Brokerage industry remains hooked on high-priced product

The boom and bust alternative investment industry recently has been enjoying record sales of high-priced products, including private credit vehicles like nontraded business development companies.

For the past 10 years, Blackstone, Blue Owl and a host of others have sold illiquid BDCs to clients through financial advisors, with BDCs promising – and delivering - high-yields, despite warnings of high risks and high costs often buried in hundreds of pages of disclosure.

As this column recently noted, the shaky private loan market that BDCs have fueled since the credit crisis is leaving many wondering what the loans in these funds are actually worth.

In turn, investors are now rushing to get their money out of such funds, which can be difficult because these investments aren’t traded on an exchange and typically buy back 5% of their shares from worried clients each quarter.

With alts, there’s a boom and a bust.

Just this week, Morgan Stanley  said it was limiting clients’ redemptions at one of its private credit funds after investors sought to withdraw almost 11% of shares outstanding, according to Reuters.

“A flurry of bad news following several credit issues in recent ‌months has drawn fresh scrutiny to the roughly $2 trillion private credit market, as investors question the health of loan portfolios and the resilience of borrowers in a higher interest rate environment,” according to Reuters.

Add on the recent spectacle of unsound, high-risk deals like the bankrupt Inspired Healthcare Capital to the mix and the conclusion is clear.

Many broker-dealers remain, although they would deny it, hooked on high-priced, high-risk product.

Why?

For the commish, the juice, the money, the profit.

There’s no doubt that alternative investments generate more revenue for the firm that sell them as opposed to low-cost, exchange-traded funds.

As Morningstar noted in a report last year, BDCs and real estate investment trusts that have limited liquidity, like those currently under pressure, “are making private markets more accessible but are much pricier than public market funds.”

“Fees for semiliquid funds can be 2 to 3 times higher than open-end funds when incentive fees are included,” according to Morningstar.

The broad financial advice industry has preached for decades that it was distancing itself from a sales-oriented approach that generated lucrative commissions. It was going to focus on charging clients an annual fee for advice and service, a more consultive relationship.

On the surface, that appears true. Broker-dealers are generating more revenue from fees than commissions, almost a direct turn around from 10 to 20 years ago.

In 2024, LPL Financial Holdings Inc., an industry bellwether, reported $12.4 billion in total revenue. Close to $5.5 billion came from advisory fees, or 44.4%. Commissions totaled $3.3 billion, or 26.6% of sales.

A decade earlier, LPL Financial reported almost $4.4 billion in net revenue, with $2.1 billion – 47.7% - in commissions and $1.3 billion – 22.7% - from advisory fees.

That indicates that the industry in the last 10 years has largely carried through on its goal to charge clients annual fees instead of one-time commissions.

But what the industry doesn’t want to talk about is the jolt to the bottom line it still gets from higher priced alternative investments like nontraded BDCs or $100 million in commissions from Inspired Healthcare private placements and other real estate deals.

“Twenty years ago, the danger to investors was a broker potentially churning their accounts, high repeat trading activity by advisors to create commissions,” said Brandon Reif, an industry attorney. “They can’t get away with churning anymore because of electronic surveillance system firms have in place. So, they turn to higher cost investments and get paid upfront.”

How does the financial advice industry and its 325,000 registered advisors and salespeople combat the underlying avarice that propels the boom and bust sales cycle of high-priced alternative investments?

Investment managers who sponsor nontraded REITs or BDCs often have an insight into the market that proves valuable to clients. Blue Owl, for example, has focused on lending to private software businesses and manages funds that kick off high-yields to clients.

The problem many sponsors is that they overbuild their platforms, offering too many funds, often with similar, overlapping strategies.

The economics of the alternative investment industry is the hurdle; the bigger an alternative asset manager gets, the more wholesalers it must employ, the more offices it must open and the more cash flow, or sales, it must generate to pay for the operation.

The managers with institutional background who focus their expertise on just one or two deals for retail broker-dealers and financial advisors will likely be the winners once the current market sell off in credit products slows down.

Alternative investments are risky by nature. Why add to the risk by working with an investment manager who’s spread thin?