Elizabeth’s note: Mark Hurley provoked some RIABiz readers with a negative assessment of the worth of most RIA practices. See What to make of Mark Hurley’s latest prophesy that most RIA firms will go out with a whimper. In this column, another of the industry’s broad thinkers, Bob Veres, offers a different vision for the future of our fast-evolving industry. Scalable RIA firms are not only possible, he argues — they are already multiplying and growing more profitable.

When outsiders look at the RIA world, they often have trouble believing how fragmented and small these businesses typically are. We live in a micro-business industry.

Consider some remarkable facts. Of the estimated 29,000 independent RIA firms listed in the Investment Advisor Search database, 13,500 are state-registered, meaning they have less than $25 million under management. Roughly 47% of the competitor firms in the RIA space probably generate less than $250,000 in revenues.

Of the remaining 15,500 firms, it has been estimated that 40% will move to state registration, meaning 6,200 firms have less than $100 million under management, and plausibly have less than $1 million in total revenues. Meanwhile, approximately 70 umbrella RIAs run by independent broker-dealers are each composed of between 500 and 1,000 smaller advisory firms whose principals function as IARs.

Remarkable accomplishments

Add it all up, and you find that at least 95% of all firms that provide investment advice as their primary stock-in-trade would qualify under the Small Business Administration’s definition of “small” businesses ($7 million in annual revenues), and well over half fall within the World Bank and International Finance Corp.'s definition of “microbusinesses”—a category that more commonly includes companies whose sole employee is a woman in Bangladesh working at home with her newly financed sewing machine.

Viewed in this way, the RIA universe is all the more remarkable for its accomplishments in recent years. The Cerulli organization recently announced that sometime in 2012, the independent “channel” will have as many consumer assets under management as, in aggregate, the U.S.-based brokerage firms: UBS, Merrill Lynch et al. The growth rate of independent RIAs exceeds brokerage firms, national and regional banks and the entire insurance industry.

In my recently completed white paper (The Future of the Financial Advisory Business: Opportunities, Challenges and Trends in the Second Decade of the 21st Century, available for free at www.bobveres.com), I pose an interesting question.

What would happen if the independent RIA firms do what every other service industry (notably the legal and accounting professions) have done: amalgamate smaller firms into regional multi-partner entities with their own dedicated marketing teams (and budgets). The firms would have a significant presence in the local business community, plus the increased scale and access to resources that come with the size of a normal business entity. Is it possible that those firms would become more effective competitors in the marketplace at large?

This is not a hypothetical question; in fact, the trend is already well under way, pushed along by a powerful group of drivers. Among them: the aging of the baby boomer founders of most advisory firms (average age: 55-57). Those founders now are considering transition strategies—including mergers with other advisory firms.

How smaller firms are able to compete

In addition, the market downturn and the Great Recession created a new awareness of the importance of scale and management expertise. Meanwhile, the democratization of inexpensive practice management advice, offered by online service providers like Quantuvis and ActiFi, a growing ecology of outsource and support organizations, and new methods for incorporating professional software into advisory firms (sometimes gaining the principals a 1,000% return on their investment or more) are all making it possible for smaller advisory firms to compete.

The report examines each of these drivers in considerable detail. But the bigger picture question remains: What would the world look like if the RIA community undergoes a phase transition from practices to businesses large enough not to qualify for global microlending programs? The white paper suggests that we are looking at several interesting changes in the RIA space:

More profitability and take-home profits for company owners. The Moss Adams 2009 report on company profitability found that “mature solo” practices (which typically have of one professional and 150 active clients) typically generate a little under $207,000 a year in pretax income per owner. Owners of firms characterized in the study as “market dominators” (which have, typically, 13 professionals and 742 active clients) took home an average of $454,000.

A broader spectrum of RIA firm sizes. Some observers expect the advisory profession to evolve as the legal profession has. Some 48% of practicing attorneys work in solo practices, but 356 firms have more than 100 attorneys, and another 381 employ between 51 and 100 lawyers. Two firms each have more than 3,500 attorneys nationwide, working out of more than 65 offices.

Orders of magnitude more operational efficiency. Larger advisory firms will be able to specialize in one or more specific client niches, allowing them to customize their services and provide those services more efficiently. Advisors will be able to educate themselves more in the operational business challenges of their doctor, small business, or corporate executive clients. In addition, advisors will be able to cultivate more efficient, targeted marketing and referral programs.

A new competitive equation. The white paper boldly predicts the demise of the brokerage retail business model, but one doesn’t have to go that far to envision a very different world from the one we practice in today. As an understanding of the fiduciary standard becomes more prevalent in the regulatory world and in the press, and especially if mandatory arbitration clauses are ended, brokerage firms will increasingly have to defend their conflicts of interest—trading for their own account and recommending that their customers buy what they no longer want to own; recommending AND managing mutual funds; taking companies public AND recommending that their customers buy these new shares, etc.—in a public forum, and in court. The prediction is that these conflicts will carry increasing liability, which means that more firms will try to scale back their brokers’ RIA activities. That, in turn, will cause the best brokers to look for greener pastures—those increasingly scalable, multi-partner firms that are evolving in the RIA space.

Meanwhile, local marketing efforts by larger RIA firms would create more competition for firms who have, in the past, had exclusive access to the advertising media.

A few more points. The white paper also predicts that advisory firms will increasingly find ways to work with less-wealthy (middle market) clients at a profit. It foresees the emergence of a New Investment Paradigm (and more sophisticated investment management activities) and predicts professionals will offer new services like career counseling and budgeting/expense control advice. Larger firms will be able to bring more services in-house and create mutually beneficial alliances with a wider range of service providers.

The point here is that the RIA world has entered one of those periodic phases of rapid evolution, which will create a very different-looking world than the one we inhabit today. Some advisors will see these trends clearly, and navigate through them with such effectiveness that they increase market share. Others, as always, will be blindsided by the trends, respond slowly and grudgingly, and risk falling into irrelevance.

And, as always, the trends won’t care who participates in them; they’ll change our world in ways that were, in hindsight, remarkably predictable. For independent RIAs and their firms, the white paper paints a very bright future, achieved, in part, at the expense of brokerage firms, but more importantly, achieved by increasing size, scale, managerial excellence, better external support and internal utilization of software, more focused services and better models for serving a larger percentage of the population. All of these are logical developments; as we watch them unfold, we are likely to ask ourselves: why didn’t we begin this evolutionary journey years ago?

Bob Veres has been a commentator, author, speaker and consultant in the financial services industry for more than twenty years. He authored The Cutting Edge in Financial Services (Bloomberg Press, Jan. 2003), and has presented at many of the financial planning industry’s largest professional conferences. Mr. Veres is also editor and publisher of Inside Information, an interactive subscription-based information service for financial planning professionals. Download his controversial white paper at www.BobVeres.com.