Battle of the business models
RIAs keep gaining, while small broker-dealers are feeling increased pressure from the pandemic as well as the need to comply with Reg BI
It’s been going this way for years, but the pandemic is adding fuel to the advice industry’s realignment. Prior to 2020, some small broker-dealers had begun pulling the trigger to sell out to larger rivals, which have more robust RIA platforms and a greater ability to spend on the technology needed to shift advisers to working from home during the pandemic. And that only appears to be accelerating.
For example, near the end of April, LPL Financial said it was buying Lucia Securities, a small broker-dealer and RIA with 20 advisers and $1.5 billion in assets. A month later, LPL, the leading independent broker-dealer and RIA with more than 16,000 reps and advisers, hit the repeat button and said it was purchasing E.K. Riley Investments, with 35 advisers and $2 billion in client assets.
Lucia and E.K. Riley fit the definition of a small broker-dealer — a firm with less than 100 reps with retail or wealth management clients. Such firms have been fighting rising costs related to technology and compliance for more than a decade.
THE FINAL STRAW
Small broker-dealers have been teetering for years. Failures of high-priced alternative products, from hedge funds to private placements and nontraded real estate investment trusts, were mainstays of the financial crisis in 2007-2009. Following the great recession, dozens of small firms that made their living from commissions on sales of those products closed in the face of costly lawsuits, as well as new regulations, compliance and technology.
COVID-19 is another such storm for smaller broker-dealers. Add in the Federal Reserve’s recent move to slash short-term interest rates to zero, which means broker-dealers will see negligible revenue from spreads on clients’ cash holdings, and the storm intensifies.
“With the craziness of this pandemic, we may lose another 300 firms by year’s end, in my opinion,” John Busacca, a longtime advocate for small broker-dealers, wrote in a recent email advocating his election to the board of governors of the Financial Industry Regulatory Authority Inc. He is the CEO of Broker Dealer Exchange.
To Busacca’s point, it’s been a bruising 10 to 15 years for broker-dealers of all stripes, but particularly smaller firms. The number of broker-dealers has been roughly cut in half, as he notes, to 3,000 from 6,000.
FLOCKING TO RIA SIDE
Over the same period of time, reps and advisers have been flocking to the RIA side of the business. That should only intensify as the investment advice industry grapples with the pandemic.
“The large major firms, both RIAs and broker-dealers that have hybrid advisers, have been investing in technology to be prepared for such a remote working situation,” said Marina Shtyrkov, senior analyst at research firm Cerulli Associates. “Smaller firms didn’t have the resources to invest in technology and that sets them up for failure.”
Scale, she said, whether on the broker-dealer or RIA side of the business, “has allowed those respective firms to invest in technology that positions them, perhaps unintentionally, for this type of event.”
“Those firms have the digital resources, including video conferencing and e-signature, in place and ready to go. This disruptive event was the tipping point for advisers to use these new technologies,” Shtyrkov said.
In March, as local governments ordered many businesses to close and workers stayed home, the economy and market experienced a liquidity crisis, as many have noted, which lawmakers quickly addressed with an unprecedented $2.7 trillion in a variety of stimulus packages. What’s likely coming is an economic and unemployment crisis in which small businesses in particular could be challenged.
In the financial services arena, nothing could be more vulnerable than small to midsize broker-dealers that still rely on commissions for a large part of their revenues.
“It wasn’t like small broker-dealers were in great shape before the pandemic and this all happened,” said Brian Hamburger, president and CEO of MarketCounsel, which advises breakaway brokers. “I’ve been hearing for 15 years that these small B-Ds wanted to make a move and shift over to a fee-based RIA business so they won’t be as reliant on commission income.
“But commissions can be more profitable, which is why so many of those firms have procrastinated in changing their business model,” Hamburger said. “There wasn’t much of an immediate incentive to do that. And now we’re in a business environment where commission products are much harder to sell due to Reg BI.”
Yes, Regulation Best Interest, which is meant to raise the advice standard for brokers, is yet another thorn in the side of small broker-dealers. The change in regulation is intended to reduce conflicts of interest for brokers and move the broker standard closer to a fiduciary.
“Reg BI and the pandemic both represent potential headwinds for smaller broker-dealers, which tend to have more limited financial resources and infrastructure than their larger competitors,” said Michael Rose, associate director for wealth management at Cerulli.
“For smaller broker-dealers, the impacts of coronavirus have likely felt like an accumulation on top of the challenges and costs associated with Reg BI compliance, Rose said.
“Smaller firms may benefit from being more nimble, with the ability to identify and implement operational changes without the added complexity associated with multiple layers of bureaucracy,” he added.
“Small firms just don’t have the resources to invest in attorneys and staff to make sure they are protecting themselves and following the regulation,” said Amy Webber, president and CEO of Cambridge Investment Research Inc.
While the number of broker-dealers is shrinking, the opposite is true for RIAs.
The independent and hybrid RIA channel increased its adviser head count to more than 63,000, up 21%, in the five years ending in 2018, according to Cerulli Associates.
In the same time frame, the number of RIA firms grew to nearly 17,000 from approximately 15,500, according to Cerulli.
JUST GETTING STARTED
Dan Arnold, the CEO of LPL, said his firm is just getting started when it comes to broker-dealer acquisitions.
“This climate may also create more M&A opportunities, and our approach here remains the same,” Arnold said in a conference call with analysts at the end of April to discuss first-quarter earnings. “We are interested in firms that are aligned strategically, financially and operationally, and we’re starting to see opportunities materialize like the acquisition of Lucia Securities.”
“M&A continues to stay on our strategic radar,” Arnold said, adding that the firm sees opportunities “across the small B-D and RIA segment of the marketplace.
“In environments like [the one] we’re coming out of, we would anticipate, based on what history would tell us, that there would be demand and opportunity for continued consolidation within that segment of the marketplace,” he said.
But it’s just not LPL that will benefit; executives from other broker-dealers with large-scale RIA platforms say they are in discussions to buy small broker-dealers.
To that end, in April, Cambridge Investment Research hired Steve Chipman as senior vice president of strategic initiatives to focus on acquisitions, Webber said.
Chipman previously worked at Advisor Group.
“I see this as a real opportunity,” Webber said. “We have to make sure to offer flexible structures for deals to buy firms that others may not.”