IBDs Navigate The Pandemic
April 1, 2021
By Eric Rasmussen, FinancialAdvisor
The Covid-19 pandemic frayed the social and economic bonds that the world takes for granted, shone a light on vast inequality, revealed who had the resources to carry economic burdens and who were the most vulnerable to depredation.
And that’s just the independent broker-dealers (IBDs).
Here, as in many areas, the virus exacerbated trends already in place—it gave a boost to big firms already armed with resources, that were diversified enough to shelter precarious income streams, and that had the capital wall to withstand the onslaught of competition (and protect debt service). The pandemic also hastened the tech arms race among IBDs, since the hearts and minds of clients and rep recruits were now being won through the internet, not in hotel lobbies. Just as teachers had to do their jobs through Zoom, so did broker-dealer reps, not only to talk to clients but to talk with prospective B-Ds they wanted to affiliate with like LPL, Commonwealth and Raymond James.
That meant a rush by a number of companies to figure out how to catch up technologically and reallocate their spending, says Rich Steinmeier, the managing director and divisional president of business development at LPL, the largest U.S. IBD.
“With everyone rushing out the doors and rushing home, you started to separate the wheat from the chaff,” he says, meaning some firms were better able to handle a dramatic upheaval. “You get into very discrete things around the integration of e-signing capabilities into client paperwork. Firms that don’t have that are firms that are left very far behind.”
Jon Henschen of Henschen & Associates, a recruiter in the independent space, says the move to work at home has been a double-edged sword. Firms likely saved money on travel—not an unimportant thing in an industry with low profit margins—but the feeling of firm culture suddenly vanished. It’s hard to feel the vibe of a broker-dealer you want to join if you can’t meet face to face with your new partners or find feelings of affinity with new colleagues. Cultural fit is a big reason reps break off and go with new firms.
There were a few trends that likely struck fear in executives at these firms: that they couldn’t recruit in a pandemic that kept everybody at home (at least in the first few months); that equity market values were falling precipitously in the first quarter, which ate away at fee revenue; and that plummeting interest rates were going to remove the spreads that broker-dealers enjoyed in cash sweep accounts and other products, an important part of their bottom lines.
The last one loomed large over private equity-owned firms with massive debt loads, including Cetera and the Advisor Group, in an industry known for having thinner margins than the RIA space. Moody’s Investors Service said as much in credit downgrades last March. The ratings agency said the cut in the fed funds rate to 0% to 0.25% would directly attack the profitability of Advisor Group at a time when its annual debt service was reportedly north of a whopping $180 million.
“Although Advisor Group’s February 2020 acquisition of Ladenburg Thalmann has helped it expand its scale, it has also substantially worsened its debt leverage, and the risks of operating at higher leverage are magnified in the existing challenging macroeconomic environment,” Moody’s said. However, in updating the outlook to stable in January, Moody’s said the company’s “seasoned management team swiftly lowered expenses, raised efficiencies and adapted the firm’s operations to a new remote work environment. In addition, Advisor Group was able to accelerate its integration of Ladenburg Thalmann, realizing a large portion of its forecasted expense synergies ahead of schedule.” The firm also did well in retaining advisors, the agency said.
Moody’s also upgraded the outlook of Aretec, Cetera’s parent, to stable from negative for similar reasons—noting the negative effect of lower interest rates on the company’s cash balances but nodding approvingly at the company’s swift lowering of expenses.
Paul Reilly, the chairman and CEO of Raymond James, speaking at a virtual institutional investors conference on March 1, said that “overcapitalization” helped his own company last year. “Fortunately, people talk about Raymond James being overcapitalized, and we are heavily capitalized, but if felt pretty good in March and April and May [of 2020] to have all that liquidity and capital, so we never worried about getting through the time period that certainly had challenges.” He said that the firm’s heavy investment in mobile platforms had helped the shift to advisors working from home. “Almost four years ago we rolled out our advisor’s desktop where they could do everything on this they could do in their office.”
And again, in the broker-dealer space, costs matter. “Frankly, it helps with our real estate costs if we can keep average occupancy down,” Reilly said.
But he also spoke about the hurt lower interest rates have exerted on broker-dealers. “We had a tough last fiscal year only because when the Fed lowered interest rates in March, 40% of our run-rate of pretax earnings were gone overnight. But it’s ironic that with our focused growth and the growth in assets, partly by the market but a lot by our retention in recruiting, we really ended this last quarter with records.”
Jamie Price at Advisor Group says his firm has enough cash flow to serve its advisors and make necessary changes in the competitive landscape. He is not worried by the IBD network’s debt load.
Just by looking at firms like LPL or Raymond James, you might come away with the view that broker-dealers actually had a good year, says veteran broker-dealer executive Larry Roth.
“Historically the larger broker-dealers have earned a significant amount of revenue and profits on their spreads on their cash sweep accounts,” says Roth, who in the past has run both the Advisor Group and Cetera and now runs a consulting firm, RLR Partners and is involved with a SPAC, Kingswood Holdings. “When Covid hit, interest rates dropped dramatically and that for the most part has really significantly reduced the spreads earned by broker-dealers.
“The flip side of that is … the markets not only rebounded but they’re now at highs,” Roth continues. “So from a revenue standpoint on their fee-based assets, even with the difficult first quarter, they had a really good year. Assets are up across the industry. You can see that if you look at LPL or Raymond James.”
Indeed, LPL’s stock price was up 12.5% for the year and has surged about 545% in the last five years. Its total advisory assets, according to its Form 10-K for the year ending December 31, 2020, rose to $461.2 billion from $365.8 billion in December 31, 2019, a 26.1% increase. Total net revenue rose to $5.872 billion from $5.625 billion the year before. Gross profit, however, fell 3.2% to $2.103 billion for the year from $2.172 billion for the year ended December 31, 2019.
The lower interest rates also mean lower debt service costs, Roth says, since they have given IBDs an opportunity to refinance, which helped his former firms, Advisor Group and Cetera. With the outlook on equities still upbeat and more investor money moving off the sidelines, he says, the prospect for fee-based asset coffers (and thus broker-dealer income on the whole) should be bright.
Regulatory Scrutiny
The squeeze in profits comes at a time when regulators are looking closely at broker-dealers, however. In addition to the trouble many firms are getting into over the revenue sharing they do with mutual funds, broker-dealers are increasingly being watched for how they handle client data. Those IBDs working with third-party vendors found out in 2020 that they could run afoul of Finra rules if they weren’t careful.
In April, Kestra was fined $125,000 after it contracted with a third-party vendor to help reps move onto the platform and in the process disclosed nonpublic information about clients who were moving, populating a spreadsheet with Social Security numbers, driver’s license numbers and financial account numbers (not to mention their birthdays) all without notifying the clients, who were officially still with their previous firms. Securities America got hit for the same amount for the same infraction in February of this year.
LPL got hit with a $6.5 million fine on December 1 after Finra said it had failed to maintain a supervisory system for record retention and that from 2014 to 2020 the company failed to fingerprint 7,000 non-registered associated persons and screen them for disqualification. Finra said a former rep, identified by the FBI as James T. Booth, exploited the weaknesses in LPL’s compliance regime to run a Ponzi scheme and convert $1 million in LPL client money.
Henschen says there’s incentive by small and midsize firms to share commissions on alternative assets—a big profit center for them. But it’s important, especially if the products are illiquid, to make sure they are being sold properly so that Finra doesn’t start knocking on doors and sanctioning both reps and IBDs.
Recruiting Bent But Unbowed
According to industry participants, Covid be damned, the major trends in the broker-deal world haven’t stopped at all, especially not the pace of advisor recruitment.
If an advisor was affiliated with a firm that seemed ill-prepared for the Covid upheaval, he or she might have wondered if the grass were greener elsewhere. “Where we saw advisors moving to were more stable places that had greater scale [and the] greater capacity to make investments, and [LPL was] a beneficiary of that move,” Steinmeier says.
LPL’s advisor head count increased to 17,287 from 16,464 in 2019, according to the company’s 10-K. Raymond James’s total advisor count, meanwhile, increased to 8,233 from 8,060 on December 31, 2019, though the firm admitted that it lost some in the fourth quarter of 2020 to retirement and the increasingly competitive recruiting atmosphere. Advisor retirements are emerging as a serious headwind for many firms with older reps.
One recruiter saw little slowdown last year. “It’s miraculous, I can’t believe it, to be honest with you,” says Jodie Papike, the president of Encinitas, Calif.-based placement firm Cross-Search, who says she is still looking at very big teams wanting to move. The firms doing the best at recruiting were the ones offering the largest resources with transition assistance and back-office help, she says. It also helps if they have stable ownership.
Bad back-office help is the last straw for advisors and makes them want to quit, Papike says. She also says that those advisors working in the employee channels of broker-dealer firms have also had time to rethink their arrangement since they are working at home and feeling as if they are quasi-independent anyway.
Doug Ketterer, the CEO of Atria Wealth Solutions, and Eugene Elias, the company’s COO, say that back-office help became important this year because technology was suddenly of paramount importance, yet many advisors had not used it to its fullest capacity and needed help getting through it. Elias says they are asking, “How do I really use e-signature? I need to communicate effectively with my clients: What’s the best way to do that? … Hey, my clients want to send in documents. Is there a way to do that securely?” Ketterer says the firm’s recruiting doubled year over year.
Andrew Daniels, the managing director of business development at Commonwealth, acknowledged it’s harder to woo advisors to a platform when they can’t get a feel for the culture at the home office, and the firm’s total advisor head count for the year was 2,012, only five more than in 2019. “2020 was a slightly lower recruiting year that normal,” he says. “I’m not going to blame Covid, although I know Covid was a factor. I know others in my peer group had strong recruiting years.”
To that end, Commonwealth announced at the end of last year it would be offering more to advisor recruits in the form of forgivable loans. According to an SEC filing, the firm had $48.1 million in forgivable loans outstanding to advisors at the end of 2020. “There isn’t room for a firm to be grossly out of whack under or over,” when it comes to payout, Daniels says.
But he said the firm added assets, growing from $200.7 billion in total assets under management in 2019 to $232.5 billion at the end of 2021. Commonwealth is trying more aggressively to lure breakaway wirehouse brokers with a bundled pay grid that looks similar to what they are used to, Daniels says.
Amy Webber, the president and CEO of Cambridge, said in an e-mail that her rep count for the year rose to 3,632, a 6% increase from 3,407 on December 31, 2019, and she adds that gross production per advisor “also increased to $308,639 from $298,538 the year before.” Total assets under advisement rose to $137 billion from $114 billion.
The scramble for advisors can be gauged in many ways, one of which is by the amount of forgivable loans that are being offered to reps to stay for a certain amount of time (say 10 years). LPL’s amount of unforgivable loans increased 24% to $419.2 million at the end of 2020 from the end of 2019, according to SEC filings. Henschen says that some midsize firms he knows of are seeking to be acquired so that they’ll be able to pony up more for those loans.
Jeff Nash, a mergers and acquisitions advisor with Bridgemark Strategies, says, “2021 could be the greatest advisor movement year in easily a decade, maybe two decades, maybe ever.” He gives three reasons for that: One is that the wirehouse payment grids become stingier during market turmoil—at the same time advisors are working at home, already feeling independent, and seeing payouts of only 40% when it could be much higher at an IBD. Meanwhile, Reg BI and its thorny requirements for commission sales will likely force insurance broker-dealers to want to sell. And consolidations means people hit the exits. The other trend is the move away from small boutiques.
The cost to compete is getting steeper as firms offer more competitive transition packages. “A few years back, top-tier transition deals we would see maybe in the 40% range” of gross dealer concession, says Nash. “Now we’re seeing the numbers on the higher end for the bigger producers literally at 60%, 70% maybe even upwards of 80%. And on the lower end, those numbers have gone from 10% to what could be 40% or 50%.” Smaller firms aren’t as profitable as larger firms, he says, because larger firms have revenue sharing deals that smaller firms can’t get, “so the transition money plus the ongoing economics of profitability become harder and harder for smaller companies to compete. Overlay that with the continuous squeezing of compliance costs.”
He says culture and fit are important, but advisors aren’t often looking at the full comprehensive financials when they are deciding to join a firm. The questions to ask are not only what are the costs and net payouts of working at a firm but what will the costs and net payout be five years in the future.
“A lot of firms will offer transition money, they’ll tell you what their payout is,” Nash says. But on top of that the advisors will be paying fees. “Independent firms will largely have platform or program fees. There can be other types of trading costs and other types of technology fees. There can be surveillance fees. So there’s a lot components to cost that should be completely understood.”
Technology, service and compliance are the top reasons reps leave a broker-dealer, Nash says. Reps with bigger books don’t like being told to follow the lowest-common denominator compliance that’s designed to keep a herd of smaller reps in line.
Henschen says that he’s been focusing more on IBDs that are hybrid and dual-clearing friendly. He says that the move by companies like Schwab to go to zero commissions is having an impact on broker-dealers, which still charge for trades. Many of the big broker-dealers aren’t bashful about adding on admin fees and markups on third party managers. He says LPL and the Advisor Group have lowered their admin fees, using a grid for higher producers. But overall, he believes the zero-commission era will put pressure on broker-dealers to reframe their value for their advisor reps.
“This last year when firms like Schwab brought their ticket charges down to zero, that just added fuel to go dual-clearing,” Henschen says. “I’ve had advisors who were in wrap accounts paying 30 basis points and that pays for billing and performance reporting—30 to 35 basis points—and we can go into a scenario with a broker-dealer who is dual-clearing friendly and bring the ticket charges down to zero and bring the administrative fee down to a flat $50. So going from 30 to 35 basis points down to $50 per account annually is about a 90%-95% drop in their expense.”
Things like that will attract reps.
“These flat charges aren’t with larger broker-dealers, they’re with small and midsize broker-dealers,” he says.
