The following is an edited transcript of a webcast, “Unlocking Profitability: Key Differentiators of the Most Successful Advisory Firms,” held Sept. 25. Speakers included IN Adviser Solutions director of research and consulting†Kelli Cruz and Mark Tibergien, chief executive of Pershing Advisor Solutions LLC.
This webcast was sponsored by Pershing Advisor Solutions.
Ms. Cruz: Mark, with regard to operating-profit-margin target, what do you consider to be a solid mid-range target, and what figures are at the high end and the low end of the range?
Mr. Tibergien: Well, the optimal advisory firm should try to get to a gross profit margin in the 60% range and an operating profit margin in the 25% range.
When we look at that operating margin before distribution of dividends or ownership interest, what we're trying to understand is what influences that outcome. What we find is that minor changes in the gross profit have a profound impact on the operating profit of the business.
So it isn't a question of cost control as much as it's a question of pricing, of productivity, service mix and client mix that really dictates the outcome of the most profitable firms.
So if you're close to that 25% operating profit and a 60% gross profit margin, you're operating a very solid business. There are some firms that do more and many firms that do less, but that's the way to think about it.
Ms. Cruz: I want to turn now to marketing and business development. We know from the results of the 2012 InvestmentNews/Moss Adams Financial Performance Study of Advisory Firms that on average, firms are allocating about 2% of their total expense budget to marketing and business development activities. Is that the typical budget you see from the firms that are growing aggressively? What is the right amount for firms to be allocating?
Mr. Tibergien: Over the years, it's hovered around the 2% to 3% range, and frankly, that hasn't changed for as long as we've been doing this study.
The practical reality, though, is that that's more of a result than a plan. People are fairly random about how they approach business development and marketing, and the lack of a marketing strategy probably creates a negative impact or a negative spend for many of these advisory firms.
CREATING A BRAND
When we look at how firms are addressing the marketing question, what we generally find is that they spend 2%, but not necessarily on things that are actionable. They may be things like websites or community involvement or other activities that are nice and that are a demonstration of presence, but they're not necessarily systematic. They don't create new opportunities, they aren't measured in any form, and they tend to be random and incidental.
So the question is, how does an advisory firm not only create its brand through marketing but create results through business development? And what we find is that the elite firms are actually spending time training their people, including those who are afraid to build relationships outside of their friends and family, to go out and find business. And it isn't like “Death of a Salesman”-type selling, but it is a conscious effort to build relationships, position yourself in the community and do things that are more active that way.
Ms. Cruz: That gets back to some of the data that we shared. One of the top tactics or activities is the website, and that's a pretty passive way to go about marketing versus the second-highest activity, which is community involvement. It just strikes me that sales and marketing aren't very comfortable activities for the typical adviser.
Mr. Tibergien: I mean, let's just face it — we're even afraid to use the word “sales.” We're lumping it all into marketing.
And so let's just use the website as an example. It is passive. The question is: What are you doing to draw people to the website? Having one now is something that you just kind of expect; if you're in business, you're going to have a website. Now, if you have a website, is it dynamic, and do you have any kind of a process that encourages people to come to it? For example, do you do any kind of thought leadership that you get press on in your local community that would cause people to say, “Maybe I can go to that website and download it,” and once it's downloaded, it's a name that is recorded and it gives you an opportunity for follow up.
So the question is, how systematic are you at creating new leads and creating a process for pursuing them?
Ms. Cruz: There are two places I want to go with this. The first is training. Part of the challenge here may be that firms don't compensate their advisers for new-business development and that they need to look at their incentive plan design. I mean, we still have firms that are paying discretionary bonuses. And we know firms are challenged, especially smaller ones, on how to train staff. Is there anything out there that can help firms with sales training? Do you have any thoughts on compensation?
Mr. Tibergien: The first thing we know is that compensation, by itself, won't drive behavior, so it has to be coupled with active management and with expectations. So the idea here is, first, how do you, as a founder and a leader, give people the confidence to do the kinds of things that you had to do in order to build the business? That becomes the first hurdle — overcoming that natural resistance people have to building external relationships.
The second part of it, then, is: How do you create accountability for the individual to be developing centers of influence, putting on events that interest people, and then conducting some method of follow-up? As an example, one way to approach this is if you had — let's just call it a sales coach instead of marketing; I'm going to use more stark language just to create a distinction — so if you had a sales manager or a sales coach, somebody that you retain on some sort of basis, you could work with your relationship managers and say, “All right, you have to set up four appointments with centers of influence or prospects this week. I'm going to hold you accountable for that.” And when they come back, you tell them: “I'm going to debrief you on what the experience was and what the follow-up should be.” And so it's very much an on-the-job kind of approach to teaching people how to engage centers of influence and prospects in meaningful dialogue that will drive the business to you. Again, it doesn't have to be overt sales, but it has to be some form of engagement that you follow.
The third element is how you align compensation with the behavior that you seek. If it's discretionary compensation, then it's not tied to any particular behavior. But if you're going to have incentive compensation with a portion of it geared towards how many new clients are brought in, a key element of that should be some measurable effort that says that if I'm going to reward you for business development, it has to be more than accidental business; it has to be a systematic approach to reaching out to the market to drive some sort of an outcome.
Ms. Cruz: From our study, we know that the number of new clients and revenue attributable to having a dedicated business development officer has remained static for the industry as a whole. Yet we do see that there is a steady commitment, mostly on the part of larger firms, to a BDO role. Only 15% of total respondents reported having a dedicated role, and those BDO positions were mostly concentrated among the larger firms.
Those larger firms report having luck with that new-business-development role. Are there some things we can glean from the success that larger firms are having? What advice do you have for firms out there that might still be considering having a dedicated business development officer in their firm?
Mr. Tibergien: Well, I think your use of the word “luck” is probably appropriate because, generally speaking, when you're dealing with individual clients, having a business development person who will not be involved in the ongoing relationship is difficult and random at best. If the purpose of that business development person is to help the relationship managers to capture more opportunity, then I think that's a higher-impact way to approach the business.
On the other hand, if your practice is geared towards institutions or 401(k) plans — or decisions that are not personal per se but are more corporate or institutional — then having a dedicated business development person tends to make sense because the way in which those opportunities are presented may be in the form of [a request for proposal] or other framework for selection, and they tend to work better in that case.
So I don't know that having somebody who is a bird dog who's going out there and finding leads for a wealth management firm geared to individuals is necessarily a winning strategy, but I think that the idea of having somebody who is helping others to develop those relationships makes a whole lot of sense.
Ms. Cruz: One of the findings from top performers is that they are targeting clients from the perspective of peak earnings. In terms of how they're defining ideal clients, top performers really stood out: They showed a significant preference for clients 45 to 54, and they had a significantly lower preference for pre--retirees, that's 55 to 65. We think this difference could be one of the key drivers of top performers' higher growth, giving them a bigger opportunity for asset gathering and organic growth as those earners build retirement savings. Are you seeing that, Mark, in terms of a focus on which clients they're targeting?
Mr. Tibergien: Well, I think that any strategy that's based on people with money is a little shallow. Obviously, the first criterion is whether or not you're going to be able to do business with them. But I think that you have to add more characteristics than just whether or not they are peak earners or accumulating. I think you have to say what line of work they're in, or how is it that they happen to be peak earners. Are they lottery winners or are they business executives? Are they high-tech engineers? Are they in the medical profession? What is it that's driving it? Or are there other characteristics that might be demographic. Are they of a certain church group or ethnic group, or are they gay or lesbian? Do they have hobbies that might suggest that they're people of affluence?
I like the idea of not building a business solely on boomers who are going into retirement, because eventually, that's going to come back to bite you. Those people will die and their assets will be distributed, and you may not have an opportunity with the next generation. But if you're systematically focused on the pre-retirement or the retirement market and you can manage the natural attrition that occurs there, then that can be a good strategy.
But in the end, saying that you want people with money as clients is not a sufficient strategy. There have to be other elements that allow you to position yourself in the marketplace. So just imagine if somebody asks who your typical client is, and your answer is “people who are earning money.” It's hard for me as a client to make the connection that you understand what my needs are and that you're going to be unique to me. But if you build on the model a little bit more by describing your business and who you serve in a way that might resonate with me, then I might be more inclined to do business with you.
Ms. Cruz: A question from the audience: At what point do firms transition to having dedicated management — in other words, people who are not responsible for production?
Mr. Tibergien: When you're probably at $600,000 to $750,000 of gross revenue, you need to start thinking about whether or not you can have at least a part-time professional manager in there, assuming some of the responsibilities. Clearly, when you're breaking $1 million, you have to start creating different levels of accountability within the firm and having people doing things that you shouldn't be doing. It just becomes a question of what you can afford to do.
One of the reasons why the top-performing firms are the top- performing firms is because they're investing in capacity. In many cases, the advisers don't really love managing people or building a business; what they love is working with clients. And so the sooner that they can get out of the way of how the business is running and focus on what they do well and allowing others to drive the bus, the faster that they're going to grow.
HIRE A GENERAL MANAGER
So it's a point of moving forward, then taking a step back. But it may be that you don't hire a true CEO but instead a general manager who can help you with executing on the strategy that you've conceived. That probably would be the optimal way to think about professional management in most practices.
Ms. Cruz: A listener asks: At what point do you recommend going from a sole practitioner to hiring staff? This person's around $250,000 in gross revenue and has no staff.
Mr. Tibergien: I think that's the same principle as professional management and a question of what you can afford. I think that the driver of that really depends on the number of clients you have and the nature of your clients.
Typically, when you're starting with an advisory business, you're taking everything that breathes, and so part of what you have to do is to think about culling that client base so you can focus on where you make the greatest impact.
But what we find is that advisers who begin to surround themselves with people who can help them manage their business lives tend to be far more productive and far more profitable, long-term. So I think at $250,000 I would definitely be thinking about it, but I probably would use a benchmark of how many clients do you have, and what can you afford to spend, beginning with an administrative assistant and then moving from there.
Ms. Cruz: What should that first hire be — strictly an admin person, an assistant, a paraplanner? Again, I think that goes back to the type of business that you're running, but where do you see yourself needing the help and how you create capacity?
Mr. Tibergien: I think the guideline there should be, what things shouldn't you be doing? What things don't add value to your business? And all of us have those things. It's a question of being comfortable enough to empower others, to delegate to others, things that we're not good at or have an interest in, and we don't add any value to our business doing.
Ms. Cruz: Outsourcing and technology also play a big factor in leverage and capacity.
Another question based on your observations about profit margins: Average gross profit and operating profit benchmarks are often shown based on a broad range of assets under management and not often by specific region. In a big market in a high-cost region such as Los Angeles, would you modify the 60% gross profit and 25% operating profit?
Mr. Tibergien: There are always regional differences. I think the biggest difference regionally is the overhead cost, because that cost of doing business is higher.
If you happen to be in a market where your professional compensation is higher, then part of what you have to do is adjust your expectations on the revenue side. Bear in mind that this is not a score; this is not you comparing whether you're better or worse than others. It's saying, “I'm establishing a target or a benchmark that helps inform the way in which I manage the business.”
So 60%, I've seen many firms in Los Angeles and San Francisco and New York have the ratios that I'm talking about — if not better — because they also happen to be in richer markets, they have larger talent pools and they can be more systematic about the way in which they do business. So a 60% gross margin and a 25% operating margin is not inconceivable and, in fact, in smaller markets, it might even be more of a challenge because you don't have necessarily the same client pool, the same talent pool and the same high level of productivity that you might have in a larger, more expensive urban market.
So it's true that we're looking at averages, but the key here is that when you compare your numbers with this study's results, the question is, what is the size of the negative variance? Frankly, you should compare yourself to the top performers, not to the average, because the only time you want to be average is when you're below average. So if you compare yourself to the top performers and you see a negative variance, you have to ask what the causes are and what it would take to get close to what the median is for the top-performing firms.
As an example, if my gross profit margin is 55% and the target is 60%, that 5% negative variance should tell me that I need to look deeper at my pricing. Am I squeezing out as much productivity as is reasonable within my business? Is my client profile right, and is my service offering right? If I can think in those terms, then I can use the benchmarking as a management tool rather than a score card.
Ms. Cruz: Let's talk now about pricing and fees. A finding from our study this year is that average fees are higher across the board. In the 2010 study, average fees ranged from 0.52% to 1.17%, depending on the asset level. This year's study shows average fees ranging from 0.63% to 1.53%. Mark, are you seeing fees increasing, and do you think this is an effective method for firms to increase revenue and profitability?
Mr. Tibergien: In some cases, it's the only method for increasing revenue and profitability because many firms don't have the capacity to grow, so the only way they can grow revenue not dependent on the market is to adjust their fees.
But the question is whether or not the advisory firm is demonstrating value to its clients so that it can rationalize the increase in fees. We are consistently finding across the country that some of the top-performing firms, at least a third of them, have made some effort to raise their fees, either by spreading out the asset-level break points at which they determine what will be charged or by charging supplemental fees.
This study reveals that on the lower end of the client base, advisers are saying — and this would go, by the way, to the previous question on operating margin and gross margin — “My average cost of serving a client is $4,500, but I have 100 clients that are only paying me $3,500 a year.” Well, that means you have a whole bunch in your client base that are subsidizing the smaller clients.
So an approach to that might be to say, “In order for me to deliver an appropriate client service experience, I have to figure out a way in which to get the client to pay my costs plus some margin for delivering services to them; otherwise, it's not worth working with them. Otherwise, the more of these I get, the more I lose.”
LOSING CLIENTS CAN BE GOOD
So the way in which some firms will do this is that they'll say, “In order for me to deliver my client service experience, I need to charge a minimum fee of, let's say, $6,000.” And you can do this either in the form of asset management fees — “If you have sufficient assets, I'm going to charge you the same as others, or you can write a check for the difference for me to deliver other things, like financial planning” and all those other solutions that you provide.
I've found that to work effectively in many cases. In some cases, the client says, “I don't think you're worth it,” or, “I don't think I can afford to do that.” At that point, you want to be prepared to refer them to someone else. Sometimes it's a good idea to lose clients. As painful as it is, the more that you can shift your business to relationships that are optimal for you — where you can generate a return and you feel good about working with them as a businessperson — the better you're going to be, and it's OK. Sometimes there are clients that are better served by somebody else who has a different service model.
Ms. Cruz: Why is that such a hard thing for practices and firms to do?
Mr. Tibergien: Well, it's human nature, I think, especially if you like the people, if you feel like you have an obligation to them, maybe they were a critical part of your early-growth phase. And by the way, there are certain circumstances where you may discount the fee just because you value the relationship, or it's your mother or there's something that is going on that would cause you to say that you want to be at a lower rate for them. But it's when you make the exception the rule that you have a problem.
It's human nature to avoid the discussion of money. Every adviser I know says that they have clients who can't talk to their spouse or to their children about money. And in many respects, financial advisers can't talk to their clients about money, either. They're afraid it's going to seem dirty or too salesy or somehow inappropriate for what it is that they're delivering.
Eventually, you just have to get over it and say, “Look, it's a professional decision. It's not about friendship.” It's the notion of, “I'm delivering something of value, something that will profoundly impact your life, and this is what the market is saying that I'm worth, and this is the value that I believe I'm delivering. Are you willing to pay for it?”
You know, you don't find attorneys and accountants and doctors eagerly discounting their fees or keeping them down.
Ms. Cruz: Another interesting finding is that top performers are much more likely to change fees on a case-by-case basis. About half of both groups, 48% of top performers and 49% of all other firms, implemented across-the-board increases at all levels of their fee schedules last year, yet top performers were much more likely to review fee increases on a case-by-case basis, 43% of top performers versus 28% of all other firms. Any thoughts about why that would be?
Mr. Tibergien: Not knowing the motivation behind it, I can only speculate. I suspect that part of it is saying, “In some cases, the clients are paying me the value that I'm delivering, and in other cases, they're not.” So the notion of being a little more deliberate about that strategy doesn't offend me at all. It's a thoughtful approach to pricing that shows that people are thinking about what that relationship is worth.
Some people might be inclined to charge extra for a client who's a pain — as compensation for pain and suffering — but in other cases, it's more deliberate.
PRICING EQUITY A WORRY
The question is, how do they get to their pricing structure in the first place? When you tend to be discriminating in your fee structure, the thing you always worry about is fee equity or pricing equity. What you want to be careful about is that, knowing that many of your clients know each other, there's always that risk that you will be discovered. So in the course of thinking about your pricing strategy, make sure that it's something that you can defend in the event that you're ever confronted on it.
Ms. Cruz: I want to talk a little bit about the balance sheet. Historically, most advisory firms have laughed, if you will, at the discipline of the balance sheet. I know we are finding, though, that more top performers are using the balance sheet to help manage their business. Mark, could you take a couple of minutes to talk about the importance of the balance sheet and how it helps firms manage their business?
Mr. Tibergien: The balance sheet tells you two things — the ability to pay your bills and the ability to withstand adversity.
When you look at the structure of the balance sheet, on the left side, it's showing you what you own in the form of assets, and on the right side, it's showing you how you fund what you own by a combination of debt and equity.
USE OF LEVERAGE
So as we look at advisory firms, the larger they get, the more capital they require, not at the level of a manufacturing or distribution or retail operation, but there's capital required, for example, because they are operating for three months without income; they may be billing on a quarterly cycle. Or they may be expanding, and they have leasehold improvements or fixed assets like computers and other equipment or furniture. So the reality is that there are both intangible and tangible assets that tend to accumulate on the balance sheet, and every adviser needs to think about how they are managing that side of their business. So if you're in a growth cycle, the debt-to-equity ratio tends to be a good clue as to whether or not you're operating at a sound level.
But the second element that comes into play is that we've seen an uptick in advisers' using debt or financial leverage to build their businesses. They may do this for acquisition purposes; they may do this for recruiting purposes. As a custodian, Pershing gets frequent requests from advisers or prospective advisers to consider some kind of working-capital loan to help them with a strategy. And oftentimes, when we go through that analysis, more times than not, we'll say yes, but it's not uncommon for us to say no because the financial adviser is a large credit risk. They may have personal obligations that exceed their ability to repay or they may have a history that demonstrates a tendency not to repay, so that becomes an issue as well. We have to be thinking about how you are going to finance your growth and whether or not you can afford to repay the loan — and not out of collateral.
The other thing to think about is that there's a rule in funding that says, match your funding to the useful life of an asset. The reason that you don't have a 30-year loan on your car or a one-year mortgage is that those examples would be misaligned. So when you're matching funding to the useful life of an asset, think about it in these terms. If you have leasehold improvements or equipment like computers that you're purchasing for your business, the reason that you don't use short-term debt is because that's misaligned, and all you do by using short-term debt is create a working-capital problem. It's putting financing against the wrong kind of asset, and that's when advisory firms tend to get in trouble.
Ms. Cruz: Let's talk a little bit about hiring and what we're seeing with top performers in terms of building capacity. One of the questions I get asked a lot, especially from smaller firms that are growing, is that they're never sure when to make that hire. What's the right time? If they don't time it right, they've reached capacity, and it's almost as if they can't take on new clients because they just don't know how they're going to serve them. Yet there's the stress of, “If I hire ahead of the curve, how am I going to be able to afford to do that?”
So what are some of the financial metrics advisers want to be looking at, and also, what are some of the practices that help firms figure out when the right time is — before they hit that capacity level?
Mr. Tibergien: Running a business is like running a personal life in that, to the extent that you can save and accumulate while you're flush, it's often a good idea. And I recognize that advisers, in the early phases of their practice, are just one step ahead of the sheriff in terms of the money they're allowed to save.
A GROWTH CYCLE MOVE
But if your business is truly in a growth cycle, where you're adding the right kinds of clients — paying you the right amount of money — then generally speaking, you should know when you're at capacity and try to hire when you're 70% to 80% of capacity. And part of this process of hiring is to say, is this somebody to whom you can delegate some work so that it can free you up?
So a little exercise that you want to go through when you're making the hire is to say, if we use an example of a gross profit margin of 60% and you're thinking about hiring an adviser, that 60% is your contribution margin. So let's say that you want to hire another adviser and that that person is going to cost you $100,000 all in, their salary, their benefits, the cost of the equipment and the furniture. What you would do is, you'd divide the $100,000 by 0.6, and that would give you your break-even point on that person. So what that would tell you is the revenue number — $140,000 — that you have to generate to cover the cost of that hire.
DOING THE MATH
And then the next question is: An average client is paying me $10,000 a year, so if I divide $10,000 into $140,000 of new revenue that I need to generate, it shows that in order to break even on this hire, I need to add 14 new clients. Now my question is, “Is that a reasonable expectation? Can I accomplish that within the next 18 months?” If so, it's probably — you know, it's a bet and that's the nature of business; nothing is guaranteed — but it at least allows you to frame it in chunks that you can make a decision whether or not it's a reasonable calculation or gamble, or something beyond the pale.
Ms. Cruz: Given that top performers are more likely to pursue mergers and acquisitions, consolidation continues to play a role in the evolution of the industry. What type of M&A activity is Pershing Advisor Solutions seeing and what are your thoughts on these developments?
Mr. Tibergien: Well, I think that M&A activity is increasing. We certainly are seeing it at Pershing in terms of adviser-upon-adviser mergers and acquisitions, rather than selling to consolidators. I mean, there still is activity among the roll-up firms and the consolidators to bring firms together, but the greatest activity is among other firms that are saying, “We need to get to critical mass.” In fact, I would say almost every adviser who uses Pershing Advisor Solutions has said to us that they would be interested in looking at merger or acquisition opportunities.
The challenge is that sellers have been deluded into thinking their practices are worth more than they are. And it creates some friction in a normal market, where buyers are attempting to negotiate a reasonable outcome but they're dealing with people who are fairly emotional about the transaction themselves. You miss the opportunity to do things.
M&A LIKELY TO INCREASE
The second part is that advisers who are going through mergers and acquisitions tend to look at the numbers and forget the cultural aspects of whether or not an integration makes sense.
But I think that for a variety of reasons, from regulatory reform to margin compression to the talent shortage to the need for professional management and business continuity, the trend towards mergers and acquisitions will increase.
And I don't think of it as an exit strategy but as a growth strategy. As difficult as it is for people to be thinking about sharing their sandbox with others, from a business standpoint, it may actually be more beneficial to them if they can think about how their business could transform if they could offload things to other people and if they could share their expenses in a way that might be transformative for their business.
Ms. Cruz: One last follow-up on that: We're seeing more creation of groups of advisory firms that are looking to buy firms. There's a new match service that was launched recently.
In the experience I've had in this area, especially when I'm out doing presentations, when I ask the question, “How many sellers are there in the room?”very, very few hands go up; everyone's a buyer.
So is it possible that there are more sellers out there and they're just reluctant to raise their hand? If that's the case, how are these matches going to come about?
Mr. Tibergien: That's a subject people don't want to come out of the closet about, because as soon as they reveal that they're for sale, that can be used against them, especially if it's a community event, so I think people tend to be reluctant about that.
But the first point I'd make is that planning for a sale is not the same as planning your succession. They're two different concepts. One is ownership transition; the other is planning for the orderly transition of your business. One is a liquidity event; one is a management event.
So I think that this notion of selling is an economic question and a growth question. I think that if we frame it in terms of who'd be interested in a merger, I think as a more comforting thought, that's probably a phrase that people could get behind because they'd say, “Sure, I'm always interested in a merger if it's going to be beneficial to my clients and to my business.”
In private conversations, the number of people who are contemplating it is quite substantial, not least because, in spite of what I just said about the succession issue, many people realize that if they don't deal with this question, their clients are going to be left holding the bag because, one way or the other, they're leaving; voluntarily or involuntarily, they're out of the business.
They're going to die with their boots on or they're going to walk out on their own two legs.
So the question is, how do they ensure that some level of money goes to their heirs in the event of their getting out of the business, and how do they ensure that their clients are tended to in a proper way?