As a former communist, I am highly trained to detect the early signs of an approaching revolution. It is well known in former communist circles that unmet expectations and a sense that one is being exploited are necessary preconditions for any successful uprising. The financial advisory industry is showing pre-revolutionary signs, as many younger advisors very much expect that they will become owners or partners in the firms where they work. But they are finding that the older generation — the advisors who founded and own those firms — are not so open to sharing their equity. In my not-so-humble opinion, the classic struggle between capital and labor will define the dynamics of this industry for the next 10 years.
My prediction is that many firms will struggle as they lose their best young people because they never gave them a path to equity. My further prediction is that many of the firms acquired by banks, consolidators and other acquirers will struggle to retain younger professionals because they offer limited equity.
At the same time, firms that have the ability to recruit and retain young advisors by wisely offering up their equity will have a lasting competitive advantage. This is true across the entire industry and not just for the independents — even inside wirehouses, teams are becoming more and more common, and the team principal is the wirehouse equivalent of an independent firm partner. In other words, I believe the same process is going on across the entire industry.
In many professions (attorneys, CPAs, consultants, etc.), there is an expectation that if you stay in the industry and work successfully in your firm for between eight to 12 years, you will become a partner. In the carrot-and-stick equation of professional services careers, partnership is the big carrot — the goal that all professionals aspire to and that is really the first measure of success in a career (the second measure is buying an environmentally-friendly Lexus).
The question for advisory firms is, can they recruit and retain talented individuals without offering any access to equity? In other words, is a clear path to equity a necessary condition for recruiting a professional into a firm, or can the current owners get away with offering something else? If they don't offer “partnership” potential, accountants, lawyers, CPAs and other professionals will have to drastically and dramatically change the career paths in their firms — and potentially the kind of compensation they offer to employees in the earliest stages of their careers. The salaries will probably have to be higher along the way, but the sense of career commitment will probably be lower almost regardless of the compensation. There are certainly examples of accounting firms that were consolidated into public companies or consulting firms that went public, and in all of those cases recruiting and retention became a challenge — especially retention of the senior professionals who were on the cusp of making partner.
At present, advisory firms are setting the stage for a nice-sized revolution as most of them either avoid the subject of equity altogether or are purposefully ambiguous about it. In the 2006 Moss Adams Financial Performance Study of Advisory Firms, we found that only 10 percent of all firms in the industry have admitted a new partner, and of those, only 33 percent have been internally promoted (joined as employee and then became a partner/owner). This is a very small slice of the industry, and it worries me.
These are the reasons why owners are reluctant to promote partners internally:
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They don't want to share control of the firm.
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They don't believe they have qualified candidates.
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They can't see how they will get paid fair value for the equity they sell to the junior people in the firm. To make it worse, they misread the distribution of some equity as a prohibition against future sale of the business.
Let me address these concerns one by one. Believe me, this is better than waiting for the Red Army to force a decision later.
The Issue of Control
I think the reality is that control always gets diluted as a firm grows, and that is actually a good thing. Delegating (and relegating) control makes it possible for a firm to hire more employees and reach more markets. We have to be clear on one thing, though, growth is the only reason to introduce new partners and owners into the firm. Unless you are growing, there is no reason to share equity. As you grow you will need to extend your reach, and that's when giving up some control is OK. As you think about control, ask yourself the question, “Control of what?” There are many things to control — client service, employment decisions, profit distribution, the decision to sell the firm. What you do when you bring in new partners is give them a voice — a vote, not a veto. A new five percent owner will not be able to sell your firm to a bank behind your back, so the anxiety is often unjustified. Not to mention that you may be missing an opportunity to unload control of all the pesky operations and administrative details.
The Lack of Candidates
The thing to remember here is that great candidates are developed; they do not simply show up at the door. It was interesting to see that in our Compensation and Staffing Survey, two-thirds of all firms were looking to hire experienced professionals, but only 12 percent of all firms were hiring non-experienced ones. Well, they have to get their experience from somewhere. To have good partner candidates, firms must recruit good talent with the potential for growth, and then groom those individuals and help them realize their potential.
Internal vs. External Sale
It is true that internal partners are not capable of paying the same high multiples that banks can offer and do not have the financial backing of the consolidators in the industry. In most cases, the firm has to provide financing for the transaction and basically let the candidate use profit distributions to finance the purchase of equity. So why sell to the internal candidates rather than to a bank or consolidator?
The answer is in what the bank or consolidator is looking for, and that is a large firm with depth of talent that can survive and thrive despite the retirement of the original owners. This is where it all gets reconciled — the presence of young, motivated partners will allow a firm to sell the founding equity at a high valuation. A transaction in which 20 percent of the equity goes to the next generation of partners at favorable terms and 80 percent is sold to an institution is good for everyone — the owners get the high institutional valuation, the younger advisors get equity and their turn to run the firm and the acquirer gets a deep team and a firm that can grow.
Many clients actually ask the question “Do we have to give them equity? Can't we just offer phantom stock?” Well, no one ever put on his business card “Philip Palaveev, Phantom Stock Owner.” Partnership is largely a sign of prestige and accomplishment, not just a financial instrument. You can “fake” the financial consequences of equity but not the emotional involvement it creates. Like they said back in my communist days, “We pretend to be working; they pretend to be paying us!”
So what will happen with the revolution? I think firms that do not systematically recruit and retain talent with equity will find the Red Army at their door. At the end of the day, almost regardless of what happens with fee compression, consolidation and all of these other favorite topics of discussion, the firms that are successful will be the firms that have the best advisors. Talented people who have strong drive, initiative and desire to work in this industry inevitably will want to have emotional and financial involvement in the outcome, and there is no better way to provide that than equity. Sometimes capital has to compromise with labor, for the benefit of both.
After trying out and giving up on communism during his youth in cold war-era Bulgaria, Philip Palaveev is now assisting clients at building the optimal investment advisory firm as a senior manager at Moss Adams LLP.
