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)!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Well, welcome, everyone. Welcome to Office Hours with Michael Kitces.
For today's Office Hours, I want to talk about advisory firm profitability growth and that infamous term I hear thrown around so often, particularly actually in smaller advisory firms who want to grow, "scale." It's a word I'm hearing cropping up just more and more often these days. "Our firm is looking at acquiring other advisors because we want to get to more scale." "I'm thinking about merging so that our combined firm would have more scale." Or just, "I'm trying to grow faster to get more scale for my practice."
And a good case in point example is a recent email I received from Ray, who asked, "Michael, our firm is trying to figure out the best way to grow and achieve better economies of scale. Right now we have about $60 million in assets, two-thirds between myself and my partner and the rest between 2 other advisors who've also tucked in under our firm, but our overhead is about 65% of our revenue. And so do you have any suggestions or growth strategies that can help us increase our EBOC?"
So, great question, Ray, and yes, you're right to be concerned, 65% overhead is a really high overhead expense ratio for an advisory firm, particularly one that's already up to $60 million of assets. You know, we sometimes see high numbers when you've got $2 million of assets because there's some fixed costs to getting your firm started, but $60 million is a healthy level. And so I'm not surprised that you're unhappy with only a 35% EBOC, which for those of you who aren't familiar is earnings before owner's compensation. So you can think of it as the total take-home pay of the owners between salary for working in the business and profits coming from the business, because usually as solos or small partnerships we don't make that distinction. It just goes into one. So we just call it EBOC or all the earnings massed together.
But here's the thing, Ray, your overhead expenses are actually so high at 65% of revenue on a $60 million practice that I would actually urge you not to try to grow from here. Because a 65% overhead expense ratio isn't a scale problem, it's an overhead problem. It's a business problem that you need to fix in your current business first.
Typical Overhead And EBOC Ratios In Advisory Firms [02:10]
And as a starting point, let's just look at what an advisory firm's profit and loss statement and margins should look like at various firm sizes. So Ray didn't mention his exact revenue, but I'm going to assume for a moment it's around $500,000 or $600,000, you know, typical 1% AUM fee on a $60 million practice. Now, if we look at the InvestmentNews benchmarking study on advisory firm profitability, which I think is one of the best ones out there as a comparison point, we find that for firms with half a million dollars of revenue, around Ray's size, typical overhead advisory firm expense ratio, 35%. Of which virtually all the remaining work in the firm beyond that is usually being done by the advisor owners, so typically, almost all of the remaining 65% is compensation to the owner.
Now, technically, a portion of that 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, we typically don't make that distinction, especially in partnerships and LLCs where there's legally no salary anyways, 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. But just to keep this in context, that means the typical firm of Ray's size has 35% overhead, 65% EBOC take-home, and Ray and his partner have 65% overhead, 35% EBOC. Like, it's completely backward.
And in fact, the most successful advisory firms in that half a million to $1 million revenue range go even higher. We've seen some recent benchmarking studies that show top performers, like, top profitability firms up to $1 million of revenue are taking home as much as 80 or 90 cents on the dollar of every dollar of revenue. So in other words, their EBOC isn't 65%, it's 80% or 90%. Usually by working with a moderate chunk of reasonably affluent clients who pay a healthy fee per client, where you don't actually need that much staff and support because there's not a ton of clients, right? If you're a solo advisor who has just 50 great clients with $1 million or $2 million of assets each and you're generating $700,000 or $800,000 of revenue to service just 50 clients, you may need no more than an admin assistant and a little bit of software. That's how you get to 80% or 90% EBOC margins.
And ironically, it's actually solo advisory firms that tend to have the best EBOC margins and advisor take-home pay relative to their revenue of any firm of any size. Because the larger a firm grows, the more staff infrastructure you need, and the more infrastructure you need, the less room there actually is for the advisor to take home nearly as high a percentage of business revenue as when you're small. Now granted, you may even get a smaller percentage of a larger number as the firm grows, but the incredibly high margins in solos and small partnership firms is why we see in a lot of industry benchmarking studies that the most profitable million-dollar revenue firms, those solo advisors take home as much as the typical partner in a $1 billion firm. There's a lot to be said for being a lean and mean advisory firm.
Advisory Firms Don’t Scale (At Least, Not On Overhead Costs) [05:17]
Now, for advisory firms that are not enjoying 65% EBOC with only 35% overhead costs, you've got some decisions to make, right? And so Ray's goal, understandably, is to say, "Well then, let's grow our revenue so that these overhead costs are a smaller and smaller percentage of our revenue, and then our overhead expense ratio goes down and EBOC percentage goes up and it starts to look better." Except that if we look at the typical overhead ratio of a firm with a $1 million of revenue, so double the size of Ray's firm, we find that at double the revenue and double the economies of scale, the average overhead expense margin from the InvestmentNews benchmarking survey, 34%. That's right, doubling the revenue of the firm took the overhead expense ratio from 35% to 34%. It's a 1% savings.
Because the reality is that when you double the size of the firm with more revenue, you have to increase your infrastructure to match it. You may need another paraplanner or support advisor. You may need another operation staff member, then you need more office space for them, then you need more software licenses for them, then you have to do more compliance oversight for them, then you need to spend some more time managing them and doing employee reviews. Then your larger business you may have to provide more robust employee benefits. And it goes on and on.
Simply put, you can't grow revenue in a vacuum. I mean, sure, you can add a client or a few and add the revenue without needing to bulk up your infrastructure, but you can't materially grow the revenue in advisory firm without starting to increase the staff costs that go with it. That's just the reality of being a service business. And if you keep your overhead costs nearly in line with your additional revenue, you will generate more total profits, you get a take-home of a larger number, but that overhead expense ratio doesn't necessarily improve. You're not literally creating scale.
And in fact, the problem is it actually can get worse. Because if you look further down the line of the industry benchmarking studies, advisory firms at $2 million of revenue have an overhead expense ratio averaging 39%. Up from 34% to 39%. By $10 million of revenue you're now approximately a $1 billion firm, overhead is 40% of revenue. At $50 million-plus of revenue, overhead is still 40% of revenue. That's right, the larger the advisory firm, the higher the overhead expenses tend to get. It's literally the opposite of achieving scale. Because now as you grow to that size, you have to actually start billing the rest of the infrastructure of the firm. Got more employees? Now you need an operation manager just to handle them all. Then you need more employees to handle the extra clients. Then you need more mid-level managers to handle all the extra employees. Then you need more hiring and HR. Eventually, you need a chief operating officer, a COO to help handle it all. And these are all non-revenue producing positions. That's the whole point of why overhead expense ratios tend to rise as firms grow.
Now, the good news is you can afford those positions when you've got more revenue and there's still more money at the bottom line that's take-home in profits, but the bad news is they cost money for all these non-revenue producing positions you didn't need when the firm was smaller. You only need them now that the firm is bigger so that you've got more people to manage in the first place. And that's why you don't actually see scale emerge in advisory firms, at least not as we grow from $10 million to $100 million to $1 billion to several billion. Maybe there's some point at $50 billion and up where you got some economies of scale. Most of us are never going to see that.
And so simply put, the idea that advisory firms scale and their margins get better as their size increases is a myth. It's just not there in the data at any point in any firm size. Firms don't see lower overhead expense ratios as they grow. In fact, they see higher overhead expense ratios as they grow because of the additional infrastructure you need to support a larger firm in what already is a service-intensive, staff-intensive business.
So here is why it all matters in the context of questions like the one that Ray posed. Given that overhead expenses in advisory firms tend to rise as they grow from $100 million of assets under management and up and Ray's firm is already at 65% overhead, trying to grow more from here not only won't fix the problems, it will probably make them a lot worse. Because by definition, the fact that the firm is so high on overhead already means that it has far more operations and administrative staff than a typical firm at the same size. Which means if the firm tries to grow more from here, it will have to hire even more staff at a faster pace to keep up with the level of productivity that it's got in the first place. So it'll have to hire that operations manager even faster. It'll have to hire those other team leaders even faster. The people that manage the people stage of the business. That further increases overhead expense ratios.
So the firm is struggling at 65% overhead margins right now, I would worry that if they try to grow and bulk up from here, it's just going to go to 70% overhead from 65% because of all the infrastructure hiring that comes at the next stage. And probably is not far off given how staff-heavy the firm is already at 65% overhead. And even worse, since by definition Ray's firm is not very productive in the literal sense that not a lot of work is getting done and revenue is getting produced per advisor per staff member, that's why their overhead expense ratio is so high, if you take an already not very productive firm and grow its revenue, you just put more pressure on what apparently are a whole lot of inefficiencies beneath the surface, which means profitability could erode even further. Because the simple truth is that growth doesn't solve profitability problems in advisory firms, it compounds them in not a good way.
So what should Ray do? Simply put, try to figure out what it takes to fix the current profitability problem. Not by adding more revenue and throwing revenue at it, which probably makes it worse, actually dealing with the problems in the practice. Now, unfortunately, we don't have a lot of details and information on Ray's practice to really know why its overhead is a whopping 65% on $60 million, but at its core, it means Ray is doing too much for his clients or charging them too little. I mean, that's what makes advisory firms less profitable with high overhead expense margins. Either Ray is giving too much service, doing too many meetings, doing too much hand-holding relative to the fees he charges and needs to do less, or he can keep doing all the great stuff that he's doing and charge more.
And unfortunately, I find this is an increasingly common situation. Firms say that say, "We charge competitive fees but we give our clients better and more personalized service. That's our differentiator." Well, I'm sorry but competitive fees with superior service is not a differentiator, it's a charity business. It means you are doing more and charging less and running not profitably. That's how you get into problems like Ray's business. There's nothing wrong with giving a premium service business, but we don't go to the Four Seasons and expect discount rates. You don't go to Disney World and expect discount rates. If you're going to give a premium service, charge a premium price and then your profit margins don't have these problems and your overhead expense ratios are not problematic.
Now, to be fair, if you've innovated some brilliant new way to do high-touch service with a fraction of the staff time and hours of labor then kudos to you. You've really created something new, and now you can really differentiate by saying, "We do more for less." But I'm sorry to be the one to deliver the hard truth, but for most advisors I see, "We charge competitive fees to give superior service" just means you're overservicing clients for the fees that you charge. You're literally not charging what you're actually worth. Where you can proudly say, "We charge above-average fees because we give you above-average service." Right? Four Seasons, Disney, other companies that are known for great experiences aren't even bashful about this. This is why Starbucks charges twice as much as the same cup of coffee I can get at Dunkin'. I paid for the Starbucks experience. And if I'm okay paying for it, I pay for it. You don't have to be bashful about that fee. Charge a premium fee if you're giving a premium service.
Now, for some firms, the way that they unwittingly maybe undermine their profitability and productivity is more subtle. It's the firm that says, "I have to do a different portfolio for every single client," even though the truth is they're multi-billion dollar firms that have just a few standardized models for clients and are doing just fine growing and attracting clients. It's the firm that allows lots of different exceptions in the portfolio for various client scenarios and then needs more operations and trading staff to manage the portfolios, doubles their meeting prep time, can't figure out why they don't have any time in the practice.
It's the firm that uses lots of different custodians to accommodate clients wherever their assets are when in reality just one custodian will work fine for most firms, and that clients who really buy into your value proposition will move the money to wherever you are. So if you're struggling to get clients to move, the solution isn't, "Let's add more custodians," the solution is, "Let's figure out how to make our value proposition more awesome so clients are willing to move to the one platform we use efficiently." It's the firm that tucks in small local advisors who don't actually have enough assets and revenue to pay their fair share of overhead for the firm, while they may add revenue to the top line but they don't add profits to the bottom line. Or worse, they subtract profits because the firm is trying to just bulk up by bringing in more advisors and revenue even though it's literally not actually profitable to serve them.
And in some cases, the problem is simply that the firm has too many small clients that aren't profitable. Who may not seem unprofitable one at a time because I know how it goes, "They hardly ever call and they don't take much work." Except when you add them up in the aggregate, they do take a lot of staff time. They do take a lot of your time. They're adding nothing to the profits and value of the practice while consuming a disproportionate share of resources such that your overhead expense margin is at 65%. Which means again, the solution isn't to grow, the solution is you have to right-size the firm and fire, or at least graduate your smaller clients to another advisor where they're a better fit. Which frankly is better for the firm and better for the client in the long run, for them to be at a firm where they're really valued and not just your accommodation, "They don't take much work" client.
The bottom line, though, is just to recognize, 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," sure, you might add a couple more clients without more hiring, but you can't add 100 more clients without hiring. And when you start to look at how much hiring you'll have to do for your next 100 clients as you try to scale, you may quickly realize that if you don't fix the core problems in the business, whether it's overservicing clients, undercharging them, not standardizing enough, not being focused enough in who you serve, if you don't fix those core problems, stacking more revenue and growth doesn't improve the profitability, it just compounds inefficiencies and makes it worse as you drown in more and more overhead infrastructure.
Again, as we noted earlier from the benchmarking study, economies of scale in advisory firms are pretty much a myth. You don't see lower overhead expenses as firms get larger because more clients just means more staff to service them, more staff means more infrastructure, more infrastructure means more costs. Not to say that firms might not generate a few percentage point of efficiencies and overhead with some growth, but that's how you get your overhead expense ratio from 65% to 62%, not down to an industry standard 35%. Which means, Ray, the starting point for your business is not to grow your business, it's to change your business. Which frankly may start with just changing your mindset around the trap that I know so many of us get into as advisors when we say we have to do something in a certain way to keep or retain our clients, when in truth you probably don't really. But these are challenges we have to face as business owners.
And if you want further perspective on how to do things differently, it's the whole point of our "Financial Advisor Success" podcast, to share ideas of different ways that advisors structure their businesses and service clients so you can find something that really works for you.
So I hope that's helpful as some food for thought, even though this was an Office Hours of a couple of hard truths. Thanks for joining us, and have a great day.