of magnitude by having so many owners representing your firm in the marketplace.

The very best firms I have seen are those that are comfortable with their partners’ taking on responsibilities. The firms empower them to do the things that are within those particular areas. For example, not every owner has to be a manager. Some owners are better as a technician, some are better as a salesperson, and some are better as an executive. If you can check your ego at the door, there are many ways to build your business.

InvestmentNews: Mark, it seems that the implication of what you are saying is that succession planning and selling the business become less of a problem if all these systems are in place and ownership is more widespread. In those cases, succession and selling the business become more a natural evolution than a one-time gigantic event that the firm wasn’t prepared for and must gear up for.

Mr. Tibergien: Firms that don’t create a career path and an opportunity for ownership for their associates are taking away one of the best markets for selling the business down the road. Those firms that have multiple partners tend to be more profitable, which makes it easier to fund the buyout. They tend to be more valuable, which makes it more rewarding for the owner who is leaving, even with dilution, and it provides a diversified market.

The challenge in the advisory business is that it’s not like selling a franchised muffler shop. What you’re selling is a way in which you render advice, and clients who value the way in which you render advice, and a team with the discipline and philosophy of the way in which you do it. Just selling the book is interesting but not meaningful, on a relative basis, but when you have continuity in the practice in the way in which you’re doing things, you enhance the value quite a bit, and you have the opportunity for succession.

InvestmentNews: When advisory firms get the study, what should they do? How should they use it most meaningfully, and what should they do first?

Mr. Tibergien: I recommend that anybody running a business use a linear process for evaluating their business. The temptation is to see if you’re better or worse than the average. While that’s interesting, it’s not particularly helpful. Even before the survey arrives at your door, compile your financial statements from the past three to five years and look at them. Then, when the report arrives, convert your numbers into the key ratios in the survey — gross profit margin, operating profit margins, revenue per client, revenue per staff — which are the critical benchmarks you should look at. I would do that for each of the years that you’ve laid out so that you can see a trend in those ratios.

Third, I would look into the report and ask: “What are firms like mine doing, according to these ratios, and what are the top firms doing, according to those ratios?”

I would compare my numbers to those of the top firms to see if there is a negative variance. When you see a negative variance, I then would calculate what I call financial impact. By that I mean that if you look at the difference between your number and the best-performing firm’s number, and apply that difference to the numerator, what would you come up with in terms of the dollar difference?

The answer to that question helps you start making management decisions about the magnitude of the problem. Do you need to manage your staff better? Create different goals? Focus on revenue generation? Improve your work flow? What are the kinds of decisions you’re going to make when you do that analysis?

InvestmentNews: Kelli, any other thoughts about what advisers should do when they get the report?

Ms. Cruz: Again, looking at initiatives or things to do that would increase revenue, one of the things that came out of the study, both in 2009 and looking ahead in 2010, is the importance of having a strategic plan or refining one. Making sure that you’re connecting the dots is a really important part of the process as well. And then making an action plan and sticking to it, or a project plan around what the activities are that you want to make progress on, and creating some milestones so that you can hold yourself and your firm accountable for making progress.

Some of the firms that I’ve worked with have really divvied up this nicely and involve the entire firm. They split up some of the things they want to get accomplished and addressed, and folks have a lot more ownership in the process because they’ve been involved in the changes that the firm is making to drive it forward successfully.

Mr. Tibergien: Whenever we get into this discussion about how advisers are evaluating their practices, people may get their back up because they are saying, “Having a bigger practice and more profitable practice doesn’t make me a good adviser.” I agree, and I want to acknowledge that this study has nothing to do with how you give advice; it has to do with how you manage your business, so that issues of what investment approach to make and what processes to use are part of a whole separate discussion that should take place independently from one about the management of your business.

InvestmentNews: What kind of strategic planning are you talking about?

Mr. Tibergien: Think about strategic planning as your investment policy statement. This informs how you’re going to invest in your business, not how you’re going to invest in giving advice. For example, if you look at the different possible strategies in this business, serving rich people is not unique. That would cover the vast majority of people in the financial advice business. So the first question you want to answer is, who do you serve? In other words, what are the characteristics of the market beyond their assets or their income? Second, what do you want to be known for? In other words, how do your current clients describe you if they’re referring you to others? Are you known as a superior investment manager? Are you known as an expert in estate planning or long-term care?

The key is to be able to define what you are by that sort of positioning. When you know that, then you know what type of people you should be recruiting, what type of technology you should be deploying, what your process is for focusing on sales and marketing, and positioning in the marketplace, what your whole compensation and reward structure will be and even what your fee structure will be. Positioning creates the framework for making informed decisions about your business.

The reason the average adviser tends to be middling in their performance is that they are over-diversified in the types of clients they are serving, and they don’t provide a consistent client experience that they can define. Such firms lack a strategy.

InvestmentNews: Since the profitability of advisory firms is still tied largely to assets under management and the markets, it would seem — given the prevailing so-so outlook for the markets and the economy over the near term — that advisory-firm management procedures and techniques will become more important than ever. Do you think that is the case?

Mr. Tibergien: Yes. The market camouflaged a lot of sins up until 2008, and we find that happening during every recession and down market.

Between 2002 and the end of 2007, the average advisory firm was growing at a rate in excess of 25%, and much of that was due to market lift. When that kind of growth is happening, you think you’re pretty brilliant. You’re making a lot of money, your clients are happy, your employees are getting paid well, you’re taking home a good paycheck, and your values are going up — but that’s not reality. Reality is how you manage through difficult times.

Growth environments are like hypertension: They’re a silent killer. You just don’t know what’s creeping up on you, and what has been revealed by the market cataclysm is that a lot of misfires were going on within practices that today have to be fixed.

InvestmentNews: There is just enough time for a last thought. Kelli, any nuggets that you would like to leave everybody with?

Ms. Cruz: I just want to emphasize something I said at the beginning. Top performers demonstrated a better “service focus” than other firms: They define their ideal client and then stick to it.

The study shows this and really gets into it, delving into how top performers offer a narrower set of services, how they leverage high-value services across the majority of clients, and how they maintain a disciplined delivery and focus in their pricing strategies so that they are able to drive client retention and revenue stability.

InvestmentNews: Mark, any last thoughts?

Mr. Tibergien: I think that today marks the beginning of a new stage in the evolution of the financial profession.

I think that when it began, it was driven by technicians.

Over the last decade, it became adopted by the life planners, who are the people dealing with the softer elements of client management.

Today, we are in an evolution in which people are focusing on how to manage their business better.

Most of the study participants know that they are really good at giving advice to clients and really good at the technical aspects of what they’re doing.

The question is, how do they apply that same sort of passion to building a practice that will endure?

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