Kitces: The future looks bleak for midsize RIAs
One of the most popular debates in the industry today is whether small advisory firms of the future will be able to compete against the ongoing growth of today’s mega-RIAs. More than 60% of client assets are now held at only 4% of RIAs nationally. While small practices seem to be most at risk, firms that inhabit the middle ground should be paying the most attention.
That’s because despite the negative forecasts, industry benchmarking studies continue to show record profits for the most successful solo advisory firms, generating as much income as the per-partner, take-home pay of billion-dollar firms. The ongoing success shouldn’t come as a surprise, given the “long tail” phenomenon observed in many industries today. Niche providers can survive and thrive as technology makes it increasingly feasible for consumers to find their way to them — from niche books on Amazon, niche music via streaming services and niche financial advisors via a simple Google search.
But, the story gets murky in the middle. As the largest firms scale operations and niche advisory firms continue to hone services further, the broad middle is experiencing business pressure from both fronts. How wide a swath? Today it would encompass firms with $100 million to more than $2 billion of assets under management.
Being too small to be big and too big to be small is becoming a real liability. As the advisory tail grows longer and the head grows bigger, the perils of this middle ground can’t be overstated.
First, let’s consider idea of the long tail idea. Instead of trying to find the next hot product to stock in inventory and sell — i.e., the traditional challenge of the brick-and-mortar store — digital businesses with a near-zero marginal cost to expand their inventory could make a substantial profit with niche items that individually sold few units but could bring profits in the online world. While brick-and-mortar music stores at the time might have only held 40,000 tracks’ worth of audio for customers to buy, Rhapsody — a popular digital music service of the time — was seeing regular downloads of its top 400,000 tracks.
Similarly, Barnes & Noble’s physical bookstores at the time carried an average of 130,000 titles, but Amazon was generating more than 50% of its revenue outside its top 130,000 titles. The typical Blockbuster video rental store carried 3,000 titles, but Netflix was generating 20% of its rentals from outside the top 3,000 films. This demand continued to shift as Netflix grew.
The success of this phenomenon has come to be known over time as the development of a platform business, which can outcompete traditional businesses by focusing not on the stocking and selling of goods, but on creating a marketplace where buyers and sellers can come together in a manner that dwarfs traditional competitors.
Thus, as Tom Goodwin once noted in a TechCrunch guest post, “Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening.”
But while the rise of the platform has been a huge success for the businesses that created them, they also have enabled the niche players themselves. Business ideas that may have never been economically viable on their own suddenly could be, thanks to platforms.
THE BIG HEAD
Stoked in no small part by technology itself, a raging debate exists around whether the future of the advisory business lies with the largest of firms that can leverage all this technology to out-scale the independent advisor, or whether independents will be able to leverage the same technology and the emergence of platform marketplaces to thrive.
Thus far, the answer appears to be both.
On one hand, there are only 687 RIAs with at least $1 billion of assets under management — and that’s out of nearly 18,000 SEC-registered investment advisers and even more state —registered investment advisors, according to data from Cerulli. But that nominal 3.8% of RIAs now commands a whopping 60% of all RIA assets, up from 2.8% of firms in 2012.
In other words, the largest firms are quickly becoming the dominant collectors of client assets, using their size and scale to grow even larger and capture more market share, and in turn attracting the most affluent clients who seem to gravitate to them. The race to be a $1 billion firm in the 2000s is now a race to hit $10 billion. Simply put, the big are getting bigger.
On the other hand, industry benchmarking data also shows that the most successful solo advisors are seeing record profits as well, with average take-home pay of more than $600,000 per year and a whopping 75% profit margin before owner’s compensation. Advisory firms have to grow above $1 billion of AUM just to return to the average take-home pay per partner of the most successful solo advisory firms that stay small — a clear testament to the power of the internet, the ultimate discovery vehicle for niche advisors.
In other words, the issue is not that the largest advisory firms are necessarily constraining the small firms’ ability to compete, nor are the small firms drawing away a material number of clients from the largest firms. Obviously though, something has to give.
THE DANGEROUS MIDDLE
In the long tail model, the big head of distribution contracted as the long tail grew longer, providing niche providers with entrée to customers they might not have otherwise been able to reach.
However, online platforms have evolved substantially since the early days. As marketplaces have grown, the challenge has become figuring out how to select from an overwhelming level of choice, which has led to new tools and systems — e.g., ratings and reviews, recommendations from others based on what you said you liked, etc. — that help consumers discover new products and services of interest based on what others think and consume.
The end result has been the rise of virality, where social sharing can prompt even more people to buy the most popular products and services, in addition to discovering more niche solutions. Thus, while the long tail has grown longer, the head of distribution has grown too — and the middle has been getting squeezed.
This shift shouldn’t be entirely surprising, as it’s simply the discovery value of the long tail platform continuing to play out. First, internet technology shrunk the middle by providing a way for consumers to locate and buy niche products and services. Then, as the platforms and their discovery capabilities grew — facilitating the tendency of humans to move in herds — the middle shrunk even further as both the most popular and the most niche benefitted. The squeezing of the middle is the inevitable byproduct of these forces.
PERIL FOR ADVISORS
The effect of being caught in this dangerous middle is quickly evident in the decline of advisor take-home pay as advisors grow materially beyond $100 million of AUM and begin down the path toward $1 billion. Given it can take a decade or even an entire career just to complete that growth path, this sting is all the harsher.
Advisory firms tend to encounter a number of challenges as they grow. The first is a capacity wall. As human beings, most advisors simply can’t mentally handle more than about 100 client relationships. This means the firm has to bring on additional advisors or outright additional partners, which increases overhead and/or splits its net profits, thereby reducing per-advisor take-home pay.
Once the firm grows past its capacity wall, it has to begin building infrastructure to handle operating as a multi-advisor firm until eventually, it hits a size and complexity wall. At this point the firm has to reinvest even further into staff, systems and technology. This is the stage where the firm hires a chief operating officer, revamps its various software tools from CRM to trading and rebalancing, and incurs a series of additional infrastructure costs in an effort to continue growing and scaling.
Even if the firm overcomes the infrastructure-building phase and clears the complexity wall, it then encounters a growth wall. It’s here that the individual efforts of the founders to bring in new clients are no longer sufficient to power the growth of an ever-larger enterprise. This in turn forces the advisory firm to figure out how to establish and formalize a brand for itself, systematizing and scaling its marketing to power growth to the next stage of becoming a regionally or nationally dominant firm.
The caveat is that many firms will never make it over the complexity and growth walls.
The dangerous middle appears to start at the point where firms reach multi-advisor status — typically around $50 million to $100 million of AUM — and likely doesn’t end until the firm is at $2 billion-plus of AUM and has managed to clear its growth wall by systematizing its marketing with a standardized company brand. Beyond this point, growth rates typically start to tick up again.
The significance of this admittedly wide range of the dangerous middle is that, as noted earlier, most advisory firm founders may spend a lifetime trying to grow from $200 million to $2 billion. To substantiate this struggle, we’re presuming a 10X growth cycle that takes 17 years, even with a healthy 15% annual growth rate — and that’s after the difficult journey of just getting to $200 million of AUM in the first place.
The steady pace of advisory firm mergers and acquisitions is understandable. In essence, more and more firms occupying this middle ground are either deciding to merge and achieve the scale necessary to become a market dominator; to sell and let a larger firm use the acquisition to power their path to scale; to tuck in and let someone else deal with the business challenges so the advisor can re-focus their energy on what they enjoy most; or simply to downsize their practices instead, reverting to a smaller, more profitable, long tail–optimized firm.
Some firms do manage to grow their way through the dangerous middle. That said, as the largest firms — Schwab and Vanguard among them — scale their marketing to grow even larger, pulling off this transition is harder than ever.
The bottom line is just to understand that as the long tail grows longer and the head grows bigger, the future of planning isn’t about whether the small firm or the big firm wins. It’s about who manages the inherent challenges of growth best, and positions themselves for the future.