The RIA Profit Margin to Weather a Pandemic’s Recession

Were wealth managers operating responsibly?

(Michael Nagle/Bloomberg)

(Michael Nagle/Bloomberg)

Asset-based fee revenue at wealth managers plunged this month alongside the fastest-ever bear market in response to the novel coronavirus. At RIAs with thinner profit margins, that could mean drastically lower compensation and even cost-cutting.

In 2018, the median operating profit margin for RIAs managing between $100 million and $250 million was 28.9%, net compensation costs. RIAs that managed more had relatively similar margins ranging between 26.4% and 30%, according to Schwab Advisor Services’ 2019 RIA benchmarking study, its most recent annual report than surveys more than 1,300 firms, which self-report.

Schwab’s data suggests the median RIA, at least in terms of profitability, is a good business relative to peers. A “healthy” operating margin — net of owner and employee compensation costs — is generally between 25% and 30%, according to Brandon Kawal, a principal at Advisor Growth Strategies, a consulting firm to wealth managers. Those businesses are probably well-positioned to weather the recent market downturn, Kawal told RIA Intel.

RIAs typically charge clients a fee based on a percentage of the assets they manage, which means fees oscillate with the value of clients’ assets. However, most wealth managers have invested an average of one-third of client assets in fixed income or other investments uncorrelated with equities; Their revenue is tied to the equity market but does not move in equal tandem.

Revenue at RIAs typically falls two thirds of the broader market’s decline, according to Dan Seivert, CEO and founder of Echelon Partners, an investment bank and consulting firm focused on wealth and investment managers. For example, an 18% market decline would result in a 12% hit to revenue. Although, the impact on revenue could be greater if advisors were overweight equities and dependent on their rebalancing.

The S&P 500 climbed more than 9% Tuesday, but the index is still down 24% for the year.

As revenue falls, profit margins will thin, and RIAs will be taking a sterner look at their income statements in 2020, according to Kawal. Less profitable firms could potentially face drastic declines in compensation and even resort to cost-cutting. Companies sensitive to interest rates and equity markets have a high exposure to the market and economic impact of the coronavirus, according to Moody’s Investors Service.

“I imagine a lot of owners are sort of stuck in the here and now [tending to clients]. As we go through the coming weeks, it’s going to be time to take a step back and really take a look at the business holistically,” Kawal said.

Compensation is the biggest expense at RIAs. At firms managing more than $100 million, 70% of revenue in 2018 went toward paying employees and owners, according to Schwab. How dramatic the impact of a shrinking profit margin will be is largely determined by whether compensation costs are fixed, revenue- or profit-based. Owners or partners with at least part of their compensation tied to profits will earn less. That’s bad news for them, but a good cost-control measure for an RIA.

“The duration [of down markets] of this is going to dictate whether or not we see cuts in other areas. Make no mistake, owners are thinking about that now,” Kawal said.

To cover fixed compensation costs, necessary infrastructure, and any debt, some RIAs might need to lower expenses.

“If you’re an RIA that has been running south of a 15% profit margin, you’re going to run into trouble,” Kawal said.

Discretionary spending, such as travel and entertainment (although no one is currently doing much of either due to the pandemic), will be the first thing to go. Next will be marketing and business development spending, especially in the immediate future as advisors spend more time with clients and are less focused on growing their business, Kawal said. Marketing budgets generally represent 8% to 15% of a firm’s revenue.

After those expenses, training and continuing education costs (beyond what is necessary to keep up certifications) will be cut.

As a last resort, for fear of compromising client service in an especially fraught time, an RIA would lay off employees. “We saw back in the [global financial] crisis, advisory firms did have to take action with headcount. That will remain to be seen what happens as we move forward,” David Canter, an executive vice president and head of the RIA segment of Fidelity Clearing & Custody Solutions, said.

A recession is expected to be part of the pandemic’s fallout. The outbreak has closed borders and business indefinitely and continues to spread. As of Tuesday afternoon, there were nearly 400,000 global confirmed cases and more than 17,900 people have died, according to a New York Times database.

RIAs are about to book a quarter with a steep drop in revenue but there’s much uncertainty about the coming ones, making business decisions even more challenging. “No one has a crystal ball so I think the best you can do is look out at the rest of 2020 and look at the best and worst case scenarios,” Kawal said.

Still, a pending recession won’t stop RIA buyers or torpedo valuations, observers say. But if it lasts beyond the coming quarter, the financial strain on some RIAs won’t be what drives mergers or acquisitions.

Even firms with operating income margins at 10% heading into 2020 might be just fine — It’s possible they built a cash reserve over the course of the longest-ever bull market that preceded this year’s turmoil, said Matt Brinker, a managing partner at Merchant Investment Management, a minority investor in and capital provider to wealth managers. Few RIAs out of the thousands are going to be in real peril and none are likely to panic and seek a sale, he said.

Brinker, who led acquisitions at the former United Capital Financial Advisors from 2006 to 2019 and oversaw more than 90 transactions, said advisors are “bright and capable” people who tend to make decisions with their clients in mind. Pure financial deals are sparse, according to Brinker.

“It’s a little counterintuitive, I’m aware of it, in an industry of financial services and analytic people we want to obsess over the financials and profitability,” Brinker said.

“But we forget that most of the advisors in this industry are really centered on the well-being of their clients. And the decision to transact for a good handful of these firms is and should be through that lens, particularly those that are seeking a strategic partner.”

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