A whistle-blowing former Merrill Lynch broker is claiming that the way wirehouses charge fees on private equity investments is in conflict with regulations and overbills clients.
The broker, Kurt Stein, is accusing dually registered brokerage firms of violating Regulation Best Interest and says he has presented his findings to the Securities and Exchange Commission in a meeting with the agency’s private fund investigators.
Stein's allegations center around the firms’ different fee structures for clients on the brokerage side as compared to the advisory side. He also contends the way those fees are often charged can cause clients to overpay. On the brokerage side, for example, clients may be charged management fees on the total amount of capital committed from day one, even if the capital isn’t called for years. On the advisory side, however, clients are charged only when capital actually is called for specific private equity investments, he says. This difference can add up to hundreds of millions of dollars over the four- to six-year investment period of a fund, he estimates.
“It’s the same old story. Wall Street is sticking it to people,” said Stein, who worked at Merrill Lynch from July 2001 to March 2018, first as a broker and then as a dually registered investment advisor, according to BrokerCheck.
“Reg BI is supposed to stop that kind of perverse client abuse. The rule is very clear. Any investment professional has to recommend the account type, either brokerage or advisory, which is in the client’s best interest. Cost matters,” he said. “I submitted this to the SEC, and they contacted me and are investigating.”
A Financial Advisor email to Jennifer Duggins, co-director of the SEC’s private equity funds unit, and Brian Caravello, a supervisory attorney advisor in the unit, requesting confirmation of the meeting was responded to by an agency spokesperson who stated, “The SEC does not comment on the existence or nonexistence of a possible investigation.”
Requests for comment by Merrill Lynch, Morgan Stanley and UBS, all of which manage private equity fund feeder funds for brokerage and advisory clients, were either declined or unacknowledged.
Stein said he first started looking at the issue about 18 months ago when a friend asked him to look over an account statement and explain how the charges were arrived at. He couldn’t. Stein’s examination of fee structures ultimately led to two stories about retail private equity fund returns, one of which appeared in Forbes, and the other in the New York Times.
Using his friend’s Merrill Lynch account as an example, Stein pointed to two Merrill Lynch feeder funds for two blue-chip private equity funds, both launched after Reg BI came into effect. The investor had committed $110,608 in one and $150,000 in the other, and by the end of May 2021, the one fund had invested $17,697 and the other invested $8,250 of those commitments. He was charged a 1% annual fee on the full commitments, which combined were $2,606.
But, he said, had the investor been directed to the advisory side, as required by Reg BI, the investor would have paid a 1% advisory account charge on actual assets invested with no upfront fee, according to the PPM, which would have been $259.
The $2,343 difference does not include an optional upfront placement fee of 2.5% often charged, with the actual percentage being discretionary.
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.
“If you are a dually licensed financial professional, you need to make a best interest evaluation taking into consideration the spectrum of accounts you offer (i.e., both brokerage and advisory accounts, subject to any eligibility requirements such as account minimums),” the SEC wrote in a staff bulletin designed to provide clarity on the issue. “Firms should provide clear guidance, through policies and procedures and other instructions to their financial professionals.”
This month, the SEC started charging firms and registered reps under Reg BI for violations for unsuitable investment choices, and more charges are expected as dually registered firms try to navigate the new terrain without losing the very profitable aspects of their business.
A North American Securities Administrators Association report late last year found that broker-dealers have been slow to make big changes in the way they do business, especially when it comes to reconciling fee structures. “NASAA’s member states did not see the tide-turning reforms they had expected to see in the broker-dealer industry after Regulation Best Interest took effect,” wrote Melanie Senter Lubin, NASAA President and Maryland Securities Commissioner. “This examination reveals that while there were some improvements, most firms are operating in the same manner as they were under the suitability rule, especially when it comes to harmful compensation conflicts.”
How dually registered broker-dealers handle Reg BI in practice remains to be seen. After decades of consolidation, the idea of divesting brokerages from advisory services would be an anathema, sources agreed. And raising the fees on the advisory side to match the brokerage side would put an end to the business, as clients could make the same investments and pay substantially less at registered investment advisors who don’t have the same conflict.
Several private equity executives said these decisions on how fees were charged are determined by the wirehouses. Regarding the RIA world, they said fees were substantially less even though it wasn't completely clear whether fees were determined by the advisor or custodian.
Besides Duggins and Caravello, Stein submitted his documentation to Michael Rufino, formerly with Finra and now with the SEC; Joseph Borg, former president of NASAA and director of the Alabama Securities Commission; Ricky Locklar, senior special agent at the Alabama Securities Commission; Lev Bagramian, former senior professional staff member of the U.S. House of Representatives and now director of the House Financial Services Committee Investor Protection, Texas.