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Already facing a slow recruiting environment and pinched profit margins, the independent broker-dealer industry is suddenly eyeing a major new competitor—RCS Capital Corp.
In January, RCS Capital announced it was acquiring Cetera Financial Holdings and J.P. Turner & Company, creating a nearly 9,000-advisor rollup virtually overnight.
RCS Capital, controlled by non-traded REIT king Nicholas Schorsch, last year announced acquisitions of three other broker-dealers: Investors Capital Holdings, Summit Financial Services Group and First Allied Holdings.
Schorsch’s flurry of deal-making has gotten everyone’s attention, but major industry players are not all that surprised at the development. “I’m actually surprised that there’s not been more consolidation with small broker-dealers,” says Wayne Bloom, chief executive of Commonwealth Financial Network.
For smaller firms, “it’s just so expensive [with] the technology and compliance” costs, he says. These firms can rely on clearing firms for critical support functions, but even that route is labor-intensive for broker-dealers, Bloom says. “And you can’t off-load compliance.”
This is a recurrent theme. “I would not want to be a smaller or midsized firm right now,” says Amy Webber, president of Cambridge Investment Research.
Schorsch’s buying spree is simply the most visible part of the consolidation picture, Webber says. Many smaller firms are quietly looking at their options. “We’re talking to a number of potential [sellers],” she says. “The industry still has a lot of firms in the $15 million to $100 million [gross revenue] range, and those are the ones looking carefully at their opportunities to sell out.”
Low interest rates in particular are hurting broker-dealers. “A lot of firms are dependent on [earning spreads from cash] sweep accounts, but there’s no money to be made there,” Bloom says. That problem is an industry-wide phenomenon, crimping big banks, custodians and clearing firms as well as B-Ds. Despite nonexistent interest income, many B-Ds posted double-digit revenue gains last year thanks to a roaring equity market.
Interest income is one of three main revenue sources for B-Ds, in addition to asset-management fees and commissions, says Sanjiv Mirchandani, president of Fidelity Investments’ National Financial clearing unit. Fee and commission revenues were strong last year, but with rates stuck near zero, “firms are earning less than their true potential,” Mirchandani says.
That may be one reason why an acquirer like Schorsch is making a move now to snap up independent brokerage firms. Schorsch’s plan is to build scale among his acquired firms while promising to let them operate independently.
But in addition to building scale, “you have to believe interest rates will normalize … to make the [consolidation] math work,” Mirchandani says. The prices now being paid are attractive to B-Ds looking to get out, he added, “so conditions continue to be ripe” for more consolidation.
Small firms aren’t going away, though. They just have to watch costs, stay profitable and offer value, says Don Bizub of Western International Securities, which had $57 million in gross revenue last year.
“Just because Walmart exists doesn’t mean Kohl’s goes out of business,” Bizub says. “You just have to define your niche” as a small firm.
In the next year, though, deal-making should subside—at least compared with last year, says Scott Curtis, president of Raymond James Financial Services. “Last year, there was so much of it, including [from] Schorsch, I don’t know how you can repeat that in the coming year,” he says.
While independent broker-dealers struggle with low rates and higher compliance costs, they continue to benefit from the hot “hybrid” advisor market.
Researcher Cerulli Associates defines these “dually registered” advisors as those who run their own RIA firms but also maintain an affiliation with a broker-dealer. In 2012, the most recent data Cerulli has, dually registered advisors grew assets 21.5%—the largest increase among all advisor channels. In fact, the dual category surpassed $1 trillion in assets for the first time.
Over the five years through 2012, asset growth averaged 7.2% per year, compounded, for the dually registered channel. Only the RIA channel grew faster, at 8.8%.
In contrast, asset growth in the traditional independent broker-dealer channel averaged just 2%. The hybrid channel is strong because many advisors who set up their own independent RIAs still want to access securities products, like variable annuities, structured products or non-traded direct investments.
“Particularly with the need for income today, the products on the alternatives side” look attractive, says Derek Bruton, managing director at LPL Financial. “A lot of those are available only through the brokerage” side of the business.
While the hybrid structure has been the most popular channel, independent broker-dealers may be seeing a shift back toward the more traditional affiliation model where all of an advisor’s business is done under the B-D roof. “We’re starting to hear that more and more hybrid advisors are finding their way back to the corporate RIA [of their broker-dealer],” says Jim Crowley, chief relationship officer at Pershing LLC. Why? “Primarily because of the effort needed to run multi-custodial systems and to support multi-jurisdictional regulatory audits.”
Webber at Cambridge agrees. “Two of our largest [independent] RIAs had the SEC show up at their doors for the first time last year, so they’re thinking about” using Cambridge’s RIA, she says. “They see the writing on the wall—that the SEC and states are going to show up [regularly] for audits, instead of never.”
Raymond James has also seen increased interest from independent advisory firms seeking the simplicity of one custodian. “Advisors tell us there is too much manual checking required to make sure there are no errors in reports sent to clients,” Curtis says. It may not be a trend yet, he says, “but we are having [enough] conversations that causes me to think we’ll see more of that.”
Some of the firms considering a switch to a corporate RIA may be smaller outfits that have gone independent in recent years. These newer firms have been surprised by cost pressures, Mirchandani says, “and they’re finding that running a business is not their cup of tea.”
In a similar vein, more independent RIAs are looking at using their broker-dealers’ managed account platforms to provide more sophisticated proposals and reporting, Mirchandani says.
“We see advisors continue to outsource a bit more,” Bloom says. The majority still manage client portfolios themselves, but are now more likely to use Commonwealth’s platform or a turnkey asset management program for smaller accounts, while still customizing larger portfolios.
Driving the trend is the efficiency of off-the-shelf programs and lower pricing on pre-packaged advice platforms, Bloom says.
More Advisor Movement?
Last year was relatively quiet on the recruiting front as the strong equity market kept advisors in their seats. But observers expect that industry consolidation may drive more movement this year.
“In the last couple of months, we’ve received phone calls from advisors [at the] firms that are consolidating who have decided they don’t want to be in that environment,” says Webber. “The phone is definitely ringing.”
“Anytime there is merger activity, advisors use it as an opportunity to look at the marketplace and consider their options,” says Bill Morrissey, executive vice president of business development at LPL.
But Bloom dismisses any idea that there’s going to be a flood of movement as a result. “I think people will sit and wait, and see how it works out,” he says. “I’m always stunned at how long people stay with a bad relationship [because] the pain of changing [firms] is so high.”
Weakness in the markets might also help firms with their recruiting numbers. Last year was relatively slow because of the bull market. “Advisors tend not to move around a lot when markets are good,” Webber says. Nevertheless, Cambridge attracted $52 million in new production last year, and this year $55 million to $60 million “is not out of the question” if early trends continue, she says.
Last year, LPL landed 321 new advisors, down from 505 in 2012. Morrissey says recruiting has been “steady” but remains relatively slow as advisors are careful to evaluate their options. “It’s a big decision” to go independent, he says. “It’s not just a job change.”
Commonwealth recruited advisors with nearly $33.4 million in revenue last year, Bloom says, and the firm has “commitments” of about half that amount already this year.
Curtis declined to discuss specific recruiting data at Raymond James Financial Services, but he says advisor visits to the firm since the end of its fiscal year in September are running ahead of where they were a year ago. Moreover, Raymond James’ various brokerage and custodial platforms have enjoyed a flurry of new recruits in recent months.
More important than recruiting new advisors and assets, though, is increasing the productivity of existing advisors. Brokerage firms “get a much better return on investing in organic growth than in chasing the next advisor,” Crowley says.
Money spent recruiting new bodies doesn’t always pay off, he says. “It’s not always a natural fit from a cultural standpoint,” and firms get distracted by transitioning a constant stream of new people.
“It can’t all be about consolidation and trading advisors back and forth,” Mirchandani agreed. For independent firms “it’s about building a community [of advisors], a culture, and the ability to invest in things like practice management that drive advisors’ growth.”
Independent broker-dealers as an industry serve as a haven for smaller advisors, which makes it tough for many firms to attract bigger producers. As of 2012, the average assets per advisor in the independent broker-dealer channel were just $22.8 million, according to Cerulli, less than half the $56.7 million in the RIA channel and only a quarter of the average $107.4 million managed by wirehouse advisors.
Some think the independents may be able to gain more wirehouse advisors as the product and service offerings improve on the independent side. Independents must offer more sophisticated lending products, financial planning and performance-reporting tools and the ability to trade in multiple currencies, Crowley says.
The independent firms’ recruiting cause will be helped as the wirehouse retention deals continue to wear off, says Larry Papike, president of Cross-Search, a recruitment firm. Independents typically pay 15% to 25% of trailing-12-month production as a recruitment incentive—a fraction of what the wirehouses offer.
But a smallish deal from an independent might now be enough to pay off the remaining balances on retention packages for more wirehouse representatives who want to go independent, Papike says. Wirehouse producers are “looking to come out of those [retention deals] whole,” he says.
The Age Problem
More than any other competing advice channel, independent broker-dealers suffer from an aging advisor workforce. It’s a problem industrywide, of course: Cerulli Associates reports that the average age of all financial advisors is 50.9 years and that nearly a third fall into the 55-to-64 age range.
Among independent brokerage firms, 9% of advisors plan to retire in five years or less—more than any other channel. Regional firms are second at 8%, then RIA firms (5%) and wirehouses (4%). “It’s an issue, particularly with the [amount] of assets controlled by advisors aged 60-plus” at the independents, says Mirchandani, who estimates the figure at around $2 trillion. “Much of that will probably change hands in the coming years.”
Independent firms haven’t yet cracked the code on how to bring in the next generation of affiliated advisors. Few rookie advisors get their start in the independent channel, and new entrants today want a salary and a visible career path—something that’s in short supply among the smaller practices that dominate the independent contractor world.
“Broker-dealers continue to struggle to recruit new young advisors into the industry to offset those advisors who are nearing retirement,” wrote Kenton Shirk, associate director at Cerulli in a January report. “As the advisor population ages, broker-dealers and custodians are at risk of losing [assets] as advisors exit the industry.”
Advisors need to create a team environment within a practice large enough to offer new advisors a career opportunity, Webber says. “Our advisors find that by building an organization, younger people are attracted to them,” she says.
“Having teams in place with a built-in succession plan is really important,” Mirchandani echoed. “It’s building the ark before it starts to rain, so to speak.”
The good news is that the industry is very much aware of the issue. “There’s a lot of discussion right now about succession,” says Curtis. “This year, the pace of transitions and acquisitions [at Raymond James] is slightly ahead of last year. But the requests for practice valuations is up significantly. Clearly it’s on the minds of advisors.”
“For the last few years, succession planning is among the top three topics our advisors say they want to address,” Bruton says. “It’s understandable. It’s their retirement.” At LPL, the average advisor/owner is age 58, Bruton adds.
“The key thing is to partner up or bring in someone you feel very confident about in becoming your successor [and] put in place a scheduled succession plan,” Curtis says.
But in practice, it’s not always as easy as you might think, he adds. “There are a lot of sweat, tears, blood, money and emotions that go into it over time.”
Raymond James has a dedicated team to help advisors through those issues, he says.
LPL last year formalized its succession planning service, called LPL AdvisorLink. The firm is now proactively reaching out to older advisors with aging clients who aren’t growing—signs the advisor could be a good candidate for succession planning.
Cambridge offers what it calls a Continuity Express program, where solo practitioners sign an agreement with the firm to take over in an emergency. Its Continuity Partners Group takes advisors through the full process, from coaching and valuation all the way to funding the transition, Webber says.
“We’re seeing 10% growth in ‘same store sales’ from practices that are doing succession planning or practice-management planning,” Webber says. The planning process gets advisors to focus on the business, follow a plan and be held accountable by a coach.
Formalizing a succession plan also forces advisors to get serious about engaging with the next generation of planners, Webber added.
A major stumbling block in succession-planning efforts is finding the money to finance a buyout by a junior partner who usually has limited resources. In recent years, firms have become more involved in arranging financing.
“Some firms are very creative in their valuation of practices and financing succession plans,” says Mirchandani. “I think more are starting to look at how to do it [but] we haven’t seen a standardized way” yet.
Raymond James will refer advisors to outside financing sources, Curtis says. LPL finances up to a third of the purchase price, Bruton says, in the form of a repayable note “with pretty aggressive terms. … The way we look at it, this is our capital going after more [assets] through more acquisitions or recruiting.”
In the end, succession planning is really about building a growth strategy, Crowley says. “The elements are some of the same things—how advisors bring in new talent, and how they build teams.”
Like a recurring nightmare, regulatory challenges just won’t go away.
Independent firms are worried about several pending regulatory initiatives that could force significant changes in their businesses. At the top of the list is a new fiduciary proposal from the Department of Labor, expected to be released in August, that would impact advisors who work with participants in retirement plans and possibly IRAs—which would mean just about all advisors. The re-proposed regulation is expected to address conflicts of interest in the way advisors are compensated.
The Financial Services Institute is worried that the proposal could outlaw commission products in IRAs. “The use of commissions is most prevalent among smaller client accounts [and] the result we fear would be smaller accounts having a harder time getting advice,” says David Bellaire, FSI general counsel.
“It would have significant implications for our industry,” Curtis says. Conflicts would have to be eliminated, “so you would not be able to differentiate in pricing between clients on any qualified plans or IRAs. For smaller clients, it could make it economically unfeasible to work with them.”
Bellaire says the DOL may have addressed some of the industry’s concerns, but it’s still unknown what the final proposal will look like.
A separate effort by the SEC to possibly develop a common fiduciary standard for anyone giving personalized financial advice is still up in the air. In February, SEC chairman Mary Jo White said that making a decision to proceed with a new standard is still a primary focus for the commission. Some industry observers, though, think it’s unlikely the SEC will tackle the fiduciary hot potato while bogged down with mandatory rule-making on other fronts.
Meanwhile, Finra should soon be filing with the SEC a closely watched proposal that would require advisors to disclose recruitment incentives they receive when changing firms.
Some observers have speculated that such disclosure might negatively impact recruiting. The FSI has raised privacy concerns about the proposal, and is worried it could spur more advisors to drop their securities licenses.
Late last year, Finra floated for comment another new idea, a proposal known as the Comprehensive Automated Risk Data System, or “CARDS,” that would capture and retain a huge amount of client account data for compliance purposes.
Industry executives are concerned about how such a massive data-collection scheme would be used, how customer privacy would be protected, and the costs of implementing the system. On the product front, independent firms will almost certainly see continued scrutiny over sales of illiquid securities, judging by the exploding sales of non-traded direct investment programs.
Sales of non-listed REITs and business development companies surged 84% last year, to $24.5 billion, according to the Investment Program Association and Robert A. Stanger & Company. The huge increase came despite warnings from regulators about the risks in the illiquid, high-commission products and despite several enforcement cases brought against firms for misleading sales of non-traded securities.
Finally, the tax status of advisors who work as independent contractors is still susceptible to legislative attacks on both the state and federal level, Bellaire says. Legislators want to address what they view as inappropriate classification of employees as independent contractors by employers who want to avoid taxes or worker-protection laws.
“But our members are different,” Bellaire says. “Financial advisors often leave the employee-model firm because they want to own their own business. That’s different than someone who is forced into independent contractor status.”
Despite the financial and regulatory pressures, independent broker-dealers are well-positioned to grow and benefit from the trend toward independence, Crowley says. “A lot of demographic shifts are working in the independent firms’ favor,” he says. “There are more investors today that need more help than ever with changes in the tax code, with retirement plans, educational planning and estate planning [but with] fewer advisors to serve them.”
“There may be some shift [by investors] to alternative providers like robo firms,” Bloom says, but the demand for good advisors will remain. “The demographic trends, growing wealth and the importance of saving for your own retirement makes this a wonderful business.”