Much continues to be written about the departure of Credit Suisse, Barclays and now Deutsche Bank from the U.S. wealth management market (the European Three). The pundits chalk up their demise to their lack of scale, as if size in and of itself solves all problems. Their size may have accelerated their demise, but the true source of weakness has more to do with the underlying structure of wealth management at many of the U.S. investment banks, where market share is being lost to independent firms. These banks are also grappling with high advisor turnover and unsustainably high acquisition costs.
The same corrosive dynamics that plagued the European Three underlie the foundations of the Big Four (Morgan Stanley, Merrill Lynch, UBS and Wells Fargo). The Big Four have a fiduciary responsibility to their shareholders to address these problems. In the current environment, management teams only have a few tools that they control to address these issues:
· Reduce advisor payout
· Reduce expenses by eliminating products and services and/or client support
· Increase retention of advisor payout to reduce or eliminate advisor departures
· Drop out of the Protocol for Broker Recruiting and institute non-competition and
non-solicitation clauses in advisor contracts.
None of these options are good for advisors or their clients. It gives the firms more control over the client experience in an environment where the firms are driven by profitability as opposed to what is best for the client. We position that, similar to the metaphor “a canary in a coal mine” where coal miners used caged canaries to detect deadly carbon monoxide in mines, the demise of the European Three is a harbinger of the future for the Big Four.
The European Three and the Big Four all attempt to grow their business primarily by acquiring advisors from other firms. The acquiring firms rationalize recruiting because they are buying “good productive businesses that will improve their finances.” However, herein lies the problem. The firms believe they are buying the businesses (and pay dearly for them), yet the selling advisors view the transaction as nothing more than a lease with a finite time horizon. If the acquiring firms are forced to model their acquisitions based on a reasonable return on capital during the life of the contracts, the acquisition deals would be significantly smaller than the payment of 300-350 percent of trailing 12-month revenue headlines bantered about in the market place today. After all, how can you justify paying an acquired advisor three times their trailing 12-month revenue when the underlying business margins are 10 percent or 20 percent?
According to our calculations that would require 15-30 years for the Big Four firm to recoup the cost of the acquisition deal. The scenario becomes even more interesting when you note that the standard contract only covers a 9-year period. How do you make money with economics like that? The smaller firms may have had a shorter runway than the larger firms, but those same structural weaknesses exist at the larger firms none the less. If anyone of the Big Four attempted to break from the pack and offer recruiting deals that are economic they would likely see their pipeline of newly recruited advisors disappear overnight. Coupling this structural weakness with the fact that the Big Four are in net liquidation (absent market gains), with more assets leaving than are coming in, a dearth of new advisor recruiting would be devastating to the net new money at the Big Four, creating an even more visible downward spiral.
Consider the fact that since March 2009, the S&P 500 Index has gone from an intraday low of 666 to 2,100 (an increase of approximately 250 percent) as of this writing. Yet, despite the market trajectory the Big Four continue to produce lackluster profit margins. What would happen to their margins if the market declined significantly? What will the Big Four do to manage their overall business and margins going forward given these structural challenges? Something has to change, even if it is not advisor or client-friendly.
The Big Four now have more of an oligopoly than ever before given the news of the European Three, which means they have more control of a portion of the U.S. wealth management market than they had previously. Historically, if advisors didn’t like a policy of one firm they could easily find a new home. Now, more of the seats are controlled by the Big Four, reducing optionality for advisors. Consequently, the Big Four will be able to change their models with less advisor fallout. Those who ignore these warning signs are doomed to suffer the same fate as coal miners who witnessed the canary dying and chose to do nothing.
John Straus is chairman and CEO of FallLine Securities.