Theoretically, wealth management firms should fare much better and be able to experience significant growth from mergers with practices formerly based in wirehouses. After all, wealth management firms offer all the benefits of independence: they have well established operations that wirehouse converts would otherwise have to build on their own, strong and well established reputations, offer the camaraderie of a partnership and last, but not least, they have talented and motivated staff. Theoretically, this should appeal to all but perhaps the largest of wirehouse teams. Then again, theoretically, the Seahawks should be in the playoffs.
My experience has been that the theoretical benefits of a merger between a wirehouse practice and an independent wealth management firm rarely happen because:
- It is difficult for wirehouse brokers to go independent in the first place.
- The merger requires a match of personalities and an interpersonal relationship that is difficult to establish.
- Often, both sides have very poor negotiation skills.
- Wirehouse recruiting bonuses get in the way and are difficult to refute.
- Joining an existing firm often does not meet the entrepreneurial desires of the advisors in transition--let's face it, a lot of large wealth management firms start to feel like wirehouses.
It is often said about wirehouse brokers that they, "do not understand independence." This comment encompasses a broad array of issues such as the sense of responsibility for every detail of the business and the willingness to get involved in menial operational tasks that independents have. It is a change in mentality that is not easy or natural and wealth management firms simply need to be patient in the process of introducing their colleagues to the joys of managing their own operations.
What is particularly difficult for wirehouse converts to understand are the mechanics of the investment process and the how the firm is managed. Wirehouse brokers have trouble understanding that the advisory fee is separate from the investment management fee that is charged by third party funds or managers, and is separate from the custodian charges, which can be transactional or based on the assets. This results in confusion over how the pricing for the client works and some skepticism about whether this is really better for the client. The mechanism also creates some uneasiness over how clients will view this complex structure of responsibilities.
Owner compensation is another common issue. Years of training have conditioned brokers to think in terms of "payout" and to calculate their income in such terms. The process of base pay plus share of profits is confusing and again makes advisors uneasy over how the numbers work. They struggle to understand why having a salary and a share of the profits is better than having 50% of YOUR business. In particular the transition from MY business to OUR business troubles many.
There is also general confusion during the process of merger discussions about who is supposed to be pleasing whom. Unfortunately, both sides feel like the other side should be "pitching" them about why they should make this move, and both sides feel somewhat indignant that the other guys are expressing skepticism.
The merger of a wirehouse practice into an existing wealth management firm is a negotiation and should be approached as such. My view is that a wealth management firm should approach the wirehouse broker almost as they'd approach a client, putting their best foot forward. Presenting the firm well, impressing the advisor and convincing him or her of the strength of the team are necessary for constructive negotiations to proceed. Expecting the broker to "pitch" the wealth management firm is unrealistic--they see all these other firms give them extensive sales pitches and offer money . Emotion and pride here are counterproductive.
When a broker joins an independent wealth management firm, they are buying into the team of existing owners as much as they are buying into the economics and the operations. Therefore it is crucial that both sides get to know each other personally. Too often, the discussions jump straight to the payout numbers (see above) and it's tougher to sell a broker or team on the independent firm using pure numbers today.
Over the last four years, the amounts offered as recruiting bonuses by wirehouse firms have escalated, from 120% of the trailing 12 months of revenue, to a stunning 300% (not that 120% was not stunning at the time), which was offered towards the end of 2009. Honestly, from a purely financial perspective, I can't find an argument that answers why an advisor would not take such a deal. The sheer amount of money--and the fact that it is all offered up-front--trumps almost all other analysis of how much the equity of an independent firm might be worth. Thankfully it is not all about the money, but then again, money has a lot to do with it--and it has been difficult for wealth management firms to argue with the massive amount of up-front money. As they say in my native Bulgaria: "When you are given--take! When you are chased--run!"
The ethics of the bonuses are questionable, at best, and many advisors are rejecting them on that basis alone. They strongly resemble the $5 "Gucci" bags sold on the sidewalk--something's wrong here. Let's consider some simple math: An up-front bonus will make sense to a firm as long as it is not higher than the present value of all expected future profits from a relationship. For example, if I expect to have a 20% profit from affiliation with an advisor, and I expect her to be with my firm for 10 years, it would be rational to offer, say, 40% of that advisor's revenue as an up-front bonus. After all, I expect 10 years of 20% profit or roughly 200% of their current revenue. A bonus of 40% represents about 2 years of profit and I will still have the remaining eight years. Of course, net present value will drive the number down to about 123% assuming a 10% discount rate. Obviously, if I am giving up 130% as a bonus, I am either betting that this practice will grow dramatically or I am just not quite good at math.
Now, let's apply the same analysis to a 300% bonus. In such cases, the bonus is tied to a 10-year contract. For the bonus to make any sense financially (ignoring growth, for now), the profit on the business will need to be upwards of 49%, and that's just to break even, (using a 10% discount rate for NPV calculations). The lower the discount rate, the lower the necessary profit. Considering that the large books of business that are recruited this way have payouts of upwards of 50%, there is no way that any firm can break even solely on the distribution revenue, meaning revenue generated by commissions and advisory fees for planning, advisory and similar services. The answer has to be in the non-commissionable revenue of the firm: revenues that are not paid to advisors but are paid for the client, directly or indirectly. This category includes, but is not limited to, trading tickets and trading margins, interest on cash balances, margin lending profits, marketing fees paid by investment managers, proprietary managers and funds, etc.
Ultimately this is a cost born by the client--whether that's an explicit out-of-pocket cost or an opportunity cost. Much of that cost is necessary--after all, someone has to execute the trades and maintain the accounts. However, this is not a cost that the advisor can negotiate or scrutinize on behalf of the client and therefore the potential for abuse is clearly there. An independent advisor will always have the ability to at least try to improve this cost on behalf of her clients by negotiating with the custodians--although many advisors do not pay attention to this. A wirehouse broker is essentially accepting their bonus in return for putting the clients in a captive execution environment, where the fees can be onerous.
To get a sense of the magnitude of the fees, consider that the normal profitability of a branch office should be about 15% to 20% after home office allocations. With a 15% distribution profit, the firm will need to have a profit of 33% (as percentage of the advisor's revenue), or more, on the non-commissionable revenue to just break even. This means that the non-commissionable revenue must represent at least a third of the revenue paid. Since the firm will likely want to do a bit better than just break even, the non-commissionable revenue must be more than half of the fees and commissions paid by the client. In other words, for every two dollars the client pays in fees, they end up paying a dollar of other cost that the advisor has no control over.
I admit I am speculating a lot here and relying on a simplistic analysis, but I can't see another way to crunch the numbers. This kind of economics always reminds me of Milo Minderbinder in Joseph Heller's book, Catch 22, who was buying eggs in Sicily at four cents per egg and selling them in Sardinia for three cents, and still making a cent in profit for every egg.
Wealth management firms often create partner arrangements and internal equity and pay mechanisms that make it difficult to add external partners. Examples include pay systems that reward tenure over production, and equity systems that place a big premium on the firm's equity, requiring a steep buy-in cost.
Last, but not least, if an advisor wants to be independent, they are likely to have a bias toward having their own firm. When someone decides to buy a house, they almost never buy a condo if they can afford the house. This is especially true for the large wirehouse teams who have the resources to establish all necessary functions on their own. It is also true that many of the largest wealth management firms start appearing very wirehouse-ish. They develop some rigidity around operations and decision making, they slow down their decision making; they start running too many decisions "up the flagpole" and get too centered on their existing pay structure. For this reason, many of the mergers tend to happen between mid-size wealth management firms and mid-size advisory practices.
I believe that independent wealth management firms can find great growth opportunities in recruiting wirehouse teams but they have to be realistic about the difficulty of the process and be able to walk in the other advisor's shoes. The key is often in defining the right target--those who have over $1 million in revenue are often not the best candidates for joining an existing firm. My experience has been that a lot of the successful mergers are with up-and-coming advisors who have great potential but are still looking for help, camaraderie and teamwork. Joining an existing firm is a complex and difficult decision for the person making the change and a true test for the partnership of an existing firm. The theoretical appeal is there, so sooner or later the practice should follow, no?
Philip Palaveev is president of Fusion Advisor Network. He can be reached at
ppalaveev@fusionadvisornetwork.com.
No comments:
Post a Comment