|Forbes.com, Spring, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
Well, that would be a surprise: While you’re mulling on the benefits of cashing out on Apple gains or curious about the legality of your exposure to cannabis stocks like Cannabis Science, you expect to turn to your wealth advisor for the best advice. The last thing on your mind is that he or she simply might no longer exist (legally speaking).
First a step back to the “60,000 foot view” of the wealth management industry and a few observations on how it might evolve over the next decade.
The industry is far from homogeneous and is extremely fragmented, with more than 19,000 firms, according to Brave New World of Wealth Management: Opportunities, More Competition, Demographics and Growth Conundrums by Mark P. Hurley et al 2013.
However, it’s possible to group them into one of three general business models:
Evolving Businesses – approximately 200 firms that have taken the difficult steps necessary to evolve and survive the departure of their founder or founders.
Books of Business – nearly 18,000 wealth managers with relatively low annual revenue and no obvious strategic plan to survive the departure of the founder or founders.
Tweeners – 1,000 to 1,200 firms that have substantially greater scale and profitability than those in the “Books of Business” category but, unlike “Evolving Businesses” have been unable to take the necessary steps to evolve beyond a founder-centric model that resembles a large sole-proprietorship.
In the interest of full disclosure, my firm, Wealth Enhancement Group, is a registered investment advisor (RIA), and uses LPL Financial as its broker-dealer to offer securities. LPL Financial is a prominent RIA custodian and an enabling partner to more than 13,500 financial advisors and approximately 700 financial institutions.
Forces Driving Industry Revolution
All three business models face the same five forces that will combine to create an operating environment that is vastly more challenging and competitive than the one all firms have experienced in the past two decades. These include:
1. Fewer new millionaire households with more firms competing for them. In just about any geographic market you can find more large firms with sophisticated business development than even a decade ago.
2. Aging client bases with higher capital consumption. An aging client base creates a drag on wealth manager revenues in two distinct ways. First, older clients often increase their gross rate of capital consumption and second, as a group they have a reduced appetite for investment risk. The result is a greater net capital consumption by clients which reduces the wealth managers’ assets under management and the corresponding fees paid by the clients.
3. Potentially prolonged period of low return on lower risk assets. It’s well known that the Federal Reserve is taking its time reversing the steps which led to some of the lowest yields on fixed income securities ever. Nearly all wealth management clients allocate a substantial portion of their portfolios to lower risk asset classes so again there is pressure on wealth managers in terms of slower growing assets under management.
4. Operating costs accelerating at a rate higher than inflation in general. According to a FN Fiduciary Network study, wealth managers are experiencing average annual cost inflation of at least 5-7% and typical wealth manager non-owner compensation costs can top 10% annually. There are other costs coming down the road namely compliance costs, both for the in-house compliance needed and the external legal fees anticipated.
5. Aging founders. For many wealth managers who started their businesses in the 1980s and 1990s, their single most valuable financial asset is their equity in their business. Consequently, the value they receive for that equity will be a key determinant in their ability to sustain their current lifestyle in retirement.
Survival Of The Fittest
In the opinion of the authors of Brave New World of Wealth Management which I also share, most “Evolving Businesses” will be able to consistently grow their profits at least 5%/year into the foreseeable future only by increasing the number of new clients (to maintain revenue growth rates) at a time when the supply of prospects has stagnated and sustaining the costs to handle a larger clientele. There are a few ways to accomplish this including increasing efficiencies, offering more specialized services and acquisitions.
However, the “Tweener” category has far less room to improve efficiency or cut costs and certainly has less chance of financing specialized services or acquisitions.
The largest group, the “Books of Business,” will largely be at the mercy of broader forces sweeping through the industry and their owners will almost certainly have to work much harder to be paid significantly less.
Of these categories, it seems that the “Tweener” category will no longer exist a decade from now. Some will be acquired, merged or rolled up and the rest may begin a long slow decline that at some point in the next four to seven years will accelerate suddenly.
Is this the group you have your money with? Or is it with the 19,000 firms that range from very small proprietorships to businesses with more than $50 million in annual revenue (but average under $3 million) who will be battling brokerages, insurance companies and accounting firms (more accurately called money managers) for potential fee-only clients?
Brave New World
The ultimate shape of this industry a decade from now is one in which 150 or so extremely profitable, large firms will manage the vast preponderance of assets. In the opinion of the authors of Brave New World of Wealth Management the organizations which will still be viable in 10 years must meet two criteria:
1. It must be an independent RIA. Note that standalone brokerages, insurance agents and other organizations which sell products on a commission basis cannot offer advice.
2. It must derive at least 50% of its revenues from providing advice that goes beyond traditional money management. Note that problem-solving is the core value-add of a wealth manager; they must provide advice regarding asset allocation, financial planning and tax planning customized for each client’s circumstances. By comparison, money managers are focused almost exclusively on maximizing investment returns within a particular investment strategy.
Compliance Will Thin The Herd
Of all the issues facing wealth advisors, one of the most rapidly changing is the increasingly adversarial regulatory environment. This forces wealth management firms to spend more of their time on resources and compliance. While most firms have been examined only once every four or five years – and some managers only once a decade – the SEC is under great pressure to take a more aggressive and scrutinizing stance.
Further complicating matters, the regulatory framework is ill-suited to address advances in technology such as social media – with limited guidance from the SEC on what is appropriate and legal. This represents more than a cultural issue, it will mean wealth managers must spend more money on legal advice and more time on compliance issues.
The point person for compliance will have to be more qualified (and more highly compensated) than in the past.
The changes sweeping through the industry will be quite unpleasant for many. They will have to spend more time and money on regulatory matters at the same time capturing new clients will become harder and existing clients become smaller as capital consumption accelerates.
The largest firms, the Evolving Businesses, are most likely to overcome the challenges to growth and become substantially larger businesses after a period of consolidation. However, hundreds, or even thousands of firms will cease to exist. Aside from the 150 or so extremely profitable firms which will manage the vast preponderance of assets, the industry’s remaining 19,000 participants may not fare so well. Although they can remain in business, they may be marginally profitable and have little enterprise value.