The Big Blur
April 1, 2022
By Eric Rasmussen, FinancialAdvisor
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As Jodi Perry, president of Raymond James’s independent contractor division sees it, the history of the broker-dealer industry is only half-written. In the last decade, the business has seen a wave of consolidation as firms with huge capital resources gobble each other up, leaving smaller firms to try navigating a rocky course of fee compression, regulation and a brutal war for talent—(especially talents with the biggest books of business).
According to Cerulli Associates, the top 25 firms control 68% of the assets under management and 58% of all industry advisor affiliations.
If the advisory world were seen as a tableau on the wall of a museum, the lines would increasingly seem meshed as the broker-dealer space bleeds into the RIA field. These camps in the past had their lines better demarcated. Put simplistically, RIAs were the ones who got paid money for talking: They took fees and offered counsel, while broker-dealers scooped money off trades and transactions. A crude narrative, but it stuck (and stung).
Over the last two decades, however, the rise of hybrid models and broker-dealers’ increasing adoption of fee models have changed the game. According to Cerulli, RIA firms have even had to redefine their value proposition now that broker-dealers are stepping all over their fee-only cred.
“Ninety three percent of advisors across all channels anticipate that at least half of their revenue will be fee-based by 2023,” said Cerulli in a March report. “RIAs Defend Marketshare with Service Expansion. “Advisors have more opportunities than ever before to not only become an RIA, but to operate like an RIA inside the B-D chassis.”
Some of the largest companies now hesitate to even call themselves “broker-dealers.”
“Today north of 80% of our assets are advisory,” says Andrew Daniels, managing principal of business development at Commonwealth Financial Network. “We’re really a national registered investment advisor with an accommodative broker-dealer built in. I don’t even really think of us as a broker-dealer anymore.”
Advisors in the IBD channel clearly want to do business differently (or at least be perceived that way). They are less happy to be thought of as salespeople pushing annuities and other expensive investment vehicles. Instead, they want to be perceived as paid advice providers, offering their services through a variety of models.
Derek Bruton, a senior managing director at Gladstone Group who, among other things, counsels RIAs and broker-dealers, says the continued focus on fees has paid off for IBDs, especially after the S&P 500 saw double-digit growth in the one-, three and five-year periods ending in February. Market appreciation boosted managed money balances directly—and allowed B-Ds to enjoy steadily rising asset management fees.
Advisors are also less inclined to leave their current firms when things are rosy, Bruton says. “I’m talking to a lot of very happy management teams at broker-dealers right now,” he says.
But while organic growth has been good, the recruiting effort is less stellar than it could be, except at maybe a half dozen firms. “Getting new blood and advisors into firms continues to be a struggle if your name is not LPL Financial or Raymond James or Ameriprise or Advisor Group or Cetera.” In other words, appreciating markets might have helped many firms paper over what otherwise would have been lackluster growth in rep count.
Firms of all sizes face constant demands from their reps, staff, clients and regulators, and that’s driving constant innovation in both products and platforms. The increasing complexity of regulations has been “emotional” for many firms, Bruton says—a huge drain on financial advisors’ resources in what’s always been a margin-constrained business. New SEC leadership has turned up the heat with its stronger version of Regulation Best Interest, which asks firms to explain not only why and how they are using various investments but even to explain their recommendations for once innocent-sounding activities like 401(k) rollovers.
Still, despite the fact they’ve got regulators closing in on them—trying to unpack and deconstruct confusing and conflict-ridden pricing models—IBDs also have certain advantages that come right down to economics 101: There are more opportunities to offer the services that their advisor affiliates are willing to pay for, and with a certain amount of price elasticity.
The bottom line is that most advisors often don’t like (or aren’t good at) running businesses, Bruton says. Consequently, they are happy to have a broker-dealer and its corporate RIA take stuff off their plate (and pay fees to do it). That means they’ll pay for tech, compliance, marketing … you name it. “There’s a trend among [reps] right now and that’s to drive down the complexity of their business,” he says. “And yes, the B-Ds, as they introduce new [unified managed account] platforms into their business or new products and capabilities on the alternative side or crypto or whatever it is, those are money-making opportunities.”
Bruton says new fee-based services will keep gaining popularity as clients move upstream from the mass affluent category to the high-net-worth category, something that’s happened after years of market appreciation. Broker-dealers can even mark up charges on things like, say, $200 per month of errors and omissions insurance, industry watchers say. (One recruiter says high E&O fees might be a sign to advisors that their broker-dealer has gotten greedy.)
Jon Henschen, a recruiter with Henschen & Associates, is a critic of the hidden fees that broker-dealers charge clients and reps. “There are still aspects to advisory costs,” he says, “which need to be and will get vetted more thoroughly going forward for potential conflicts of interest, including proprietary advisory platforms, markups on money manager management fees, markups on mutual fund management fees, markups on advisory administrative fees, platform fees charged for holding assets at third-party custodians [such as] TD, Schwab [or] IWS, or for holding TAMP assets direct at the TAMP.”
‘Retain’ Is The Name Of The Game
Simon Hoyle, a Houston-based advisor recruiter for Henschen & Associates, says it’s become even more imperative for broker-dealers to hold on to their existing advisors (and their assets) longer by offering them things like longer-term forgivable loans. He also points out that many of those forgivable notes are in the end paid for by the clients through transaction charges or fund-sharing fees, things the clients might not know and that regulators might not like.
(See Hoyle’s story on page 60.)
The pressure to recruit is especially growing on those IBDs trying to lure recruits from the wirehouses, where the cultures have always demanded big bonuses and large production payouts. Commonwealth’s Daniels says his boutique firm has traditionally been behind the curve in that particular recruiting race, and that’s prompted Commonwealth to change gears: It added four recruiters to its team last year and also started bundling fees into payout grids in a way that made sense to wirehouse brokers, he says.
Pressures to recruit and retain reps continue to climb. LPL saw its forgivable loan balances for advisors skyrocket last year. According to its 10-K released in February, the loans in its non-repayable category rose from $460.2 million at the end of 2020 to $772.7 million at the end of 2021. That’s a 68% increase. (LPL claims the $772.7 million does not entirely represent forgivable loans but includes some smaller categories the company will not disclose.)
The big year-over-year increase, in any case, reflects the firm’s desire to write a lot of checks and hold onto the force of more than 900 advisors it acquired from Waddell & Reed (and perhaps banish memories of its less-successful effort to hold on to reps from National Planning Holdings a few years ago). LPL’s managing director and divisional president of business development, Rich Steinmeier, says the company held onto $63 billion or so of the $71.2 billion in assets held by Waddell & Reed advisors when the acquisition was announced.
Raymond James wants to retain assets too, and has launched a practice succession planning platform called “Practice Exchange,” an M&A tool offering buyer-seller matchups for advisors.
“The most important thing to us,” says the firm’s Jodi Perry, “is supporting the next-gen advisor and retaining the assets. In Practice Exchange, if they haven’t identified their own succession plan, we have sort of a matchmaking process where we can help advisors internally find successors.”
Hoyle and other recruiters say the race among IBDs to offer bigger payouts is going to pinch somewhere, and they think it means cutting down on services. “Some of the big B-Ds, their head count has shrunk, so the [ratio] of advisors to home office employees [has] changed. So maybe it was 9-to-1 or 10-to-1, more in that ideal range. Now we’re seeing some numbers where it’s closer to 15-plus” advisors for every home office staffer.
Recruiters say those companies leveraged up with private equity debt are more likely to have cut services—and that it happened at just the wrong time. “Service has gotten so bad at some firms where they can’t get a call back, they can’t get the right answer,” says Jodie Papike, a recruiter at Cross-Search. “And it’s driving people so mad that they are actually leaving for service issues, and it’s a pretty consistent pattern. I think the pandemic had a lot to do with that, with a lot of firms obviously having back office people work from home, and then some broker-dealers and firms are not bringing all their employees back.”
Private Equity’s Role
As they have watched the price of LPL Financial, the nation’s largest IBD, rise from $42 a share in April 2017 to over $172 recently, private equity investors have been attracted to the brokerage business, and private equity-backed firms own two of the biggest IBD networks, Cetera [and its parent company, Aretec] and Advisor Group, the former broker-dealer network for AIG. Advisor Group won a giant prize in Ladenburg Thalmann in 2020.
Both Cetera and Advisor Group were in the crosshairs of credit analysts in 2020, however, because they had shouldered huge debt burdens just when Covid crushed the market. Both companies then made impressive bounce-backs, however, returning to stable outlooks at the credit rating agencies. It was a combination of cost-cutting and recruitment that put the blush back on the rose. Ultimately, an initial public offering could be an exit strategy for both IBD networks.
Jamie Price, the current CEO at Advisor Group, says that there’s been absolutely no pressure by private equity ownership to cut costs. In fact, he says private ownership means the firm doesn’t have the quarterly pressure of shareholders breathing down their necks to force decisions on things that might require more long-term thinking.
Price does agree, however, that the nature of fees in the business is changing as regulators demand more transparency about ticket charges. Advisor Group made its own changes accordingly in January 2021. “We eliminated rep-paid ticket charges,” Price says.
He says instead that advisors can use no-transaction-fee funds that pay sub-transfer agency fees to clear and settle. These funds produce statements from the fund company, and though they are a little more expensive for the client, about 10 basis points more, the client is now getting more transparency about what they’re paying for, Price says.
Charging fees on inactive client accounts is one area where the SEC is looking to crack down on both B-Ds and fee-only RIAs. Last September, Michigan-based Regal Investment Advisors, an independent RIA, was fined almost $1 million for earning fees on accounts that were seen as orphans. Another area regulators are targeting is fee-sharing arrangements with fund companies and other vendors.
According to Larry Roth, the managing partner at RLR Strategic Partners, these changes have had a direct impact on the kinds of products broker-dealers’ clients are using. “The cost to serve a fee-based client at the customer level has dropped somewhere between 25 and 50 basis points over the last three years,” says Roth, who in the past worked as CEO at both Cetera and Advisor Group. “And most of those savings have come from allocating away from mutual funds, ’40 Act funds, and into ETFs and index funds.”
Covid also ironically helped broker-dealers by allowing them to cut costs when interest rates were low. Firms were able to save on canceled travel and conferences and consider refinancing leases at a time when more staffers were working at home on Zoom.
But Roth also notes the threat that RIA consolidators with private equity backing pose to the independent broker-dealer space. Private equity investors are willing to pay much higher multiples for RIAs than they are for hybrid fee-and-commission firms. “That’s a threat, a real threat,” Roth says.
He cites such big deals as Sequoia Financial Group’s acquisition of 32-year Royal Alliance veteran Kevin Myeroff and his team at NCA Financial Planners, a firm in the Cleveland area with $1.7 billion in assets. (Royal Alliance is a part of Advisor Group). In a similar transaction, Focus Financial added another Royal Alliance firm, Cassaday & Co., a D.C.-area entity with $4.7 billion in assets.
RIAs backed with private equity money might pay a stunning 20 times EBITDA for the fee-only business of a major hybrid RIA, Roth says. In contrast, a hybrid RIA would only pay eight times EBITDA for a rival. “The broad trend is that since many of the large advisors affiliated with the large IBDs are almost exclusively fee-based, there’s a risk that they’re going to be picked off by the consolidators,” Roth says.
IBDs must also contend with an aging population of reps. Pandemic-related challenges and a strong market for sellers are prompting a growing number of advisors to retire.
Advisor Group’s Price says his head count of producing reps as of mid-February was 9,750, down from 10,000 at the beginning of 2021, but he adds, “The amount of referral business, inflows, asset flows into our business was a record year for us as a company, even on a per advisor basis. Obviously we got larger with the Ladenburg Thalmann acquisition, but if I even take the head count into consideration … and do it on a per advisor basis, asset flows were a record for us.” Also, he says, “a lot of the advisors were leaving the industry and retiring out.”
Papike says the competition is all a win-win for the advisors themselves, who have more choices of where and how much they want to work and for how much payout. “When advisors are looking to make a change now, they have so many options that it can be a bit overwhelming,” she says. But on a down note, she adds, the private equity firms throwing all the incentive money into the pot makes it ever harder for midsize and small broker-dealers to compete.
LPL’s Steinmeier says advisors are indeed leaving smaller firms that lack scale and infrastructure, especially if they couldn’t adapt to work from home. “We would characterize ourselves as a net winner over the last couple of years,” he says. “We’ve had two record recruiting years in a row,” he adds, saying 2021’s recruitment number was also double the year before.
Stealing The Fed’s Sunshine
As the Fed fights higher inflation by raising interest rates, it will be a double-edged sword for broker-dealers. On one hand, higher rates hurt markets, which hurts assets under management, and thus revenue. Nor does it help to have a lot of debt if interest rates head north.
But on the whole, higher rates greatly help broker-dealers, since the companies can make more off their money sitting in client cash accounts, usually through third-party bank cash sweep programs. That’s a pain-free revenue injection.
Or, as Raymond James put it more soberly in its Form 10-Q at the end of last year: “Based on our high concentration of floating-rate assets that are funded from clients’ domestic cash sweep balances, we estimate (based on static balances as of December 31, 2021) that an instantaneous 100 basis point increase in short-term interest rates would result in incremental pretax income of approximately $570 million annually, with approximately 65% reflected as net interest income and 35% reflected as account and service fees.”
Such amounts could also create significant war chests for huge acquisitions and mergers—and more forgivable loans.
Tech Arms Race
There’s not only a recruitment war but a tech arms race. Steinmeier touts LPL’s acquisitions of two fintechs, the trading system platform Blaze and the proposal generation system AdvisoryWorld. The firm’s LPL Labs, an innovation tank, introduced a pilot service in the spring of 2021 called “Paraplanner” that helps advisors develop comprehensive financial plans on behalf of advisors. “To develop a good financial plan is somewhere between four and 10 hours,” he says. “You’re doing discovery with the client. You’re inputting that into a financial planning software of your choosing. You are drawing interpretation off of that. You’re drawing conclusions and putting forward a set of actions that the clients should take to maximize the probability of success. … Our team would actually do all of that on behalf of the advisor and then we deliver that to the advisor.” LPL then charges per plan developed.
Tech is still a problem for a lot of smaller broker-dealers and reps, especially if they are using patchworks of different processes. Maura Creekmore is a managing director at the clearing firm BNY Mellon Pershing and co-head of its Wealth Solutions segment. She says smaller broker-dealers lean on her firm a lot. (The firm recently launched Pershing X, an end-to-end tech platform that’s meant to stitch together the different technologies broker-dealers are using.)
“Smaller firms are spending a lot of money on compliance,” Creekmore says. “They are not able to invest in new advisors or new tools.” She says the ones that are able to thrive are niche players. “Whether they are working with tax consultants or maybe are specialized in divorce … there are so many unique ways that these smaller firms are finding ways to help the community.”
Raymond James is meanwhile rolling out more virtual services to help, Perry says. “With Covid, it really feels like it made its rounds through almost everyone. So if someone’s branch professional is out for a couple of weeks and they need someone to fill in, especially if it’s a solo practitioner, we’re creating more of those virtual services where we can support someone from the home office instead of them trying to do everything on their own or going without.”
“Technology is everything at this point,” Perry says. “If we can give an advisor back minutes in a day, hours in a week, and days in a month, then I think we’re doing our job from a technology standpoint.”
In a world where the ways people make money is increasingly under scrutiny, Perry says, “Everybody has to be able to articulate and show their value.”
