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Why expenses are up and profits are down for RIAs

Last year wasn’t a very good one for RIAs when it came to generating profits and controlling expenses.

Firm expenses rose more quickly than revenue, according to the 2016 FA Insight Study of Advisory Firms: Growth by Design. Median overhead per client jumped 31%, and overhead expenses as a share of revenue for a typical advisory firm leaped to 38% last year, up from 34% in 2014.

As a result, critical 2015 income metrics failed to surpass last year's record highs.

Median operating profit declined more than 6 percentage points to 19.6%. Median income per owner dropped 24% to $318,000. For every dollar of revenue generated in 2015, the typical firm converted 48 cents to owner income, defined as job compensation plus operating income. That's down from 55 cents in 2014.

In addition, the number of firms able to maintain sustainable growth also declined, from 33% of all firms in 2014 to 26% in 2015.

"We're seeing a sharp decline in firms that are maintaining sustainable growth,” says FA Insight principal Dan Inveen.

"Much, though not all, of the recent downturn in advisory firm performance, can be attributed to security markets," says Dan Inveen, a consultant for TD Ameritrade. "We found that an average of 90% of all revenue is generated by asset-under- management fees. As a consequence, security markets can act as powerful tailwinds but which can subside or even reverse course.

"As revenues decline, firms simply can’t adjust their costs quickly enough," Inveen continues. "This is partially due to the inflexibility of certain fixed costs. Nonetheless, it may be a good idea to maintain all team members in a downturn. It’s not as if your workload is lightening. And it's important to have capacity on hand when markets turn upward again."

Read more: Advisors Must Focus on HR & Management, FA Insight Study Finds

Advisers can do more to insulate their firms from down markets, says Inveen. "Improving operational efficiency, providing superior client service and fostering more proactive business development are just a few of the areas described in the report that can help advisers," he says.

Sustainable growth, another key metric for advisory firms, may be an Achilles' heel for the industry, the study suggests. (TD Ameritrade in June acquired the research, benchmarking and consulting capabilities of FA Insight.)

"If you drill down there really is reason for concern," Inveen says. "We're seeing a sharp decline in firms that are maintaining sustainable growth, which suggests that the current industry slowdown may be more severe than simple rates of growth might suggest."

About one-third of those surveyed were found firms whose growth was "at-risk.” They experienced significant growth but encountered growth-related challenges, including not enough spending time on business development or over-burdening staff with too much work or extra hours.

Other growth-related pitfalls include escalating overhead, high staff turnover due to hasty hires or burnout, and declining service quality. All are the result of what the study terms "out of control growth."

How can firms achieve feasible, sustainable growth?

First principals must decide whether to grow organically or through mergers and acquisitions.

The most common type of M&A was one solo adviser acquiring another’s existing practice, the study found. That was followed by a firm acquiring a book of business only and one firm acquiring another firm with multiple professionals.

Marketing, new client business development and operational efficiency were the organic growth drivers that firms said they would emphasize going forward, the study found.

Other firms said they would emphasize offering a superior client experience, getting more business from existing clients and improving the expertise of team members in their efforts to generate additional revenue.

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