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Is Your RIA Firm Prepared for a Market Downturn?

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Written by: RIA in a Box 

With the strength of the markets over the past few years and frequent reports of registered investment adviser (RIA) record profits and growth, it’s hard to not be excited about the future RIA industry. However, when times are good, it’s also often the best time to begin planning for when times may not be so good. As we all know, markets will turn at some point in the future. As such, this post highlights some areas that principals of RIA firms should be looking at when thinking about building an enterprise that can thrive and survive in good and bad market times.

In working with over 1,200 investment advisory firms on a monthly basis to help solve compliance, operations, and technology challenges, we’ve identified six critical areas of an RIA business that principals should be focused on addressing in order to properly prepare for and survive a market downturn:

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  1. Fixed vs. Variable Cost Structure: Today, there are a plethora of outsourcing options available to advisory firms of all sizes. These options include firms that will assist with compliance, technology, or outsourced investment management via an array of turn key asset management platforms (TAMPs). We generally observe that RIA firms are carrying too much fixed cost relative to revenue generally due to the desire to continuously hire full time staff members. While a high fixed cost operating structure can produce amazing operating leverage during good times, it also can be devastating to an advisory during a downturn. Letting staff members go can be a death blow to company morale and adversely impact the delivery of client service when needed most. When markets become volatile, clients generally need the most hand holding and human touch, yet at that same time the firm is now being forced to let go of staff to preserve profitability. Our recommendation: RIA firms should outsource anything that isn’t the firm’s core strength. While many outsourcing vendors, particularly TAMPs, charge on a variable cost structure tied to assets under management (AUM) that can lead to reduce operating leverage and profitability during strong markets, a variable cost structure can be a life saver during a rapid market downturn as it quickly allows a firm to realign its cost structure to match its reduced revenue. In addition, consider structuring employee incentive compensation to more closely mirror overall firm performance (e.g. total firm AUM, revenue, etc.).
  2. Stop Selling Investment Performance: Our firm’s president, GJ King, spent a number of years at Goldman Sachs in the private wealth management group. One of his greatest takeaways from the experience was the unique approach that his mentor, a very successful advisor at the firm, during prospect meetings. To begin, the advisor would immediately acknowledge to the prospect that he could not beat the markets, nor was he even particularly special when it came to portfolio management, and if that was what the prospect was looking for, he or she would inevitably be disappointed and should look elsewhere. Instead, he would focus on what he could help the prospect accomplish as it related to financial planning, estate planning, and his or her future legacy and why he, as an advisor, was uniquely positioned to assist. In many ways, the advisor was preaching the merits of the Advisor’s Alpha, a phrase coined by Vanguard many years back. Suffice to say, this advisor’s client retention over the years has been nothing short of remarkable due to his focus on setting the right client expectations and delivering on them from the beginning. Our Recommendation: Evan an RIA firm that has an impressive investment performance track record should be very cautious in marketing such performance as it’s value add to clients. If the markets turn and the investment performance fails to live up to its hype, there’s a good chance the firm will lose a sizable number of clients during a downturn leading to a significant and perhaps catastrophic decline in revenue.
  3. Address Client Concentration Risk: Any client that generates 5% or more of an advisory firm’s revenue poses client concentration risk. Like many small businesses, many RIA firms get their start by landing a single or small handful of large clients that leads to great success for the firm. Often these initial client(s) also have referred a number of additional clients to the firm over the years. Thus, the overall influence of a large client is often under estimated by the firm for if the client was to leave, it’s possible other clients would follow. Furthermore, at times a large client has negotiated such favorable pricing that the client may not be as profitable as it may seem at first glance. Our Recommendation: From the beginning, an advisory firm should be razor-focused on diversifying its client base. A market downturn leading to reduced revenue from all clients coupled with the loss of a key client and the clients that he or she may influence can be difficult for a firm to recover from.
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