The fast view
- Over the last two decades, most advisors migrated out of the commission business model and into the ongoing-fees-on-AUM business model.
- However, growing assets and advice fees over time by continually adding more clients, leads to an inevitable growth in the number of staff in a practice.
- The more important metric to watch is not total firm revenue, or total firm profit. What matters is profit per owner.
- To scale a firm, do not focus on adding more clients, but focus on improving the quality of clients.
A highlight of our 2023 Ninety One Investment Forum was the talk by Micheal Kitces, a US financial advisor and renowned author of numerous books on the financial advice industry, which focused on confronting one of the most common challenges facing growing financial advice firms: How to deal with the inherent trade-offs (and difficult decisions) involved in growing your advice firm whilst keeping it the type of firm where you actually want to work.
These are some of his key insights.
Our formative years in business shape our behaviours
Many advisors in their 50s and older today (in both the US and South Africa) started their careers providing financial advice in exchange for selling insurance products and receiving upfront commission payments. The average advisor business twenty years ago was a simple one – a single advisor with one or two assistants, a very high work rate and a (really large) revenue line that reset to zero every year.
Scalability in these businesses was limited and, more importantly, revenue growth plateaued once the practice surpassed 500-700 client files. Advisors in these businesses quickly found out that the major factor limiting their growth was time. There are only so many hours in the week, month and year to go out and prospect and find new people with whom to do business.
And so, at some point in the past 20 years, most advisors migrated out of the commission business model and into the ongoing-fees-on-AUM business model. It took a few years, but advisors found that smaller annual advice fees from a client very quickly compounded to dwarf the large upfront commissions on insurance products.
Michael relayed research that showed that it takes the average US advisor between 5 and 10 years of building their AUM-fee book before the revenue from that book exceeds the revenue from commissions. And after that they never look back.
He summarised it with the following graphic:
Figure 1: Building an advisory business
However, unlike with the commissions model, growing an advice firm by adding more clients is not always the best strategy.
And so, we arrive at what was really the crux of Michael’s talk – the pitfalls facing advisors who wish to grow their annual advice fee practice.
Once again, Michael summarised the progression of an annual advice fee practice with a very instructive graphic.
Figure 2: The accidental business
What Figure 2 illustrates so well is that growing your assets and advice fees over time by continually adding more clients to your book leads to an inevitable growth in the number of staff in your practice.
Whilst the smart use of technology can help a practice curb the growth in their operational staff headcount, it has proven tricky to sustain strong revenue and client growth without adding paraplanners and additional advisors. As a matter of fact, advisors typically found that, after a period of strong client and asset growth, there almost inevitably follows a period of capacity creation that leads to an increase in the staff complement of the firm.
Dunbar’s number
The reason Michael held up as the main cause for the correlation between a growing client base and advisor/paraplanner headcount, is Dunbar’s number. According to Wikipedia, Dunbar’s number is ‘a suggested cognitive limit to the number of people with whom one can maintain stable social relationships — relationships in which an individual knows who each person is and how each person relates to every other person’.
Basically it represents the number of people with whom a single human being can have a meaningful relationship. And according to Dunbar the limit for human beings is around 150. This suggests that once an advisor practice reaches 150 core clients, it becomes significantly more difficult to grow the client base without adding a relationship manager – either a paraplanner or another advisor.
Higher revenue does not necessarily equal higher profits
And so, we arrive at the key question facing most successful smaller advice firms at some point in their life cycle. Is the only way to grow profitability to grow your client numbers (and by implication grow staff headcount), to turn your successful lifestyle or boutique advice firm into a corporate institution? And what if your vision for your practice is not to build a large corporate advice firm?
At this stage, after discovering the limit of Dunbar’s number, most readers are probably suspicious of this statement. If growing your client load inevitably leads to increased advisor headcount in your practice, clearly the more important metric to watch is not total firm revenue, or total firm profit. What matters is profit per owner. In this regard Michael shared some instructive data from the US investment advisor market regarding owner profitability and firm size/lifestage.
Figure 3: Scaling an advisory business
Figure 3 shows that on average, as firms progress from solo-advisor firms through the boutique stage all the way to large corporate (which he calls a super ensemble), there is an increase in the profits per owner. There is no doubt that benefits of scale do kick in for larger-headcount advisor firms, improving profitability.
But what is surprising is if one looks at the profitability of the top-performing solo-advisor practices (as opposed to the average single-advisor firms). Top-class solo-advisor practices in the US make as much profit for their owner as would the average large advisory corporates!
Maximising your profits in a smaller firm
So what differentiates an ‘average’ solo-advisor from a ‘top-performing’ (and higher-earning) solo advisor? Michael shared several real-life advisor examples from his home market. At risk of oversimplifying a complex situation (as success in business is rarely due to one factor only), Michael did have one observation that seems to be a common thread among all smaller successful firms. They are all super specific about the client load they take on, because they know that additional client load leads to additional staff for the practice, which changes the nature of the business. They aim for the client load that will give them the business they want (whether that is a 50-client lifestyle business or a 250-client boutique firm) and they proactively manage that number – resisting the urge from their commission-earning days of growing clients at all cost.
Conclusion
Growing your advisory firm is a top priority for all financial advisor firms – in South Africa as well as globally. But how do you grow your business without turning it into an operation where you as the owner and CEO spend more time managing staff than you spend working with clients?
From the US experience it turns out that you can grow a hugely profitably small advisory business, without losing the essence of the firm, if you proactively limit your client numbers and constantly improve your client quality. Rather than focusing on adding more clients, focus on improving the quality of your clients. Don’t take on new below-average clients – carefully cull some existing below-average clients and replace them with high quality-opportunities.
Do this consistently for a few years, and you might well be surprised at the end result!
