Positioning Your Firm for the “Equity Bull Market” in Wealth Management

Categories: Private Wealth Management, Risk Management
Brian Lauzon, CFA

As a financial adviser, have you ever stopped to think about whether your wealth management firm operates as a business or a practice? Or whether it even matters — to clients and/or prospective buyers? To learn the answers to these questions and more, I spoke with Brian Lauzon, CFA, managing principal of AdvisorAssist, a consulting firm that supports the compliance and business planning activities of both new and existing advisory firms.

Lauren Foster: In a recent conversation, we were discussing the management of wealth management firms and you made an interesting distinction between “businesses” and “practices.” Could you elaborate?

Brian R. Lauzon, CFA: Sure. Even among the diverse universe of independent wealth management firms operating today, there are certain distinct patterns among their leaders with respect to how they approach managing their firms.

I characterize practices as firms that are managed to shorter-term objectives, specifically maximizing near-term cash flows (owner’s compensation).

Their leaders bring on support resources to maximize the time they can spend on their desired activities (portfolio management, relationship management, sales) or to maintain their desired work-life balance.

Businesses, on the other hand, manage more to long-term objectives by reinvesting into the firm, developing institutionalized processes, building firm-level branding, and fostering a team-based approach to delivering value to its clients.

Their endgame is to build a firm with enterprise value. This distinction is not necessarily binary. Many firms fall somewhere within this continuum.

Is one approach better than the other?

Not necessarily. There are pros and cons to each. A capital markets analogy might help make this distinction more clear.

I tend to think of a practice as similar to an unsecured bond held by the firm’s owners. Cash flows constitute the vast majority of the return that they derive from owning this asset, as their owners receive recurring outflows (“coupons”) that occur throughout the lifetime of the firm. (Of course, unlike most bonds, these cash flows will fluctuate based on revenue growth and expenses.)

When the planned (or unplanned!) departure of its founders occurs (“maturity”), the firm may have some limited residual value, if they can demonstrate a continuing cash flow to a third party. But these cash flows carry significant uncertainty so there is limited “par” value remaining.

This approach is often adopted as a low-risk strategy because as cash is generated, it is taken out of the business and redeployed in ways that provide more immediate benefits (e.g., lifestyle, retirement savings, etc.)

Yet, at the same time, these owners are taking on significant event risk, because along the way they remain highly (or exclusively) dependent on the founding adviser(s).

Businesses are more akin to equity securities. Cash flows are budgeted to pay operating expenses, including base and incentive compensation for their owners and their staff.

Excess cash is reinvested to accumulate additional (cash-generating) resources like people and technology. These resources are coordinated to continue to grow their firm, expand capacity and ultimately become part of the firm’s value proposition. Resources are devoted to improving and institutionalizing processes that become assets of the firm as well.

If management decisions are well executed, the firm’s enterprise value increases thanks to more predictable, portable cash flows that grow at an attractive rate. (Just like stock in a publicly traded company.)

Determining which is better depends on the individual. There’s an “equity bull market” going on in the independent wealth management world, so those who believe they can participate are shifting towards the “business” approach.

What do you mean by an equity bull market?

The demand for personal investment advice has never been greater and, by all indications, will continue to increase into the foreseeable future. Industry participants have long recognized this and continue to roll out new technologies and platforms to support the entrepreneurial wealth manager. Wirehouses, IBDs (independent broker dealers), custodians, and large RIA firms are all aggressively pursuing top advisers. Many of these providers have earmarked capital to help attract talent.

With so much attention being directed towards these “advisers in motion,” valuations for well-managed, “institutional quality” wealth management firms have gone up significantly.

This emphasis on firm management (as we call it in the CFA Institute Global Body of Investment Knowledge) sounds a bit like what occurred in the asset management industry years ago.

Asset managers and wealth managers have very similar business models. They are both talent-centric, high-margin businesses that rely on earning and maintaining client trust to produce recurring advisory fee revenue.

The biggest difference lies in the characteristics of their client bases.

Years ago, sophisticated institutional clients recognized that proper asset manager due diligence should include an assessment of the organization that supports the teams that produce performance.

The nature of their due diligence grew to include an assessment of operational, organizational, and regulatory risk, as well as any conflicts of interest that could impact them as clients.

They also became increasingly apprehensive of investment strategies that relied heavily on a single individual. Asset managers responded to these needs. They invested heavily by recruiting and training business management professionals, improving operational infrastructure, and adding technologies that enhanced portfolio oversight and risk management. They also placed more emphasis on team-based investment strategies, moving away from the legacy “star system” approach. These client demands completely changed the skill set needed to manage an asset management firm. Looking at the industry today, many of the most successful firms are led by non-investment professionals. This is a drastic shift from 20–30 years ago.

For the most part, wealth management clients have not imposed this level of due diligence on their advisers. Instead, they have relied heavily on personal connections or the recommendations of family and friends when seeking an adviser.  But this is changing rapidly. The wealth management industry is maturing in a path very similar to asset managers 20 years ago.

Should clients care about how their adviser manages their firm?

In many ways, they definitely should. Clients care about the quality and consistency of their adviser experience at any point in time as well as in future states. The quality of their experience is improved when their adviser adopts a team-based approach to service delivery. They benefit even more when the team is well-managed, well-trained, and follow formalized processes. The consistency of their experience improves when their adviser takes a forward-looking view of the firm.

This includes maintaining a comprehensive compliance program, a formal approach to transition planning and business continuity, and developing a deep talent pool. Clients gain comfort and confidence when they see steps taken to mitigate risks that could disrupt their advisory relationship. They feel like their interests are being protected.

What trends do you see (or expect to see) that could affect the way wealth managers approach the management of their firms?

1) Changes in Regulation

Increased regulatory oversight is going to continue to “raise the bar” on how independent wealth management firms are run. They are digging deeper into internal processes during examinations, rather than checking to see if advisers can simply produce required books and records. Regulators are conducting more off-site reviews and surveillance of advisory firms to uncover false or misleading disclosures, weak internal controls, and inconsistencies within regulatory filings. They refer to this as a “Rudy Giuliani” approach, believing that going after smaller infractions will help surface larger ones. (When Giuliani was mayor of New York City he championed the “broken windows theory” of law enforcement. The idea is that you pay attention to small things, otherwise they get out of control and become much worse.)

The notion of advisers being “too small to matter” to regulators no longer exists. The SEC and states are recruiting heavily to bulk up their adviser oversight staff. It looks like we will have a former prosecutor (Mary Jo White) as head of the SEC, which is quite a departure from previous appointees.

2) Client Sophistication

Clients are becoming more educated in how to evaluate advisers and will continue to rely less on referrals from friends and more on their own research and due diligence. This is particularly true with Gen X/Y. Sure, it can be uncomfortable for clients to ask their advisers about potential conflicts of interest and their succession planning. But advisers who are prepared to adequately answer these questions have begun to initiate these discussions with clients and prospects. Over time, these topics will become more commonplace and will be an immovable component of adviser selection.

3) M&A and Business Model Innovation

We all see the emergence of new RIA platforms, varying aggregator models, growth-by-acquisition strategies, and general M&A activity among wealth managers. Generally speaking, these trends are incredibly positive for the industry. They illuminate the fact that certain wealth management firms do have enterprise value. They also reduce industry inefficiencies and expand the strategic options available to well-managed firms.

An interesting side note: These trends are identical to those that occurred in the asset management industry back in the mid-1990s. Absolutely identical!  We can learn a lot from the resulting successes and failures.

These trends have spawned an inflow of investment capital into the wealth management industry. And since capital is the only true arbiter of value, the management practices followed by those involved in M&A activities will ultimately raise the bar for the rest of the industry.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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