The Next Rung
By Dan Jamieson
April 1, 2015 Financial Advisor
After last year’s frenetic merger activity, together with strong equity markets and a competitive recruiting environment, independent broker-dealers are recommitting to organic growth. They’re also making plans to reinvent themselves for the next generation of advisors and investors, by building practice-management and consulting services, addressing the challenge of planning for succession and beefing up their technology—even by coming up with some robo-like offerings.
Last year, the industry was fixated on the rampant merger activity of real estate investor turned broker-dealer player Nicholas Schorsch and his RCS Capital Corp. (RCAP), which purchased Cetera Financial Group.
That changed in the wake of an accounting scandal late last year at Schorsch’s American Realty Capital Properties. After that, the REIT mogul ended any associations he had with his publicly traded companies, including broker-dealer owner RCAP. “Schorsch is no longer affiliated with our parent, and was never affiliated with our retail business,” says Larry Roth, chief executive of Cetera.
Thus, compared with last year’s M&A activity, the environment this year seems downright placid. There was a “fair amount of noise in the market” after the accounting fiasco, Roth adds, “but we hope to see less of that in the future.” RCAP is still open to making strategic acquisitions, but for now is more focused on growing organically, Roth says.
Meanwhile, competitors who had hoped to get a flood of calls from advisors at the RCAP broker-dealers seem to have been disappointed. “We’ve seen less activity out of the Cetera organizations than I would have anticipated,” says Scott Curtis, president of Raymond James Financial Services.
Even if RCAP’s spending spree for broker-dealers slows, industry executives predict continued consolidation as firms seek to protect margins by building scale. The “costs of compliance and technology are all very expensive,” says Wayne Bloom, chief executive of Commonwealth Financial Network. “So if you don’t have critical mass, I think it will be very difficult to survive.”
“Industry margins continue to deteriorate” as the commission and fee rates gleaned by broker-dealers are pushed downward at a time of increased competition, says Bill Morrissey, managing director of independent advisor services at LPL Financial.
B-Ds will also have to spend more on technology to remain in compliance with regulators and meet the increasing demands from clients for improved access to their investment information, Curtis says.
The growing cost pressures are, of course, particularly hard on small firms. While each firm is different, Fidelity executive Sanjiv Mirchandani thinks it will be tough for B-Ds to survive unless they are at $50 million or more in revenue.
“Among those cost pressures, litigation is an ever-going risk,” says Mirchandani, the longtime head of Fidelity’s National Financial clearing unit who has also recently been given responsibility for the RIA custody business. “You don’t want to be in a position where, with one bad arbitration ruling, you’re going out of business.”
Look for outside investors to continue playing a role in consolidation. “There is still a lot of private equity [money] in this space” looking for deals, says Mirchandani. Outside investors understand that there’s a rosy future for the independent advice business—since there will be fewer advisors and a growing demand for advice from an expanding population of retirees. “If you get the right price, retain the assets, get the scale and if [interest] rates go up, you can get pretty good return on capital” from buying a broker-dealer, he says.
Stuck In Their Seats
The consolidation trend should also give surviving broker-dealers an opportunity to pick up some good advisors who may not want to remain at firms that have merged. But industry observers caution that the overall recruiting environment has slowed, and it might not change this year. Good markets beget good business conditions and keep busy brokers in their seats.
“Reps aren’t moving as much as they used to,” says recruiter Jon Henschen, founder of Jon Henschen & Associates. Sometimes people move for compliance reasons. Either the brokers have been asked to leave their firms or have issues with their firms, Henschen says. Placing those types of advisors can be difficult because broker-dealers have gotten stricter about taking on any kind of regulatory baggage.
What’s more, “there has been a little bit of slowdown on the breakaway trend,” Mirchandani says. “Advisors tend to move when markets are more difficult. Now they’re too busy” handling clients.
Despite a tepid recruiting environment, the bigger firms seem to be adding advisors and revenue as some advisors flee to quality names and others seek independent firms with significant resources and services. LPL Financial added 363 net new advisors in 2014, up from 321 in 2013, bringing its total past the 14,000 milestone.
Raymond James Financial Services gained 100 advisors in 2014, bringing its total to 3,379. “The quality of advisors we’re meeting with is consistent with last year, which was a bit better than the prior year,” Curtis says.
Commonwealth picked up almost $48 million in recruited revenue last year, up from $33.4 million in 2013. “Last year, we had the second-best recruiting year ever, and the pipeline remains very full,” Bloom says.
Cambridge Investment Research added “north of $60 million” of advisor production, says president Amy Webber, besting the $52 million gained last year. While the firm has been able to attract some high-quality recruits, in terms of raw numbers, “I don’t see an awful lot of movement out there,” Webber adds.
Cetera Financial Group added a net 123 advisors last year, bringing its total to just over 9,000. The firm’s fourth quarter ended December “was the strongest one we’ve ever had,” says Adam Antoniades, president of Cetera Financial Group.
The Cetera firms picked up 242 financial advisors in the fourth quarter, while losing 116.
“Generally there’s a negative effect on recruiting when we acquire a firm, so to see the strongest quarter like that with the bad news from our parent company … was really refreshing,” Antoniades says.
Broker-dealers also report that the “tuck-in” trend continues. Tuck-ins are recruits who join an existing branch, usually an OSJ, which offers a turnkey office and support structure. The ease of joining a fully staffed branch, with a manager to run interference and technology that’s ready to go, appeals to those who don’t want to hassle with starting up their own offices.
An established office also provides a sense of community for a recruit who is used to having some branch camaraderie, Morrissey says. Last year, about 40% of new recruits at LPL were tuck-ins, up from 25% in 2013.
Large ensemble groups that can add brokers either to existing locations or new offices under an OSJ are growing especially quickly, Morrissey says. These larger producer groups are adding value with a brand name, often in local markets or in a particular industry, with mentoring and training and with a marketing effort that’s drawing a flow of new clients.
Cambridge has three branches doing over $20 million in revenue. “We call them the B-Ds inside a B-D,” Webber says. “They are successful organizations that add a lot of value” to advisors who join. “They’re growing, and definitely here to stay.”
Last year, about 70% of Cambridge’s new advisors joined one of the firm’s existing branches, Webber adds. In 2013, that number was closer to 50%, and for 2015 it looks as if more than half of recruits will again join as tuck-ins.
Hot Hybrids
Everyone knows the so-called hybrid space is the place to be. Other than the RIA channel, it is the only channel that’s been adding bodies.
Total advisor head count has shrunk 2.5% per year over the past five years, according to a January report from Cerulli Associates (which has data through 2013). Over the same period, though, the RIA and dually registered channels were up 1.8% and 9.0% per year, respectively.
Cerulli defines dually registered advisors as those who have their own RIA firm plus an affiliation with a broker-dealer. How independent broker-dealers handle hybrids is a critical issue, especially the way each advisor balances custody assets between the RIA and B-D sides of his or her business. In that regard, IBDs seem to be making some progress by offering incentives and services for hybrid advisors to keep more assets on the brokerage side.
As of last year, hybrid advisors had 59% of their fee-based assets at an independent RIA (held away from their broker-dealers), down from 73% in 2012, according to Cerulli. The commission assets those hybrids held at their broker-dealers rose to 30% of the total, up from 16% in 2012, while fee-based assets under broker-dealers’ corporate RIAs inched up a percentage point from 2012, to 12%.
More good news: Only 28% of dually registered advisors indicated they have an interest in dropping their B-D affiliation, Cerulli says, while 58% plan to maintain some securities business.
Still, the question remains: Over the long run, will IBDs be able to retain the affiliations of their most successful RIAs? Unfortunately, says Cerulli, those advisors most adept at growing their practices are more likely to focus on the RIA model.
“I’m talking to more wirehouse advisors who are going to skip the IBD channel altogether and go directly to [their own] RIA,” says Mark Elzweig, founder of the recruitment firm Mark Elzweig Company.
To bolster their hybrid numbers, broker-dealers are hyping not only their hybrid-specific capabilities but also the advantages of using a corporate RIA owned by a brokerage firm. This option appeals to advisors who may be fed up with the hassles of running their own RIA.
And for the B-D, it keeps assets in house. “Having your own RIA doesn’t provide much of an advantage unless you’re doing something unique,” Bloom says.
“We’ve got 80% of advisors now using our corporate RIA,” Webber says of Cambridge. “Ten years ago, that number [was] the opposite.” Why the shift? “The regulatory climate is crazy,” Webber says, as both the SEC and states are looking more closely at advisors. “Three of our largest [independent] RIAs had the SEC show up at their doors in the last 18 months. They had no fun [with] their audits.”
Regulation is “certainly changing the cost side of the equation” for RIA firms, Antoniades agrees. “In a couple years [an independent RIA] won’t be economically viable except for the biggest advisors.”
Migration to the corporate RIA structure has yet to happen throughout the industry, however. That might change if regulatory “harmonization” occurs—a push to make the oversight of RIAs similar to that of brokerages. Indeed, the broker-dealer industry has been pushing for this.
In another effort to retain fee-based business, independent brokerage firms have been hard at work beefing up their own internal fee platforms and money management capabilities. “In today’s world, any [large] firm like ours has those capabilities … like rebalancing, financial planning, automated performance reporting and teams in the field helping advisors understand these resources,” says Steve Dunlap, executive vice president of wealth management at Cetera Financial Group.
Bloom describes Commonwealth as “a giant technology shop, with a giant RIA, and we also have this broker-dealer.” The vast bulk of fee assets at the independent B-Ds are in “rep-as-portfolio-manager” programs, a term used by Cerulli for accounts managed by the advisors. Advisors may use ETFs and mutual funds in these programs, but the overall allocations are their own, not the pre-selected mix offered by the broker-dealer parent or a turnkey asset management program.
However, Jim Crowley, the chief relationship officer at Pershing LLC, predicts that more fee assets in the independent channel will be managed by third parties in the future. Such an arrangement is “more efficient, more scalable and a model that over the long term … could drive a better result for investors,” Crowley says.
Cambridge has $4 billion in its own turnkey program, Webber says, up from just $1 billion three years ago. Webber sees more of that shift coming as older advisors retire. Younger advisors—as well as female advisors—tend to use third-party managers and models more, she says. Here, too, though, firms need to be careful, according to Cerulli. It takes significant resources for a broker-dealer to develop and run its own asset management platform, the firm says. Sometimes it can be stuck with a legacy system that’s difficult to scrap. Smaller firms should seriously consider outsourcing.
Making A Go Of It
Faced with the reality of increased costs and tepid recruiting, the buzz among broker-dealer executives these days is that they should be growing organically—and growing smarter.
“Clearly, our industry has a track record of growing revenue, growing revenue, growing revenue,” says Crowley. “But for the last couple years now, it’s been, ‘Wait a minute, revenue itself is not the answer to better pretax income.’”
Smart growth means avoiding unknown risks and building capabilities that will add value for advisors and their clients, Crowley says. “Today, people talk about margin compression, and we see some of that, but at the same time we see margin expansion at the leading firms,” he says. “These firms know who their ideal advisor is, their ideal investor, and they provide a suite of services that, when put together … clients and advisors truly want and are willing to pay for.”
From his similar perch clearing for broker-dealers, National Financial’s Mirchandani also sees the need for broker-dealers to attract a specific type of advisor and outsource what they don’t specialize in. “Broker-dealers often claim to be unique, but they’re not,” says Mirchandani, who adds that there will be more pressure for them to differentiate themselves in the market.
Larger firms will have to offer practice-management consulting to their advisors, both to aid organic growth and lure recruits. Advisors need help with hiring staff, succession planning and financing the next generation, says Henschen. “These are things that have been touched on in the past, but firms are getting deeper into it,” Henschen says.
For example, Cetera is adding another four professionals to its 16-member practice-management consulting team this year, says Dunlap, and a business consulting group that was part of First Allied will be made available to the entire Cetera network of B-Ds.
“There’s no substitute for having small teams from the B-D out traveling and teaching advisors how to use” the firm’s capabilities, Mirchandani says. Smaller B-Ds have a bigger challenge in developing unique capabilities like training. Many pitch themselves as places where an advisor won’t be just another production number. “A lot of advisors are not suited to the big organizations,” says Steve Chipman, chief executive at Foothill Securities, a midsize firm. He says some advisors want the personal treatment they get at a smaller firm.
A Game Of Regulatory Defense
All firms, big or small, are dealing with what they say is an overwhelming regulatory burden.
The hottest issue right now is a pending Department of Labor proposal that would impose a fiduciary standard on advisors who handle retirement plans and IRAs.
The securities industry is concerned that the DOL fiduciary rule would limit commission-based products in IRAs and harm smaller investors who often get advice from commissioned brokers.
But the White House has a different view. In February, President Obama endorsed the proposed tighter standards during a press event at the AARP, just as the proposal was being sent to the Office of Management and Budget for review before being released for public comment.
Industry observers still haven’t seen details of the latest release, but the new plan reportedly has exemptions and will not ban commission products, as the industry feared the original 2010 plan would have done. “If the requirements are relatively low, with a threshold [for exemptions] that can be easily met at a low cost, then [the plan] would not ban commissions,” says David Bellaire, general counsel at the Financial Services Institute. “But instead, if the requirements are numerous and difficult to achieve, they will in fact create a situation where advisors are unable to provide advice … to smaller accounts.”
The revised DOL plan may be favorable, “but our gut says it won’t be,” adds Antoniades from Cetera, current chair of the FSI. “The way it was introduced in the past, it really would have prohibited us from giving advice on a 401(k) rollover.”
If the rule goes the wrong way, advisors who don’t do fee business could suddenly find that “they can’t work with half of their clients” until they get the registrations necessary to convert to fees, says Webber, who is vice chair of the FSI.
Next on the list of broker-dealers’ regulatory concerns is Finra’s Comprehensive Automated Risk Data System (CARDs), which would collect customer account and suitability information and house that data for automated oversight purposes. Bellaire says such as system would be a very attractive target for hackers.
A newer issue, cybersecurity, looks to be an emerging regulatory issue this year. The steady stream of data breaches at U.S. companies has kept security in the headlines, and the topic has become a major focus for the Obama administration.
Last year, securities regulators began cybersecurity sweeps of investment firms, and this February both the SEC and Finra issued reports on what they found. The Securities and Exchange Commission found that 88% of brokerage firms and 74% of RIA firms it reviewed had experienced cyber-attacks directly or through vendors. Most of the attacks involved malware and fraudulent e-mails.
Finra said firms will need to “develop, implement and test incident response plans,” including strategies for containment, recovery, notification and making customers whole. Risk exposures from vendors also need to be managed, Finra said.
“The good thing is, firms in the financial services industry in general are probably ahead of the curve when it comes to cybersecurity,” Bellaire says. “When you are processing securities transactions and moving money electronically, cybersecurity is essential.”
The Emerging Consumer Opportunity
Like everyone else in the financial services industry, independent firms are closely watching the robo-advisor trend. While the traditional independents aren’t going to be jumping into the robo-space anytime soon, they do plan on developing consumer-friendly technology to improve customer experience and, perhaps, create a robo-like platform.
“Everyone talks about [robo-advisors] as a threat,” says Crowley. “We prefer to see it as digital enablement.” That means it will help attract the next generation of investors and help advisors handle their smaller relationships.
With the advisor ranks shrinking and assets growing, “you’ve got to have younger and more productive advisors,” Mirchandani says. “That’s where the robo [platform] comes in.”
Younger investors who’ve lived through the financial crisis, he says, will demand better consumer-facing technology. A number of broker-dealers have robo-like projects in the works for investors who cherish ready access and prefer online communication.
Commonwealth is developing a “low-cost, model-driven way to manage money and service accounts,” says Bloom, and plans to have something early next year.
Last year, a group of younger advisors at Cambridge built what Webber calls a “skeletal framework for a client portal,” which the firm is now turning into a robo-like platform.
Cetera, too, has something in the works, Roth says, but “it’s not ready for prime time yet.” The system will incorporate aspects of the firm’s existing technology.
Pershing’s Crowley, like many other observers, expects that a number of robo-upstarts will go out of business or merge with competitors. And the big B-Ds might be some of the buyers. Former LPL president Robert Moore said as much in January at the FSI’s annual meeting in Texas.
For independent B-Ds, robo-advisors might not be a threat. Instead, they might fit in well with the B-Ds’ broader strategies of serving advisors the way those advisors want, with a range of affiliation options, platforms and products.
Every trick will be needed to capture what Mirchandani calls the “enormous consumer opportunity” coming up in the years ahead. Every independent firm needs to be thinking about how to address the changing customer base, which will undergo profound changes.
If anything, the impact of retiring baby boomers is underestimated, he says. Not only will Generations X and Y come into the market, but there will also be an increasing number of female investors with mushrooming financial power.
“There is going to be a tremendous amount of money in motion,” he says.