Originally published in Financial Advisor

By Mark Hurley

The wealth management industry is chock-full of really smart people—Ph.D.’s, CFAs, CFPs, people who teach at universities, etc. They do incredible work for their clients and help protect them from doing stupid things with their money. Yet when it comes to protecting the value of their largest personal asset—their businesses—more than a few of these very smart advisors do some extraordinarily dumb things.

The top five that we have seen to date (moving from dumb to dumbest) include:

Number Five: Incorrectly using compliance consultants.

Many firms hire compliance consultants to conduct mock regulatory audits of their firms and give them advice. On the face of it, this makes a lot of sense. Nothing can more quickly obliterate enterprise value than having a compliance problem, and an extra set of expert eyes looking over a firm’s program can catch many problematic things before the regulators do.

However, incorrectly using compliance consultants can be extremely dumb for three reasons. First, consultants and attorneys fill different roles. The former help you to better manage your compliance program. The latter opine on matters of law. And one of the quickest ways many firms get into compliance trouble is scope creep—i.e., expecting their consultants to do the jobs of their attorneys.

Second, the advice a consultant provides is not “privileged”—in other words, unlike something you share with your attorney, what your consultant finds (and tells you) can be used against you. And while it is the duty of every compliance officer to cooperate with SEC examiners and provide them with an accurate picture of a firm’s compliance program, there are obviously certain potential matters that should only be discussed with one’s counsel. Sharing them with your consultant eviscerates any protection of privilege.

Lastly, many firms spend a fair amount of money to have consultants review their compliance programs and then do nothing about what they uncover. In other words, these firms have just paid extra to make an examiner’s job much easier.

Number Four: Recruiting professionals who are far less capable than themselves.

Many wealth managers have two classes of people: founders and others. The founders are extremely well paid and the others are not. And while the “others” include some successor professionals, who is kidding whom? These individuals are nowhere as capable as the founders and most will likely never be.

While such an approach may boost short-term profits, it is really dumb (and costly) in terms of enterprise value. Why? Unless a firm has successors who are capable of succeeding the founders, the owners’ only alternative for unlocking enterprise value is to sell the business.

However, potential buyers (at least when it comes to protecting their long-term outcomes) are far less worried about the selling owners than they are about the firm’s successors—since it is they who are integral to retaining clients and adding more in the future. But if your heirs apparent look like they belong in the Three Stooges, good luck in getting anyone to pay a lot for your business.

Number Three: Generating most of their new clients from only one or two referral sources.

Many wealth managers generate the preponderance of their clients from only one or two sources. For example, there are firms that capture 80% to 90% of their net new assets from custodian branch referrals. And although many such wealth managers have had explosive asset growth, their owners are deluding themselves if they believe that their businesses’ enterprise value is growing a fraction as fast.

Why? Either wealth managers are growing or they are dying. As clients get older they start to consume some of their capital and the fees they pay decline over time. Thus, any firm that is not adding lots of new clients is effectively shrinking.

Any wealth manager that captures the preponderance of its new clients from only one or two referral sources will quickly join the dying category of firms if these sources stop sending it new clients (or perhaps start charging a lot more for doing so).

Understandably, buyers find this type of concentration risk very unattractive. Consequently, they typically pay much less (particularly in up-front money) for these firms than they would pay for firms that have widely diversified referral sources.

Number Two: Their businesses are structured as C corps and not as pass-throughs for tax purposes.

One of the more surprising things we have encountered is that many wealth managers are set up as a C corp for tax purposes instead of as a tax pass-through (i.e., as an S corp or as a limited liability company). When we asked their owners why they did this, the most common answers were that doing so allowed them “to keep cash in the company” or “our company was set up before there were S corps or LLCs.”

Putting aside for a minute that a tax pass-through can retain cash and that at one point in time one could convert to an S corp without any tax penalty, there are two other reasons this is really dumb (and again, costly).

First, buyers overwhelmingly prefer to acquire wealth managers using an asset purchase structure—in other words, they do not buy the stock of the company, just its assets. They do so because they are understandably afraid of acquiring some unknown and potentially costly liability (for instance, if some employee did something in a client account many years ago that management does not know about and it surfaces later with lots of potential litigation risk).

And if a C corp is acquired through an asset purchase, the selling owners get the privilege of being taxed twice, both at the entity level and when they dividend out the proceeds from the deal. After paying all of these taxes, the owners get a lot less money.

Second, even if a seller can persuade an acquirer to buy its stock instead of its assets (and for very large sellers, buyers will sometimes agree to do so) the price the buyer is willing to pay is significantly less than that for a similar firm that is a pass-through Why? The buyer can write off—and deduct for tax purposes—the purchase price over time for the latter. But this is not allowed with a C corp and buyers adjust their pricing accordingly.

Number One: Your firm is not a lot bigger than it was six years ago, but you are not worried.

Of all these dumb things, the dumbest we have seen very smart people in this industry do to date is tied to complacency. More specifically, we have run into many firms over the last couple of years that today are only about 25% to 30% bigger than they were six years ago—firms that had $1 billion of AUM back then and now are only $1.3 billion. And their owners are not only not worried, they are feeling pretty good about their businesses.

Well, consider this: The S&P 500 is up nearly 235% since then, and absent this raging bull market, many of these firms would be a lot smaller. And a lot less profitable.

Just look at the math. They are not adding many new clients and several of their existing ones are probably consuming a good chunk of their capital. In other words, from an organic growth standpoint, these firms are effectively dying.

All of this has been masked by an insanely robust equity market, but what happens if this changes? In most firms, cost inflation is running at about 5% to 7% even though general inflation is running around 1.6%. Imagine what is going to happen to their costs if we return to inflation of 3% to 4%. Add in a slowing of the rise in the equity markets (or even a bear market), and what do you think will happen to the profitability of these businesses?

The bottom line is that any firm that is not growing organically (on a net revenue basis) at least 1.5% to 2% a year is on the verge of heading south. And their owners ought to be very concerned.

We have the privilege of working with an industry populated with many smart people. It just never fails to amaze us how many of them do very dumb things.

Mark Hurley is the Founder & Chief Executive Officer of Fiduciary Network LLC.