The industry may be adding registered investment advisers annually, but it's also consolidating at a record pace for one reason: the power of scale. Highly competitive,, aggressive growth RIAs are reshaping the landscape.
Armed with capital, they are harvesting RIAs seeking to sell or breakaways that don't want the burden of running their own firms. It seems that every week, another RIA joins the $1 billion club. I fully expect the emergence of a dozen or more very large regional and national RIAs.
Faced with increasing competition and the race to scale, how can RIAs survive — even thrive — by achieving scale and drive to higher valuations without (or in addition to) an acquisition strategy?
Dynasty Financial Partners, with the help of Advisor Growth Strategies, recently concluded a study among RIAs to determine the drivers of profitability and more specifically identify whether scale or "virtual" scale delivered by partnering can improve profitability and drive higher RIA valuations.
We found that attaining virtual scale was possible through shared platform services and that it resulted in RIAs being better positioned to realize higher valuations based on the metrics that matter most: size, revenue growth, profit margin and professionalism.
To draw apples-to-apples comparisons between RIAs that used shared platform services and those that did not, we created a new profitability measure called earnings before owner and adviser compensation, or EBAC. Given the disparity in structures across the RIA industry, earnings before owner compensation, or EBOC, does not tend to work as a meaningful measure for larger, more professional RIA firms; and earnings before interest and taxes, or EBIT, does not tend to work for smaller, owner-operated firms.
EBAC allows for comparison of the true margin of RIAs before paying advisers and owners, offering a meaningful comparison of margin across all sizes and types of RIA firms.
The research compared EBAC across a cohort of 15 RIAs with assets ranging from $200 million to $4 billion that have a shared services platform, against a customized benchmark compiled by AGS of 19 RIAs with assets of $300 million to $2 billion, as well as against the latest benchmarks from two large custodians.
The Results Are In
The research showed that virtual scale delivered through a shared services model can be an extremely effective, profitable means of driving RIA growth and value.
The shared services cohort reported EBAC of 62% of revenue on average. The other industry benchmarks saw EBAC rates from 56% to 58%.
We discovered that when firms "in-source" elements of the front and middle offices, instead of "outsourcing" to a shared services platform for virtual scale, they tend to overinvest in personnel and underinvest in their platform.
The net result was lower profit margins and very likely a less scalable business model. While the shared services cohort pays substantially more for their state of the art platform and consulting services, these higher costs are outweighed by far lower personnel costs and other expenses.
More surprisingly, the shared services firms expanded EBAC as they scaled. By continuing to outsource, they continued to benefit from virtual scale to deliver escalating margins, increasing their professionalism by reducing their operational and management complexity. Having the time to focus on high-value services that drive client delight and attract new clients, they were better able to drive growth.
This result is different than many of the industry benchmarks, which often show little margin improvement as stand-alone firms grow in scale. We believe RIA owners often overestimate their relative scale; underestimate the impact of the direct cost of employees and the time required to hire and manage non-advisory employees; and overemphasize the relative cost of technology and outsourcing solutions. As a result, RIA firms mistakenly in-source activities that would be more effectively outsourced.
Higher EBAC Yields Higher Valuations
The difference between the EBAC of the shared services cohort and that of the AGS custom cohort was 11%. To calculate the valuation difference, we adjusted EBAC to normalized EBIT by subtracting an expected payment to advisers from EBAC of 35%, which resulted in EBIT of 21% for the AGS custom cohort, and 27% for the shared services cohort. This considerable 29% difference in EBIT would likely translate into at least a 29% higher valuation for shared services firms.
A 40% payout to advisers increases EBIT and valuation for the shared services cohort to about 38%.
The analysis clearly shows that outsourcing activities to shared platforms for the benefits of virtual scale tends to drive improved margins and, likely, faster growth while resulting in significantly higher firm valuations.
In an increasingly competitive and consolidating industry, RIAs should ask themselves: "Even though we have a successful firm today, is there a path to being even more successful, more sustainable, more valuable? How can we benefit from achieving virtual scale through outsourcing versus doing it all ourselves?"
Todd Thomson is chairman of Dynasty Financial Partners.