Regulation best interest requires that the customer gets the best deal. It specifically requires that the customer gets the best account type: brokerage or advisory.
The recent NASAA report said that Reg BI has not done enough to protect customers. The report mentioned complex products being sold in brokerage accounts.
It is possible that Merrill Lynch, Morgan Stanley, UBS, etc. are all selling private-equity feeder funds through brokerage accounts and charging customers more than if the customers were allowed to buy the same fund in an advisory account. If customers use an RIA (Schwab, Fidelity), the same feeder funds are available in the cheap advisory accounts. I have been told that at least at some of the wirehouses, a small number of customers get the cheap advisory accounts but most customers are forced into the expensive brokerage accounts.
In brokerage accounts, PE feeder funds charge on the entire commitment amount. In an advisory account, they only charge on what is invested. A private equity fund does not need the entire commitment at once. The investor will commit to an investment amount. However, the fund will not ask for all of the money right away. It will call capital over the investment period. Typical investment periods last from 3-6 years. Below is a common four-year investment period. The PE fund requires the investor to put in just 10% in year one. (10%/20%/30%/20%)
The investor commits $1,000,000. He can either pay 1% on the commitment amount or 1% of what he actually invests. If he is forced into a brokerage account, he must pay on the entire commitment. He is charged $10,000 per year for 4 years or $40,000.
If he is permitted into an advisory account, he only pays on what he actually invests:
Year 1: $100,000 total invested fee = $1,000
Year 2: $300,000 total invested fee = $3,000
Year 3: $600,000 total invested fee = $6,000
Year 4: $800,000 total invested fee = $8,000
Total fees in a cheap advisory account = $18,000
Total fees in an expensive brokerage account = $40,000
The customer is paying 10x in year one and more than double over the four-year investment period. He gets no liquidity or other benefit by being in a brokerage account.
On a recent SEC REG BI call in October, Evan Charkes was featured. He is a managing director and associate general counsel for Bank of America, who supports the Merrill Lynch Wealth Management business. Charkes and other firm compliance officials said they were making sure they had evaluated potential conflicts on the advisor and firm level, including, for example, implementing levelized payments to advisors across mutual funds, share classes, annuities and other commission products. Documentation would also be key, panelists said.
Firms have taken great efforts to comply with regulation best interest. It is possible that both the firm’s and the advisors have a conflict when recommending feeder funds. PE raises about 50 billion dollars annually through retail. By charging on committed capital, the damages are potentially 500 million dollars already.
DG, a wealthy investor with accounts at several wealth managers told me, “I expect my advisor to be looking out for me. It is in my best interest to only pay on what I have invested and not the full commitment amount.”
Disclosure is no longer enough. The customers have to be given the cheapest account type.
Melissa Stein is a private equity investor living in New Jersey.