Of course, there are daredevils who have been known to dive from 36 feet into a kiddie pool. But not everybody has the talent to do it.

Diving into the broker-dealer space poses similar problems lately. The profit margins for small independents are getting shallower, while larger firms take market share. Their clients are invested in short-term investments with shallow returns. The rep ranks that might bring in new assets seem to be growing thinner. For some smaller firms, getting money out of this space has been harder than trying to drink breath off a window.

If that makes some smaller B-Ds sound like fish gulping for water, they are, and worse yet, some have stopped breathing altogether. According to Finra's count, the number of its member firms dropped by a net 122 between the end of 2010 and 2011. The number at the end of the year was 4,456 firms, down almost 11% from the end of 2007.

All the financial services companies have seen their share of bloodshed in the last few years, but independent broker-dealers have seen their problems compounded-at a time when their fees are vulnerable to market swings, they've also been forced into a technology arms race that requires deeper pockets than many have. Like the rest of the financial services business, some of their names have been tarnished (unfairly, the B-D advocates say) for questionable investments like private placements and auction rate securities passed around during the financial crisis.

Profit margins in this space, already in single digits, say participants, have eroded as a result of lower income from interest rates (which is likely to continue), shallower investment pools (as people remain heavily invested in cash), less profit sharing on products (such as mutual funds and money market funds) and the need to make higher payouts to attract talent. Tiburon polled some CEOs in this space and one likened running a broker-dealer to the grocery store business as far as margins were concerned.

If there's room to swim, there's not a lot of oxygen in the water. "The margins in the retail business have always been slim, but they are even more slim today and it's got to do with the fact that communication among the people in the industry is much greater than it was years ago," says Frank McPartland, the COO of JHS Capital Advisors in Tampa, Fla., a firm with $2 billion in assets under management. "Everything is in print or everything's on the Internet. So advisors try to find the absolute best deal, and that puts pressure on [broker-dealer margins]. And to be in the business today you have to be very sensitive to the regulatory environment and stay ahead. There's a cost to that."

If all these problems with business models weren't enough, the B-Ds have faced the wrath of the consumer and an increased regulatory apparatus aligned against them trying to find another Bernard Madoff. That means examiners spend weeks at a time in B-D offices, squeezing five-year-old e-mails out of computers.

Mark Astarita, a partner with Beam & Astarita, a New York law firm that represents some 30 broker-dealers, says the SEC, Finra and the states have been more aggressive with smaller B-Ds, which don't have as much money for in-house counsel. "Have you ever seen Finra fine or sanction a senior executive at a large firm?" he asks. "They just don't do it. When was the last time they fined a senior executive at Merrill Lynch? But they will jump on the opportunity and insist that an individual at a smaller firm take a fine or suspension, personally, where at a larger firm it would be at the firm level. Individuals can't afford to fight Finra."

A Finra spokesperson responds: "For 2011, 25% of large firms were disciplined, while only 4% of small firms were disciplined."

"From what I've seen looking at why some of the firms have gone out of business, it hasn't really been a squeeze per se," says Alex Barned, the chief distribution officer at Questar Capital (owned by insurer Allianz). "It's been a lot of these bigger regulatory hits." Some firms, he says, "haven't been able to take that one sudden shock to the system." He notes substantial arbitration settlements over troublesome financial products as being particularly problematic, forcing firms to close.

Recruiters and consultants say 2008 and 2009 offered recruiting bonanzas from wirehouses, which were hemorrhaging assets, but those companies have regained their footing, and recruiters say they are holding on to their brokers with more aggressive retention packages. Because the pool of reps, in aggregate, is also shrinking (suggests Finra data), the two trends together mean reps can demand more money up front.

It's a seller's market. Good for reps. Bad for B-D profit margins.

"Firms that were not in a great position before the crisis obviously are feeling the heat even more," says Alois Pirker a research director at the Aite Group in Boston. "So this year you'll see more M&A going on-strong firms buying weaker firms." In this environment, he says, firms that are strong like LPL will be using their heft to buy those firms that haven't built such scale.

"If you choose to affiliate with a smaller independent broker-dealer," says Bing Waldert at Boston research firm Cerulli Associates, "I think you have to ask some hard questions about the financial strength of that broker-dealer."

The answer to these problems is, obviously, more recruitment, bigger clients and bigger acquisitions-as well as the ability to build out technology platforms so that more recruits come and help along the virtuous circle. JHS Capital just grabbed Paulson Investment Co., from its Portland, Ore., parent, an acquisition that will add 75 advisors to its current 98 and raise its assets under administration to about $3.1 billion, McPartland says. And the firm is looking for another target.

Meanwhile, Barned says Questar, which benefits from its backing by large insurance company Allianz, is also looking to acquire a firm of 50 reps or more, as long as it has the right cultural and economic fit.

The Big Dogs Get The Kitty
Cetera Financial Group, an El Segundo, Calif., company that emerged from the private equity rollup of three firms in early 2010, has continued to purchase firms as well. Last year, the company bought the tax and accounting business of Genworth Financial, bringing the number of firms in its stable of B-Ds to four and adding 1,500 to 1,800 advisors to its count of 5,000. The company also recently recruited 200 new advisors from the dissolving Renton, Wash., firm Pacific West Financial Group (reps who will be folded into Cetera's Multi-Financial Securities Corp. unit). The natural speculation is that Cetera, currently owned by private equity firm Lightyear Capital, might reach the critical mass to do an IPO in the future (like LPL), though its chief is currently mum on the subject.

"The thing that we're all challenged with is the continuing volatility in the marketplace," says Valerie Brown, Cetera's CEO. "That makes clients anxious. And when clients are anxious, growth is harder. So volatility and the low interest rate put pressure on clients seeking returns as well as the typical revenue model for broker-dealers. This is a challenging time because of macro-economic issues. This requires us to be much better managers than we ever had to be earlier in the decade."

She says the Genworth unit is a new specialty for the firm. "We do believe in that segment-a tax professional CPA is really in a great position to develop a broad holistic view of what their client needs. Well-educated and trained, they become great financial quarterbacks for their clients." The Genworth tax business also had a higher penetration of fee-based relationships than other firms with this specialty, she says. Cetera deals with both commissions and fees, but the latter tend to strengthen bonds with clients, Brown says, especially higher-net-worth clients. With that type of relationship in mind, the firm has recently launched a program to nudge advisors into the fee business. It will pay part of the administration fees for net new assets, up to 100% of the fees for those with $100 million or more in net new assets. The firm also provides training to advisors who want to make the transition from commissions to fees.

"There's an educational process that an advisor has to go through to change a relationship from a commission-based relationship to one where you are earning an ongoing fee. It takes a lot of training," she says.

Brown also says that even though the times are challenging for B-Ds, the demographics are good with the waves of retiring baby boomers.

Raymond James, a firm known for its dedication to growing organically, turned heads when it said in January that it was buying brokerage Morgan Keegan & Co. for $930 million, bringing in some 1,000 new advisors to merge with its own 5,000.

Bill Van Law, the new president of Raymond James' investment advisors division, says that the Morgan Keegan acquisition was simply a good fit for the St. Petersburg, Fla. regional, but that Raymond James continues to think in terms of organic growth in which it can take advantage of the ongoing wirehouse purges.

"Paul Reilly, our CEO, described it as once in a 20 or 30-year time frame that we might come across an opportunity like this," Van Law says about Morgan Keegan. "This was an opportunistic acquisition. If you look at all the things that had to come into play for that to be attractive-good cultural fit, solid strategic fit, but also a price that made sense to integrate that business into ours in an effective manner-all those things had to come together."

It is not the beginning of an acquisition tear, he says. Instead, the firm has seen solid growth numbers organically by recruiting individual advisors-the same wirehouse reps disaffected by changes going on at their firms, working in environments of cross-selling and product pushing.

"The supply [of reps] is shrinking in aggregate, but the demand for services is going up," he says. "So frankly, we're not lacking in quality people to talk to. In terms of where people are coming from it's been no different for us than it's been for the past few years." He says the latest quarter was Raymond James' best in two years for recruiting.

Certainly LPL has been one of the biggest beneficiaries of advisor migration. The company has grown from 3,596 advisors in 2000 to 12,847 at the end of 2011, growing through both recruiting and acquisitions. The company went public in 2010, and managing director Derek Bruton says that besides benefitting from consolidation, the firm is expanding into different markets through its acquisitions of firms like Fortigent and National Retirement Partners. The latter purchase allowed the firm to focus more on the 401(k) and defined contribution space, where he says the firm wasn't as strong. "So now we are able to recruit advisors that we weren't previously able to." He says LPL has also made inroads into the RIA space. "We've grown our RIA custody business to $22.7 billion over the last three and a half years. Prior to that, we weren't able to expand into that marketplace." Fortigent, an alternative investment platform, will help LPL recruit advisors in the high-net-worth space, Bruton says.

Does Bruton think there's a fight over a shrinking number of reps, and does that erode everybody's margins? "What I've seen is not so much a shrinkage of the number of reps but the makeup of where they are today," he says. "With wirehouses not just consolidating but having issues culturally between banks and broker-dealers, we're seeing that. We're certainly benefitting from a lot of opportunities that come out of that. I think what's happening is the slices of the pie are changing shape here and advisors are going more towards independent broker-dealers and custodians."

The fastest growing segment of the advisor space, he says, is the hybrid advisor working as both a rep and as an RIA (or IAR). Studies by Tiburon Strategic Advisors and the Financial Services Institute have quoted CEOs of smaller firms bemoaning this trend, saying it is ruinous to the B-D model because advisors want huge payouts and they only give leftover securities business to their broker-dealers. But to those firms with scale, says Bruton, the hybrid model can be attractive. It lures advisors, allowing them to be nimble enough to offer different pricing models for different kinds of clients.

"Our RIA business just last year grew $15.5 billion in assets to $22.7 billion in assets so that's 46% growth," says Bruton. "Running a broker-dealer and supporting reps today with the growing costs on the compliance side and the human capital side is really putting pressure on the margins of every independent broker-dealer out there. I think when you add in the hybrid component, another business, it requires different technology, it requires different compliance-not necessarily higher levels of technology or compliance but just different, and those are all things that a broker-dealer today that is only marginally profitable cannot make."

Quality Not Quantity
Some firms, specifically in the insurance space, say that the name of the game is high producers who are "fully engaged" as Barned at Questar puts it-in other words, not dealing with side businesses.

Also focusing on selective recruiting is Centennial, Colo. firm Geneos Wealth Management, which has 250 producing reps and more than $8 billion in assets under management. The firm also has $334,400 in gross dealer concession per advisor.

"While margins in the independent B-D market have been historically tight and continue to shrink, our model has proven that with an experienced management team, coupled with industry-leading technology, a small to midsized firm can build and maintain a healthy balance sheet as well as run profitably," says Ryan Diachok, Geneos' senior vice president of business development. "While we continue to recruit, we take a very selective approach and will only bring on quality groups that meet our criteria with no exceptions. Individual producers must have a minimum of $200,000 in trailing GDC."

Pat McEvoy, president and CEO of Woodbury Financial Services, which is a member of the Hartford Financial Services Group, also says it's not quantity of advisors but quality that counts (even though the firm brought on more than 200 registered reps last year). But the main thing is that the target production of those recruits has been higher. "Our average registered rep that joined us was well in excess of $225,000 (in gross dealer concession) last year and continues to bring up our average GDC per rep (to the $175,000 area). We were not like other firms that felt like we wanted to acquire all these reps that were leaving bad firms. Firms that maybe didn't have the right due diligence procedures and maybe were finding themselves [facing] pretty big [regulatory] actions."

There are two ways to look at a rep's background, McEvoy says. "One, do they have a history of past complaints. And the other thing is, are they doing things or have they conducted transactions in products that will soon be in the scope of Finra? It used to be you could do a quick check and say, 'They've got three customer complaints. We don't want that.' Nowadays you can't look at just that. You've got to look at the breadth of their business."

"Some firms will buy business at any cost," he continues when talking about the acquisition climate. "Some firms are executing on acquisition plans at pretty much any cost and then they're letting the chaff go away and they're keeping the cream."