Advisory firms attracting private equity buyout offers on average logged just 40% of the industry average when it came to misconduct infractions. But in the five years following the acquisition, the level of misconduct rose until advisors at these previously squeaky-clean firms were engaging in the same amount of misconduct as the advisors at the firms that would not have been approached by the buyout firm in the first place, the study said.
“Our estimates suggest that private equity ownership leads to an increase of 147% in the percentage of the acquired firm’s financial advisers committing misconduct and an increase of 200% in the average per adviser misconduct incident count,” the study said, adding that the results imply there’s a value to this misconduct. “If we assume PE maximizes firm value, the increased level of misconduct implies that higher misconduct is related to higher profit. PE firms choose targets with untapped ‘misconduct slack’ and exploit this opportunity to make profit, perhaps at the expense of customers.”
While the total percentage of investment advisors engaging in misconduct is roughly 7%, the rise from far less than that to the industry average is significant, the study stated, and it’s clear from the analysis that the rise is not as much due to turnover of advisors at the acquired firm as it is to behavioral changes of the advisors who remain after the buyout. The two areas of infractions that saw the greatest increase were regulatory and customer disputes.
One possible reason for the post-buyout increase in misconduct is that private equity firms pursue more aggressive growth plans, which puts more pressure on the advisers to increase fees, even at the expense of clients, according to the study.
The post-buyout increase in misconduct occurs only at firms whose clients include retail investors, the study said. For firms serving only institutional clients, misconduct activities actually decline significantly after the buyout., the study found. “This result supports the notion that post-buyout increase in misconduct is an outcome of advisers' intentional choice based on customer sophistication, and suggests that negative impact of PE buyouts on adviser business conduct is mainly borne by unsophisticated investors,” the study states.
Another reason for the rise in misconduct is that private equity firms are unfamiliar with the advisory business, which can lead to frictions and ineffective internal controls during the ownership transition, according to the study. Looking at a sample of management buyouts of advisory firms, there was no increase in misconduct after the buyout, the study found.
“Financial advice is an opaque, complicated product for many that is purchased infrequently, and thus perhaps there is scope to take advantage of customers. The increase to firm profits by charging extra fees or placing clients in inappropriately expensive financial products may outweigh the costs of occasional violations and their associated penalties,” the study concluded.
According to Wu, there are steps sellers can take to try to influence the likelihood of a firm’s advisors loosening their ethics in an effort to meet a new boss’ expectations, and potentially tarnishing the firm’s reputation in the process.
“For entrepreneurs who've started a business and built a firm, many of them will care about what happens to their colleagues and their clients when ownership changes hands. In that regard, they need to do due diligence about potential buyers,” Wu said. “One aspect a seller can look at is if the private equity firm will be more aggressive in trying to expand the business. For the ones that are growing fast in assets under management but not increasing employees as much, misconduct usually goes up more. If the incumbent owners care about the customers, that’s something they want to consider.”