As originally published for Financial Advisor magazine.
There is a proverb that “the seeds of destruction are sown in good times.” And these have been some good times for the advisory industry.
In 2021, the average firm grew its assets under management by 22 percent, according to a survey by The Ensemble Practice. Over the last six years, the typical firm has doubled in size (between the start of 2016 and the end of 2021). The average owner income has grown over the same period by 46 percent.
Because our entire industry has been so successful, we have started to make some dangerous assumptions—and it’s important to remember that they are just assumptions. This often happens in my home city of Seattle. During the summer, it is easy to forget that we get 10 months of rain (requiring antidepressants and oversized gutters). The skies are so blue and the clouds such a distant memory. Still, as those of us who have been here for a while can tell you, taking that good weather for granted would be a mistake.
Since we’re still in the glow of these halcyon days, it is perhaps a good time to review our business models and take a hard look at our assumptions and examine some of the clouds gathering on the horizon.
Low Interest Rates And The High Availability Of Credit
Low interest rates have had a profound impact on our society and have tremendously benefited advisory firms. I will leave the macroeconomic effects to more qualified individuals and instead focus on some of the overlooked effects on the industry.
Low interest rates allow the buyers of advisories to borrow more, pay less and use the additional capital to purchase more ownership. The same effect that is driving up the price of homes throughout the country is also driving up the valuation of advisory firms. Both internal and external buyers have been able to borrow a lot to make purchases of equity, and the result has been valuations higher than ever before. Low interest rates are a bit like beer goggles: Everything looks attractive past a certain point of inebriation.
Unfortunately, the effect can be reversed. When rates go up, existing borrowers may find their loans difficult to service, and some may default. New buyers may be discouraged from purchasing or purchase less. Demand may suddenly shrink, and as we know from Adam Smith, that tends to lower prices.
The biggest beneficiaries of low interest rates have not been the internal advisory buyers scooping up five or six percent of their firms, nor are they the small buyers who purchased a book of business or two. No, the biggest winners are the private equity firms. The vast majority of transactions reported and most of the upward pressure on valuations come from private equity-financed entities. And if you looked under the hood of the acquirers very actively consolidating our industry, you would find that 90 cents of every dollar invested in firm purchases has been borrowed.
This is where the biggest danger for valuation lies. An increase in interest rates could severely cramp private equity’s appetite for purchases, and simultaneously squeeze those firms already bought to generate the cash flow required to service existing loans.
What’s more, rising interest rates typically cause the market to correct or even worse. The cost of capital for publicly owned companies grows and the appeal of bonds and other fixed-income instruments increases. Imagine for a moment that the equity markets were to decline by 15 percent as interest rates go up and loan payments rise as a result. The relationship between acquirers and their portfolio firms could change in tone dramatically, as we witnessed in 2008.
To make it worse, many ultra-large institutional investors have over the years seemingly beefed up their private equity allocations because fixed-income instruments aren’t generating as much income. This was certainly the case in the years before 2008, when banks were buying risky mortgage-backed securities, partly because they couldn’t get the old five percent from government bonds. If interest rates increase, we may see a contraction in the money allocated to private equity, and as a result, less capital available to acquire advisory firms.
The effect of these combined forces may also cause some acquirers to consolidate or divest their holdings, so don’t be surprised if a firm that was once acquired by one buyer ends up with another. Once again, we saw this in 2008 when some of the most active acquirers actually left the advisory market and sold their holdings to other consolidators or back to the original owners.
Interest rates have helped valuations tremendously, but that may not always be the case.
Credit has also been readily available to acquirers and internal buyers. Today, firms can rely on many lenders who are willing to extend millions toward internal succession or the acquisition of books of business. This has allowed thousands of employees to become owners at favorable terms and has allowed founders to put some money in the bank. It has also fueled the feeding frenzy for books of business, where services such as FP Transitions report 50 buyers or more for every seller.
Fifteen years ago, almost every single transaction I observed was seller-financed, i.e., the retiring owner had to become the bank. Today, firms not only have access to credit, but they can also shop lenders. I frequently hear our clients scoff at the rates offered by specialized lenders since they receive even better terms from small local banks.
If the credit capacity shrinks, we will witness a contraction in demand. And once again, our good friend Adam Smith would suggest that lower demand means lower prices.
The growing markets have also helped advisories a lot up to this point. When assets under management are growing by 22 percent or more simply by virtue of the markets, firms don’t really need to grow in any other way. Also, the growth created is pure gravy—it does not require any additional effort in managing client relationships or enhancing client service.
Indeed, the good markets have actually disguised the fact that most firms are not growing their client base very well at all. The organic growth rate has not been very impressive (net new client additions equal 6.1 percent), and the strategic focus for many firms has shifted to acquisitions, where the results have been very lucrative.
In a virtuous circle, growing markets also tend to make investors more optimistic and therefore more likely to invest. In fact, the best business development years in terms of adding new clients tend to come on the back end of recessions when investors approach the market with renewed confidence. A little turbulence like we experienced in 2020 seems to be the best condition for investors to consider an advisor. First, it creates the sense that “things can be a bit scary, so perhaps I need help.” At the same time, it encourages investors to think, “Things always seem to work out well in the end, so I should be investing. Just look at those 2021 returns!”
Finally, growing markets make it much easier for clients to pay their fees. When they have a 26 percent return (the S&P returned 26.7 percent in 2021), it isn’t very painful for them to accept a one percent fee. Investors have been very happy to collaborate with advisors and have mostly appreciated that collaboration.
Call your favorite airline during a snowstorm, and you are likely to be greeted with the dreaded “due to extraordinary call volume, we are experiencing longer than usual wait times” message. Every business staffs to normal levels of service, not to emergency levels. Advisory firms are no different in this regard. The typical firm in the industry has 96 clients per professional and about 45 clients per staff member (advisors and support). The service model behind these numbers assumes firms can schedule client communications normally and not field many emergencies.
Imagine a scenario where all clients are calling at the same time and seeking a meeting or a phone conversation. The sheer number of hours and people needed to respond would be daunting, and most firms are not able to handle such “peak demand.” Thankfully, emergencies have been rare, and we have come to assume that they won’t happen. As a result, most firms would admit they have pushed a bit too far the limits of how many clients they can handle.
No Rising Labor Costs
Interestingly, while revenues have grown a lot, compensation has not followed suit. The result has been extraordinary profitability and flat compensation for most positions over the last three years, something we found in the annual compensation survey conducted by the Ensemble Practice.
Advisory firms may soon experience some shocking repricing, particularly where talent is “portable.” Employees in the areas of technology, business management, general support and administration are being recruited by other industries that are willing to pay a lot more to gain valuable team members in response to their own talent shortages.
According to our PULSE survey at the end of 2021, 50 percent of firms experienced resignations in 2021. And firms offered on average only three percent in cost-of-living increases in compensation for 2022. The Social Security Administration, meanwhile, adjusted its payments by more than sevent percent.
Advisory firms, unlike brokerage firms, are currently not accustomed to recruiting from one another, even though that behavior is typical in many other industries. But in the future, poaching might make a lot of sense. If you want to hire a good advisor, she is most likely working for another advisory firm, so you just have to recruit her out of there.
And those poaching efforts will tend to have a strong influence on compensation. All it takes is for a firm to lose one valuable advisor and it will immediately reprice all the remaining advisors.
The reason there’s not a lot of recruiting between firms now has a lot to do with the young age of the industry. It’s also perhaps a function of the industry’s fragmentation, which leads to inconsistent demand. The few recruiters who operate in our space mostly focus on moving people out of wirehouses rather than moving them from one independent firm to another.
That said, you can see the cloud forming on the horizon. The largest firms we work with are starting to hire “directors of talent acquisition.”
Low Levels Of Competition
Another factor that’s worked in advisors’ favor in the past is the lack of competition: Advisory firms today rarely compete with one another for clients. Most clients who come to a firm tend to be previously self-directed investors. In our consumer survey, 44 percent of clients reported not having an advisor before joining their current firm. The remaining clients came from other independents (31 percent) and large national firms (25 percent). This stands in stark contrast to industries such as consulting or accounting, where most clients are switching from some other provider. Still, those strong numbers reflect changes: Just seven years ago, around 75 percent of new clients were previously self-directed (much higher than 44 percent).
Up until now, the lack of direct competition for clients has likely allowed firms to be much more relaxed about pricing and services. Without that outside pressure, they likely haven’t been motivated to enhance the value they offer to clients.
The Rain Will Come Back
So obviously, when markets, revenues and profits are growing while costs stay the same, when competition is weak for both clients and employees, when private equity has given firms high multiples—when all this comes together, advisors are likely to get complacent. And why wouldn’t they? Life is good.
We must remember, though, that the assumptions upon which all our future plans rest may change. And while this is not a call to build a bunker, it certainly is a reminder that a successful firm hoping to continue being successful will have strategies in place should any of these variables change. Because as much as we would like to live in denial of it, the rain always comes back to Seattle.