Trouble looms for small RIAs in next bear market

For small registered investment advisers muddling through a tough regulatory environment, the next market downturn may prove too much to bear.

That’s because the fees they collect are often tied to the value of their clients’ accounts, which generally fall in a bear market. The drop is going to spell trouble for firms that can’t keep up with the cost of satisfying intensified scrutiny from regulators or offer services to differentiate themselves in a highly fragmented industry.

Regulatory pressure has been building from the Labor Department’s new fiduciary rule, audits being conducted by the Securities and Exchange Commission and a crackdown on anti-money laundering programs. While firms are doing deals to gain scale and add services, RIAs with less than $150 million of assets are particularly vulnerable to a squeeze on profit margins.

“I can’t see how these firms will be able to afford to keep up with the pace of change in technology and services,” said Loren Pierson, president of Mercer Advisors, an RIA. “A downturn in the market may compel smaller firms to seek safety in the financial structure of a larger firm.”

It’s not just the cost of compliance that’s weighing on them. “Probably the bigger component is the cost of adding new services,” he said, such as in-house estate planning and tax advisement.

RIA buyers are looking for ways to gain a competitive edge in addition to scale to separate themselves from the pack.

Mercer, for example, said in March it was buying Kanaly Trust, which oversees more than $2 billion in assets and acts as a corporate trustee for high-net-worth families, a service Mercer doesn’t currently provide. The firm will have more than $8 billion in assets after the deal is completed.

Mercer, which is backed by private-equity firm Genstar Capital, is now negotiating smaller acquisitions with an asset range of $100 million to $300 million, according to Mr. Pierson.

Despite the strong pace of dealmaking among RIAs over the past couple years, many owners of RIA firms are reluctant to see themselves as a target for an acquisition, preferring to keep their independence as entrepreneurs.

The SEC wants to see that RIA firms have a written succession plan on their books, an important point considering the industry is filled with aging owners approaching retirement, according to Tony Mazzali, chief executive at CG Financial Services.

“It’s a mandate that they’re starting to enforce now in audit,” he said. “We all have to have a backup plan.”

Not investing enough in technology can cause headaches for clients. Some advisers are still working with paper files and don’t have customer relationship management software in place to do business, making it difficult to neatly pick up and sort through client data.

“It’s really quite a mishmash,” he said. “The bigger shops mandate using digital records.”

A firm with just $200 million in assets could have as many as 400 to 500 clients disrupted in the event of an owner unexpectedly passing away without having made the necessary investments in technology to keep track of their accounts, Mr. Mazzali said.

Meanwhile, the Treasury Department’s Financial Crimes Enforcement Network, known as FinCEN, has proposed a rule requiring investment advisers to establish anti-money-laundering programs similar to what’s already expected of broker-dealers.

“The Department of Labor is another trigger,” Mr. Mazzali said. The DOL issued its fiduciary rule in April, meaning financial advisers now need to have the proper procedures and documentation in place to show they’re putting their clients’ best interests first when it comes to retirement accounts.

The new regulation is complex and will require investments in technology to comply. “Do you want to figure it out yourself?” Mr. Mazzali said.

CG Financial Services, which oversees about $1.5 billion in advisory assets, may be an acquirer, but it’s also presenting smaller firms, typically with $50 million to $300 million in assets, an alternative to a sale. They can maintain their independence by joining the firm’s network, paying fees only for the technology and services they desire to help them clean up their back-office, Mr. Mazzali said.

Eventually, M&A in the wealth management industry will flip into a buyer’s market, and some may be left with a dying practice as suitors vanish.

If they don’t get their businesses into shape ahead of the next market downturn, or carve out a specialty that will let them survive on their own, smaller firms will struggle to find a large merger partner with more than $500 million in assets, Mr. Mazzali said.

“They’re not even going to turn an eye at them,” he said.