Kitces: Will scale really boost your firm's bottom line?

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One of the biggest reasons that established firms are difficult to unseat is because they benefit from economies of scale. Given how attractive these economies are, solo advisory firms and even smaller (e.g., less than $200 million in client assets) ensembles naturally focus on scaling up — whether through expansion of the firm or through a merger or multiple acquisitions — to achieve greater cost efficiencies.

Yet increased size and revenues don’t necessarily result in increased profits, and scaling up in a time-intensive service industry isn’t always the most effective way to increase firm profitability. Indeed, the idea that as advisory firms scale, their margins improve is a myth.

Luckily, alternative strategies can be employed to improve bottom-line results outside of growth for growth’s sake. And while these strategies don’t necessarily require capital, they do require a potentially painful gut check.

I received an email recently from a reader struggling to determine the best way to grow and achieve better economies of scale. His firm held about $60 million in assets — two-thirds between the reader and his partner — and the rest between two other advisors. Yet with overhead accounting for about 65% of the firm’s revenue, growth strategies seemed the logical thing to consider.

I wasn’t surprised that he would be unhappy with 35% in earnings before owner’s compensation. But with overhead expenses at 65% of revenue on a $60 million practice, I actually urged him not to try to grow. A 65% overhead expense ratio isn’t a scale problem, it’s an overhead problem.

Advisory firms that optimize their profit and loss statements and margins share some attributes. Assume for a moment the revenue for my reader’s firm is around $500,000 or $600,000 — i.e., the typical 1% AUM fee on a $60 million practice.

Technically, a portion would be the work in the firm for the owner while the rest would be the profits of the firm, but again, solos and partnerships with one or two advisors typically don’t make that distinction — especially in partnerships and LLCs where there legally is no salary. So we just look at total take-home pay of the advisor in the aggregate, regardless of how it’s characterized. That’s why we tend to look at EBOC instead of profit margins in firms.

In fact, the most successful advisory firms in that $500,000 to $1 million revenue range go even higher. We’ve seen some recent benchmarking studies that show top performers with up to $1 million of revenue taking home as much as $.80 or $.90 on every dollar of revenue.

This is typically achieved by working with a moderate group of reasonably affluent individuals who pay a healthy fee, and where the firm doesn’t actually need much staff. A solo advisor with just 50 great clients averaging $1 million or $2 million of assets each will allow that advisor to generate $700,000 or $800,000 of revenue.

And ironically, solo advisory firms tend to have the best EBOC margins and advisor take-home pay relative to their revenue of any firm of any size. The larger a firm grows, the more staff infrastructure is needed, which by design eats into the firm’s revenue.

The incredibly high margins in solos and small partnership firms is why we see industry benchmarking studies noting that the most profitable solo advisors take home as much as the typical partner in a $1 billion firm. There’s a lot to be said for being lean and mean.

Firms that are not enjoying 65% EBOC with only 35% overhead costs have some decisions to make. You may need another paraplanner or support advisor. You may need another operation staff member, which means more office space. Then you need more software licenses, compliance oversight, staff managers, employee benefits, and it goes on and on.

Simply put, you can’t grow revenue in a vacuum. You can add a client or two without bulking up your infrastructure, but you can’t materially grow the revenue in an advisory firm without increasing staff costs.

As a firm grows, they have to actually start billing the rest of the infrastructure of the firm. Eventually you need a chief operating officer to come in to oversee the managers, HR personnel and payroll administrators. And these are all non-revenue–producing positions.

Given overhead expenses tend to rise as the firms grow from $100 million of AUM and up, trying to grow more from here not only won’t fix profitability problems, it will probably make them a lot worse. Consequently, the firm struggling at 65% overhead margins could see 70% overhead as it bulks up, owing to all the infrastructure hiring that comes at the next stage.

If you take a not terribly productive firm and grow its revenue, you just apply more downward pressure on the inefficiencies lurking beneath the surface. That could lead to profitability eroding even further. Growth doesn’t solve profitability problems in advisory firms, it compounds them.

So what is an ambitious firm owner to do? The first challenge is to try determining how to fix the profitability problem.

This requires reckoning with the underlying problems in the practice. In the reader’s case it could mean he is doing too much for his clients or charging too little. Some firms may say, “We charge competitive fees but we give our clients better and more personalized service. That’s our differentiator.” I’m sorry, but competitive fees with superior service is not a differentiator, it’s a charity.

On the face of it, there’s nothing wrong with giving premium service, but we don’t go to the Four Seasons and expect discounts. If you’re going to give premium service, charge a premium price. Then your profit margins don’t suffer and your overhead expense ratios are not problematic.

Now, if you’ve innovated some brilliant new way to do high-touch service at a fraction of the cost, kudos. Then and only then can you really differentiate by saying, “We do more for less.” But for most advisors, “We charge competitive fees to give superior service” just means you’re over-servicing clients for the fees you charge. You’re literally not getting what you’re worth. If you offer premium service, charge a premium fee.

Some firms unwittingly undermine their profitability and productivity in more subtle ways. Think of the firm that says, “I have to do a different portfolio for every single client.” Multibillion-dollar firms do just fine with only a few standardized portfolio models for clients. Allow lots of exceptions in the portfolio for various client scenarios and you’ll need more operations and trading staff to manage the portfolio. This also will double staff’s meeting prep time. And all the while they won’t be able to figure out why they don’t have any time in the practice.

Firms with profitability problems may utilize multiple custodians to accommodate clients wherever their assets are, when in reality just one custodian will work fine for most firms. Clients who buy into your value proposition will move the money wherever you are. So if you’re struggling to get clients to move, the solution isn’t, “Let’s add more custodians,” but rather “Let’s figure out how to make our value proposition more attractive, so clients are willing to move to the platform we efficiently use.”

Other firms may tuck in small local advisors who don’t actually have enough assets and revenue to pay their fair share of the firm’s overhead. They may add revenue to the top line but don’t add profits to the bottom one. Even worse, they may subtract profits because they don’t contribute enough to the firm to cancel out the overhead they add.

And in some cases, the firm has too many small, unprofitable clients. An advisor may say, “They hardly ever call and they don’t take much work,” but in the aggregate, they consume a lot of staff time. And while consuming a disproportionate share of resources, these clients add nothing to the profits and value of the practice.

That means again, the solution isn’t to grow, but to right-size the firm and fire — or at least graduate — your smaller clients to another advisor where they’re a better fit. This frankly is better for both the firm and the client in the long run; never again would they be considered a don’t-take-much-work client.

The bottom line is to recognize that the very essence of scale means your next 100 clients are more profitable than your last 100. That’s scale. And while it might be appealing to say, “We’re not as profitable as we’d like, let’s grow our revenue and add more clients,” you can’t expect to add 100 clients without hiring.

When you consider how much hiring is required for your next 100 clients, hopefully your silver lining is a reckoning with the core problems in the business — whether it’s over-servicing clients, undercharging them, not standardizing or not focusing enough on those you serve. If those core problems go unaddressed, driving for more revenue and growth won’t improve profitability, but merely compound inefficiencies.

All of which is to say the starting point for a firm looking to increase profits is not to grow its business, but to change it.

This article originally appeared in Michael Kitces
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