When looking at retail private equity investments in the aggregate, each year of this fee disparity could add up to millions of dollars for the dually registered brokerage paid by individual retail customers, Stein argued. However, there’s still another incentive for broker-dealers to direct customers to brokerage accounts as opposed to the cheaper advisory accounts.
The broker-dealer potentially also earns a 1% manager revenue share paid by the private equity fund sponsor. However, the private placement memoranda often applies this only to the brokerage clients, not to advisory clients. For example, a Morgan Stanley PPM (Private Placement Memorandum) states, “Morgan Stanley Wealth Management shall not receive a Manager Revenue Share, Upfront Placement Fee or Investor Servicing Fee with respect to Morgan Stanley Wealth Management clients that participate in the Partnership through their advisory program.”
According to Stein, industry sources have ballparked the capital raised through these private equity funds at roughly $10 billion annually at both Merrill Lynch and Morgan Stanley. If that’s the case, and brokerage fees include an average of 1% on committed capital, a 1% manager revenue share and a 2.5% placement fee, each firm stands to make $100 million on the investor servicing fee, $100 million on the manager revenue share and $250 million on the upfront fee, for a potential total of $450 million the first year.
On the advisory side, with a 1% advisory fee on capital invested and assuming a 30% capital call the first year, revenue would be just $30 million for that first year. Years two through five, the rest of the investment life of the fund, represent additional revenue for both sides of the business, he said.
“If they’re thinking it will take five years for the SEC to catch it and five years to enforce it, that’s 10 years of revenue,” Stein said. “It’s not a small amount of money.”
Before Reg BI, Stein said, brokers would put brokerage clients into private equity funds at the same high rates. However, Reg BI was not yet in existence so there was no legal conflict. It was believed at the time that the anticipated high returns on private equity funds would justify the fees, Stein said.
“All this was disclosed. It was expensive, but that was the deal. We thought these funds were going to make 15% or 18% for the client with not much risk,” he said. “And some clients liked the cachet of it. They could tell their friends they were in a KKR fund, or a Blackstone fund. ‘Don’t worry about the fees, I’m in with the smart guys, and it’s worth it.’ Now we know that’s not the case. And the firms are stuck with Reg BI. They’re just violating the law. It’s not subtle. It’s blatant.”
In the past, Blackstone has publicly pushed back on accusations that its funds don't perform well.
When Reg BI went into effect in June 2020, the regulation required that broker-dealers adopt a standard of care with their retail clients similar, in many ways, to the fiduciary responsibilities applied to investment advisors with the Investment Advisors Act of 1940.
According to the SEC, the selection of an account type made by dually licensed financial professionals or by financial professionals working at dually registered or affiliated firms could therefore be fraught with significant conflicts of interest when one side of the business charges higher fees for similar investments.