If the cobbler’s kids run around barefoot, the financial advisor’s kids may be a little nervous about their college funds right now. A surprising number of financial advisors are not prepared financially for a year that likely will bring significant declines in revenue and therefore personal income.

In its mildest form, financial trouble will take some advisors through a personally painful period when they will have to suspend some personal expenses and delay purchases or hobbies. In a more serious, if less frequent strain, the financial disease will force ambitiously growing firms to make painful financial decisions that threaten to damage the service capabilities of the firm and cripple its growth potential. At its very worst, it will threaten the viability of recent acquisitions and partner admissions and alter the course of some of the largest and most aggressive efforts to consolidate the industry. Regardless, the financial disease will be felt throughout the industry and will have a long-term impact on the competitive landscape.

It is difficult to estimate what percent of the industry is suffering from financial trouble of one degree or another, since the affected firms are not prone to disclosing such issues. Still if I had to venture an estimate, based on anecdotal evidence, I would say that at least 30 percent of all advisors are facing personal financial issues that are serious enough to require either a loan or a significant change in lifestyle. The problem is worst among the advisors who are in their 30s and 40s and have not had enough time to accumulate personal capital outside of the practice. To make matters worst these are usually the practices that are growing the fastest and investing in staffing and infrastructure. I would estimate that at least 10 percent of all practices will have to lay off staff in an attempt to cut back expenses and maintain some level of profitability.

There are likely a handful of firms that are suffering the worst of it. No more than 10 percent of registered investment advisors and less than 2 percent of broker-dealer affiliated firms are owned by a corporate entity such as a bank, a consolidator or a CPA firm. For these firms, the future may look the bleakest. Most of the consolidation deals put the acquirer in a preferred position, essentially guaranteeing a level of profitability to the acquirer. For the advisors who sold a portion of their firm, this means a severe and disproportionate decline in income. Many acquired firms may not make enough money to pay anything to their principals. The psychological and strategic impact of such severe strain will have a lasting impact on the firm and perhaps slow down the pace of industry consolidation.

The symptoms of financial issues in a practice are usually obvious to the advisors themselves and usually hidden from everyone else so it is worth taking an inventory of the typical financial issues and the extent of their severity.

Turning Income Into Lifestyle

We have to remember that 2007 was a record year in terms of personal pre-tax income to financial advisors. In wirehouses and independent practices alike, advisors had higher income than they ever had before. Unfortunately many advisors took that income, projected its increase by 15 percent over the next 5 years and then made personal spending decisions based on that number. I am not saying that Ferraris were bought or yachts were commissioned (well… some were) but many advisors made significant purchases—a house, a new office building, etc. Many invested in property or limited partnerships. The result was often a level of debt that was going to be very comfortable if the practice continued to grow and prosper but has turned troublesome with the decline in revenue.

Before we judge such advisors harshly, we have to remember that it takes 10 to 15 years to establish a practice from start to prosperity. These are 10 to 15 years of low income (if any), conservative spending and no personal indulgence of any kind. Advisors in their mid 30s and early 40s most likely just saw some good level of income for the first time in 2007. For the first time they could indulge themselves a little and provide their families with some needed upgrades. Unfortunately in the feast after the famine, moderation is not a frequent guest. In many cases, the spending may have gone beyond reasonable levels.

That is not to say that the practices or the advisors themselves are in financial distress. However, this means that these levels of personal debt will have to be eliminated before any investment in the practice can be made. In turn, this means slower recovery and growth during the market upturn.

Staffing Up

There is always the question of whether you add staff before the anticipated growth, or whether you wait for the growth to stretch resources to a maximum before you hire. I have always believed in investing early and often in the practice, but unfortunately this decision is now in danger of backfiring on all advisors who tried it. If compensation to non-professional positions (client service administrators, assistants, operations staff, etc.) exceeds 20 percent of the total revenue of the practice or if total professional compensation (including the owners) exceeds 40 percent of the total net revenue, we may have a problem.

Letting staff go is a difficult, painful and dangerous decision. The effects to the bottom line are not as quick as one would like since there is usually some severance payment negotiated. The change inevitably affects those who stay and the effect is usually demoralizing. Finally, staffing up when the opportunity comes back is a slow process that may dampen growth for a while.

There is no easy answer to this conundrum but if 1) the owners can afford it and 2) the staff consists of good performers who will help the firm grow for years to come, my inclination is to look for ways to retain people. Both premises are very important. First, if the affordability is not there, as painful as the step may be, it needs to be taken. Going into long-term debt to finance operating expenses is not a viable option in most cases since the downturn can be long and this will paint the practice into a financial corner. The performance of the staff is very important too–finding good people is hard, but retaining mediocre ones is inexcusable. Paying for mediocre effort and skill when the practice is facing financial problems also tends to damage the motivation of the good performers.

At the end, firms who have no debt, who can afford to continue investing in people, marketing and growth and whose principals can find the energy and personal financial resources to persevere, will win the decisive recovery round. Firms saddled with personal or business debt, and recovering from expense cuts and underinvestment in the practice will be slow to recover. The pace of deal making will drag and consolidators will have to prove that they can add value to the acquired firms either by providing the much needed financial stability or demonstrating that they can help manage the firm through the storm. For the entire industry this is a painful test of whether we can all do what we ask clients to do—be careful, prudent and systematic in our financial decisions.