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A Level Playing Field

Kochis Fitz was once a small financial-planning shop that tried to win clients with $250,000 to invest. But the registered investment advisor has emerged as a leading financial-advisory practice in San Francisco, boasting $1.4 billion under management. So successful has Kochis Fitz been in winning wealthy corporate executives to its roster that the firm has been able to increase client portfolio minimums,

Kochis Fitz was once a small financial-planning shop that tried to win clients with $250,000 to invest. But the registered investment advisor has emerged as a leading financial-advisory practice in San Francisco, boasting $1.4 billion under management. So successful has Kochis Fitz been in winning wealthy corporate executives to its roster that the firm has been able to increase client portfolio minimums, from $1 million in liquid assets, to $3 million, and, most recently, to $5 million.

As a result, Kochis Fitz has come to realize that it is doing business in rarified territory and that the firm is now competing with the big names on Wall Street. “We used to compete with small boutique wealth-management firms, but now we're up against Goldman Sachs, Bessemer Trust, Smith Barney, Merrill Lynch,” says Sandi Bragar, a principal with the firm. And it seems to be holding its own, to say the least. In 2005, the firm welcomed 12 new clients with over $5 million each to its rapidly expanding practice, says Bragar, adding that the firm intends to win eight to 12 new $5 million-plus accounts per year.

There was a time not long ago when most wealthy people did not know what an independent RIA was, much less consider entrusting their net worth to one. Instead, they preferred the exclusivity of the local trust department or the comfort of a national brand name. Today, the independent RIA — often with just his own name on the door — is fighting it out with an FA who may work in the tallest building in town and is backed by a large Wall Street firm. It's a rivalry that should only intensify, but RIAs are at an inflection point in their industry's maturation. Yet, while the playing field has been leveled (i.e., access to products and asset managers), only a small slice of the RIA industry will actually have any success on that field — at least that is the finding of a study by JPMorgan Asset Management. Managing an RIA practice will get tougher: Operating costs are rising, investors expect more services, banks and insurance companies are entering the space and wirehouse rivals are recasting themselves as “open architecture” wealth managers.

Specifically, JPMorgan argues that only the biggest independent RIA firms and the best of the mid-sized shops, or about six percent of the industry, will actually continue to turn a profit and grow. In a coming shakeout the biggest fish — like Kochis Fitz — will grow bigger, while the mid-sized firms will either evolve into specialty niche advisories or get acquired by larger industry participants, the report says.

Face Off

Of course, Wall Street's retail brokerage behemoths still control the vast majority of the retail market. As a whole, independent RIAs (SEC-registered FAs with no affiliation to broker/dealers) manage around $1.09 trillion in assets, says Boston-based Cerulli Associates, whereas Merrill Lynch's global private client group alone manages $1.4 trillion, as of the firm's third quarter 2005. Still, large independent RIA firms like Kochis Fitz — those fee-based specialists with the sophistication of traditional institutional consultants — have become a formidable rival for big Wall Street firms in the increasingly heated contest over the very rich.

That's because the wealth advisory landscape has changed dramatically over the past few years. For one thing, in this regulatory climate, “open architecture” is ascendant, and that in turn has propelled advances in technology. Quite simply RIAs now have access to virtually the same data and products that wirehouses and banks do, say analysts and executives. Moreover, recent conflict-of-interest scandals at the wirehouses have inspired some wealthy investors to seek out independent — read “unbiased” — financial-planning advice. The result is a more level playing field.

“It's not complicated to get access to managed accounts, mutual funds and alternatives anymore, and so what you see now is that people no longer can compete based on proprietary product architectures because everyone has access to it,” says Charles Goldman, the chief operations officer for Schwab Institutional. “What people compete on now is service, relationship, performance.”

Now independent RIAs often have access to more products than full-service advisors do. For example, the 5,000 RIAs that use the custody services of Charles Schwab (which represent about a third of the independent RIA market in terms of assets) can select from over 5,000 mutual funds, a wide array of alternative investments, including 29 fund of funds from 11 issuers (index funds, hedge funds, real estate and private equity) and close to 800 separate accounts managers. Most of these products are offered by the big names in the business — Bank of New York, CSFB Alternative Capital, JPMorgan Undiscovered Managers, Oppenheimer Tremont. By comparison, Merrill Lynch offers 3,000 mutual funds, 65 separate accounts managers and a “wide selection” of alternative investments.

Not only can an RIA boast that he has the same investment vehicles as the big brand name firms, but an RIA can also tell clients he doesn't have the conflicts of interest that seem to go along with those national brands. “It's a marketing tool that we believe in,” says Kochis Fitz' Michael Kossman.

TD Ameritrade, for example, says that a whopping 70 percent of net new client accounts have come from the wirehouses over the past few years. (The firm brought in $10 million net new assets over the past 12 months, bringing its total up to $50 billion.)

Of course, today, brokers everywhere are remaking — and remarketing — themselves as fee-based financial advisors and planners. While RIAs have been, in general, more focused on financial planning than wirehouses, that is changing as wirehouses overhaul their vast distribution networks built on trading, commissions and proprietary product sales. “I think it's a flash-in-the-pan advantage that they have right now,” says TowerGroup analyst Matt Bienfang. “As soon as the more established names get their [fee-based RIA] programs developed, you'll see less of a migration [to independent RIAs]. At the end of the day, I see guys who already have established business migrating to the RIA model — inside of the wirehouses.”

The Shakeout

Already, competition is intense among independent RIAs and only a few of the biggest and best run firms are expected to thrive in an increasingly crowded marketplace, according to the JPMorgan Asset Management report entitled Back to the Future: The Continuing Evolution of the Financial Advisory Business. Despite growing demand for financial-planning advice, the survey says, only large firms with over $3 million in revenues and mid-sized firms with over $1 million in revenues will continue to turn a healthy profit and grow. The other 94 percent of firms will limp along, sell out at a low price or fade away.

“What we're saying is we definitely think there is going to be increasing demand for people who can offer financial advice and solutions. It's a great business to be in, but cost and competition are going to make it harder to be in this business,” says Sharon Weinberg, the lead author of the report. “A good analogy is the PC market,” she says. “In 1988, there were almost 40 companies in this industry. And between 1988 and 2004 the volume of computers rose 16-fold. Despite the tremendous increase in demand, today, there are only 10 major PC manufacturers, and Dell and HP together have almost 60 percent of the market.”

Not only are RIAs competing against one another and wirehouses, but insurance companies, small and mid-sized banks (who are getting savvier), even online brokerages like E*Trade and tax-planning shops like H&R Block are attacking the financial-advisory business. Meanwhile, profitability has been squeezed by rising costs and the disappearance of what JPMorgan calls the “hidden subsidy” provided by boom time market returns. Up until 2000, RIA firms could count on 12 percent to 14 percent annual increases in revenue from the market appreciation of client assets, JPMorgan says.

More recently, between 1999 and 2003, salaries, employee benefits and company insurance costs together increased by an average of 101 percent, while revenues grew just 37 percent. And more of the same is on the way. Employment, compliance and marketing costs should rise significantly in the coming years, says JPMorgan. As competition for talented wealth management and investment professionals gets more heated, key partners in RIA firms will begin to demand equity stakes in their firms and higher salaries. Meanwhile, RIA firms today do little in the way of marketing, but will have to start spending on it to stay in the game.

“For our business we've definitely seen that fixed costs have gone up in the last several years — compliance and marketing for sure,” says Bragar of Kochis Fitz. But, she says, her firm has been able to offset those costs. “We've run the business so we can scale all of our systems and resources, so we can take on a lot more volume. We've also relied more and more on technology. We made a very big investment for a new customer relationship management software program that we're rolling out in early 2006,” she says.

And while it's already getting harder to recruit and retain good individuals, Bragar says, Kochis Fitz's financial-planning staff has had zero turnover in the last 15 years. “Our firm culture is very people-focused, not just on clients, but also employees of the firm,” she says.

JPMorgan says that as the largest and most profitable independent RIA firms reinvest in their businesses and make acquisitions, about 25 to 50 firms with assets of $15 billion and revenues of over $50 million will emerge. Another 500 to 600 firms will grow into specialty niche firms with $550 million to $600 million in assets.

Ultimately, it's the firms that are run like businesses that are going to survive. “People argue it's not an industry, it's a profession. But it's both,” says JPMorgan's Weinberg. “There are so many advisors who are so absolutely passionate about their clients' finances, but are not focused on the finances of their own businesses. Being a professional does not exempt you from the rules of capitalism.”

The Haves and the Have Nots: Profit Profiles

High-profit ensembles and solos are the top-performing 25 percent of advisory firms. Other ensembles and solos would lose money if they paid their owners a market level salary.

High Profit Ensembles Other Ensembles
AUM $174 million AUM $72 million
Median revenue $1.3 million Median Revenue $557,000
Pretax income/owner $376,000 Pretax income/owner $104,000
Operating margin 19.1% Operating margin 5.3%
Median client size $919,000 Median client size $527,000
Op. profit/client $1,573 Op. profit/client $293
High Profit Solos Other Solos
AUM $50 million AUM $20 million
Median revenue $376,000 Median Revenue $175,000
Pretax income/owner $218,000 Pretax income/owner $70,000
Operating margin 20% Operating margin 4.9%
Median client size $373,000 Median client size $263,000
Op. profit/client $649 Op. profit/client $157
Source: 2004 FPA Financial Performance Study of Financial Advisory Practices, cited in JPMorgan Asset Management 2005 report Back to the Future.
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