In his nearly 35 years at the helm running San Francisco’s First Republic Bank, chief executive officer James Herbert has had his share of good days and bad days. Snagging the wealth management team at Luminous Capital in November 2012 was surely a good one.
In the prior three years, Luminous was able to triple its base of managed assets from around $1.7 billion to $5.5 billion. Under First Republic’s tutelage, that figure again tripled to a recent $17 billion.
This past June, Herbert had a bad day. That’s when he received word that that the Luminous team of wealth managers were “breaking away” to form their own RIA.
And so continues the steady defection of bank-based advisors that want to hang out their own shingle. It’s a trend that’s been underway for quite some time and may actually be picking up steam.
Echelon Partners’ “RIA M&A Deal Report” for the second quarter of 2019 noted 192 breakaways, which was the most of any quarter since firm began tracking the industry. Against this backdrop: a surge in RIA mega-deals, more private equity firms on the prowl and smaller RIAs in M&A crosshairs.
The surge in breakaways is the result of positive feedback from advisors who have already made the leap.
“Brokers have seen their peers break away very successfully and the move now seems less daunting,” says Carolyn Armitage, a managing director at Echelon Partners. She adds that “the learning curve (to becoming an RIA) is now much shorter, and RIAs now have a more advanced set of technology tools to help launch their own firm or join an existing RIA.”
Part of the wave of breakaways from the wirehouses is being driven purely by the profit motive. RIAs can keep much more of their revenues in hand, avoiding the heavy set of fees and expenses that captive brokers need to remit back to their firms.
“There’s no doubt that the allure of independence is increasingly evident to advisors,” says Brian Hamburger, CEO of industry consultant MarketCounsel.
Although the breakaway trend has been underway for a number of years, Louis Diamond, executive vice president at Diamond Consultants, says that the trend “is still in the third or fourth inning.”
Evolving industry perceptions surrounding industry standards are another key driver of breakaways. That’s because a rising number of planning clients are growing uneasy with Wall Street’s reluctance to embrace fiduciary standards, according to Hamburger. And he sees recent steps such as Regulation Best Interest (BI) as simply too tepid a response to the challenge.
“No amount of government rules and regulations can head off consumer demand,” he says. “Consumers want fiduciaries and they’ll keep pushing for it.”
And that’s playing right into the hands of RIAs.
“Right now, RIAs have the moral high ground, but they’ll have to keep evolving their service offerings to maintain their appeal to clients,” says Hamburger.
To be sure, the fee-for-service model can be an adjustment for clients, especially if they are coming from a broker/dealer relationship where wealth management fees are often buried within quarterly fund balance reports.
Even in a commission-based relationship, greater disclosure around fees is an unstoppable trend.
Cerulli Associates surveyed retail investors about how their advisors are compensated for the services they provide. The leading responses were “not sure/don’t know” and “it’s free or complementary.”
“Gone will be the days when consumers think they are getting planning and brokerage services for free,” predicts Hamburger.
That’s not to say that clients always balk when they learn about advisor compensation. Ed Louis, a market trends analyst at Cerulli, found that clients are “more willing than ever” to seek out and pay for financial advice and wealth management, but adds that “it’s crucial that advisors clearly articulate the value they are providing.”
Making the leap isn't always easy. Even as traditional brokers eye the benefits of the RIA business model, many aren’t quite ready to walk away from sales commissions. That’s where hybrid firms come in.
Hybrids are registered as both an RIA and a broker/dealer. This dual registration lets them run both a fee- and a commission-based practice. Some independent broker/dealers (like LPL Financial) also offer advisors an opportunity for a hybrid registration.
“In the past, these firms were seen as a stepping-stone on the way to becoming a full-fledged RIA,” says Marina Shtyrkov, a research analyst in the wealth management division of Cerulli.
Now, hybrids are starting to emerge as a more permanent landing place for advisors.
“Many advisors are finding they want to stay there as they realize that they don’t want to fully give up product sales,” says Shtyrkov. As just one example, her firm found that around 15% of RIAs sell variable annuities whereas two-thirds of hybrid advisors do.
“The appeal of commission-based revenue streams shouldn’t be underestimated,” asserts Shtyrkov.
Diamond adds that breakaway advisors should ask themselves a key question before contemplating a move to become a hybrid RIA or a full-fledged RIA.
“What is the degree of independence you are seeking?” he asks. Not everyone has the mindset to operate all the aspects of an RIA on their own.
While many advisors choose to keep operating under the hybrid model, others eventually make the leap to become a full-fledged RIA.
“True RIAs are more profitable to the advisor, and they also have much more control over areas like marketing and outside business activities (OBAs),” says Diamond. In addition, “fee-only businesses can garner much higher valuations when it comes time to sell.”
That’s because “buyers will pay more for annuitized revenue streams than for transaction-based revenue streams,” says Diamond.
Hybrids also face a growing perception problem with consumers due to high fees. Nicole Boyson, a finance professor at Northeastern University, found that the typical dual-registered financial advisor charges an average of 2.1% on assets under management, more than double the average 1% typically levied by standalone RIAs.
The higher fees are partly driven by greater use of commission sharing agreements with third parties, such as mutual fund firms.
Boyson’s research also found that hybrid advisors are subject to higher levels of disciplinary actions than standalone RIAs, and are still encumbered by conflicts of interest, right at a time when fiduciary standards are getting greater attention.
Wall Street is fighting back. Even as hybrids and RIAs garner greater industry mindshare, the major Wall Street firms are now devising ways to stem the break-away defections. And those efforts start with cash incentives.
“A lot of wirehouse advisors are being paid to stay put. That tells you an awful lot,” says MarketCounsel’s Hamburger.
Cash incentives may appeal to top-performing advisors, but other profit pressures may offset that. For example, broker-dealers often relied on mutual fund industry kickbacks to provide sales incentives, a practice that is coming under greater scrutiny as advisors are pushed to offer lower-cost investments such as exchange-traded funds (ETFs).
Tim Welsh, CEO of industry consultant Nexus Strategy, says that as revenues get squeezed and advisors see reduced payouts, “you’ll see an even bigger migration over to RIAs.”
Industry recruiter Diamond says that fully half of his clients are wirehouse advisors now looking to break into the RIA world.
These days, such a move is a one-way street. Hamburger says that few advisors ever choose to go back to the broker/dealer, “once they get a taste for the independence, the open business model and higher payouts that RIAs enjoy.”
To stem the tide, wirehouse firms are making it harder for advisors and brokers to leave. For example, Morgan Stanley and UBS both withdrew from the Broker Protocol, which had been in place to facilitate the migration of advisors and their clients to another wirehouse without the threat of litigation.
Wirehouses also often deploy the “garden leave” provision. This clause forces advisors to the sidelines for as long as 90 days, without the ability to contact clients, which is “a huge impediment to those considering a transition,” notes a blog post by Diamond Consulting.
Of course, any younger advisor looking to break into the business will now think twice about joining a wirehouse, knowing that exiting the firm may be a lot harder than joining it.
Backing out of the Broker Protocol “may have helped to slow the rate of breakaways in the short-term, but the move is bound to backfire over the long-term,” says Echelon’s Armitage. Perhaps firms like Wells Fargo and First Clearing have come up with a savvier way to protect their base of advisors and clients.
“They are creating their own RIAs to retain advisors,” says Armitage. “It’s a smart response to the problem, and we’re likely to see more of that in the future.”
Whatever the industry response, the steady flow of current captive advisors migrating to RIA platforms may soon morph into a full-fledged tidal wave.
Welsh notes that “bull markets tend to keep advisors sticky.” However, “some investor event, like a bear market, can trigger an advisor exodus.”
Diamond concurs. “The large wirehouses have so many restrictions they are practically pushing their advisors to go independent.”
John Langston, founder of M&A consultant Republic Capital Group, suggest that we don’t count out Wall Street just yet.
“The wirehouses will continue to adapt,” he predicts. And that may entail shedding their broker/dealer skins. In fact, Langston says he wouldn’t be surprised to eventually see the Wall Street wealth management platforms morph into a model much closer to RIAs.
David Sterman, CFP, is President of New Paltz, NY-based Huguenot Financial Planning