One of biggest reasons why established firms in any industry are difficult to unseat is that they have “economies of scale” – where fixed costs of overhead and infrastructure on an ever-growing business results in proportionately decreasing costs (as a percentage of revenue) and ever-larger profit margins (or available dollars to reinvest for further growth).
Accordingly, for solo advisory firms and even “smaller” (e.g., <$200M) ensembles, there has been a rising focus on how to grow –expanding the firm itself, either organically, or through a merger or (multiple) acquisition(s) – in order to achieve greater cost efficiencies and advisory firm economies of scale.
In today’s #OfficeHours with @MichaelKitces, my weekly broadcast via Periscope, we discuss why, when it comes to advisory firms, increased size and revenues don’t necessarily result in increased profits and economies of scale, the overhead expense margin and profitability ratios successful advisory firm owners can reasonably expect to see, why trying to “scale up” in a time-intensive service industry isn’t always the most effective way to improve firm profitability, and some alternative strategies that can be employed to improve bottom-line results outside of just growth for growth’s sake… which for a firm that is already less profitable than it could be, often ends up compounding the profitability problems rather than solving them!
According to the recent InvestmentNews benchmarking study on advisory firm profitability, small firms with about half a million in revenue average an overhead expense ratio around 35%. But in reality, some of the top-performing solo advisory firms can often get that number down to 20%, or even 10%(!) by giving premium service to an increasingly concentrated premium client base.
In fact, it’s only when those small firms try to grow their revenues that the firm’s expenses actually start to balloon, overhead expense ratios rise, and profit margins begin to decline, because with added capacity comes the need for added infrastructure (from more staff to more office space and more technology, etc.) to support it. Thus, ironically, larger advisory firms tend to have higher the expense ratios than smaller ones… because at a certain point, the firms end up stacking on additional overhead expenses in order to support the additional layers of infrastructure!
Fortunately, though, small and mid-sized firms have more effective tools are their disposal to improve profitability. For many firms, the biggest needle-mover is to simply raise their fees, because more often than not, profitability problems stem from the fact that advisors are doing too much for too little… or stated another way, they’re delivering a Starbucks experience at a McDonald’s rate. From there, advisors can pull other levers, including standardizing portfolio construction, consolidating custodians, “graduating” less-profitable clients out of the firm, streamlining technology, and revisiting relationships with any other non-owner advisors who don’t generate at least enough revenue to cover their overhead expenses.
The bottom line is simply that there are better ways for small to mid-sized firms to improve their profit margins beyond just trying to grow their top-line revenue in search of economies of scale. Because, in the early stages of an advisory firm, owners often accommodate specialized needs of clients out of the sheer desire to generate any revenues whatsoever and get their business off the ground. And the direct result of that is cost inefficiencies and profitability problems. Accordingly, those issues are best addressed, not by trying to grow the business itself – which can only compound the problems – but instead by changing the business. Which in turn often requires the advisory firm owner to adjust his/her own mindset and perspective away from thinking things have to be done in a certain way (the way they’ve been done in the past)… when in reality they don’t, and fixing those problems in the business are the real key to better profitability (and then, if still desired, growth)!