The Essence of Independence

By Philip Palaveev

November 01, 2008 at 04:00 AM

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The heavy hits taken by wirehouse firms during the last few months' turmoil have led many brokers who may have idly thought about going independent to look more closely at their options–no pun intended. After all, the three biggest advantages of the wirehouse model–brand name, stability, and support–were so severely damaged that a significant change in the model is inevitable. Many of the wirehouse brokers I have talked to over the years have been concerned about going independent and walking into that first meeting with a prospect without a well-known logo on their business card and the ability to speak of billions in capital and capabilities. Today, the logo may still be highly recognizable, but rather than stability and capability it conjures images of headlines blaring words like takeover, bankruptcy, and vulnerability.

I have plenty of sympathy for all advisors who face pressure to explain to clients what happened while simultaneously trying to determine if this is still the best firm for their practice. The list of questions below are meant to cover the most vital understanding of the independent model as well as the most often misunderstood issues that advisors deal with in the process of going independent.

Who is a good candidate to be independent?

The first and absolutely necessary prerequisite for independence is the desire to be a business owner and gain an understanding of what being a business owner entails. Being a business owner means that the advisor will have full control of his practice but it also means that he has to tackle all of the challenges of running operations, and in some cases, compliance, on his own. Independence also requires advisors to contribute capital to their practice and assume some financial risk since the advisor will have to pay all other vendors and employees before receiving his first dollar of compensation.

The financial commitment necessary ranges depending on the size of the practice and how the advisor chooses to set up their regulatory structure and office. Generally, advisors who have less than $250,000 in revenue inside the wirehouse should probably first consider joining an existing independent firm. The fixed cost and operating risk for them will be too high at this practice size and there are many arrangements possible where they can leverage an existing office and perhaps become a partner in the firm at some point. Advisors with revenue between $250,000 and $1 million will need $30,000 to $50,000 to establish their practice, including leasehold improvements and deposits, computers, software, and consulting and legal fees. Advisors joining an independent broker/dealer (IBD) will see a somewhat lower cost since some of the software (performance reporting system most of all) and some of the legal/compliance costs will be offset by the IBD. Above the $1 million in revenue level, firms may need as much as $100,000 or more to get set up. The extra cost will usually come from the added number of employees the practice will need plus more sophisticated software. Generally it is a good idea to have as much as six months worth of expenses available as working capital at the start.

Have recent events changed the landscape for advisors?

The fundamentals of the independent business model are stronger than ever; none of the independent firms was involved in trading on their own accounts and thus none suffered the gigantic losses recorded by the investment banks. In addition, the separation of product and advice that characterizes independence ensured that relatively few of the clients and assets were exposed to the defective investment products that hurt many of the wirehouse clients. Last but not least, much of the luster of the brand names came off and without a brand name a wirehouse is simply a very large, bureaucratic compliance department with the added benefit of a low payout.

In anticipation of many advisors leaving their wirehouse firm, custodians and broker/dealers are gearing up their recruiting programs to take in as many advisors as they can. The programs are there and much information is available but the overall capacity is not unlimited so we may actually see some firms being overwhelmed by the number of advisors who are changing.

Deferred revenue handcuffs have lost a lot of value; the golden handcuffs were often invested in company stock and at present this is not a good thing. This makes the decision to abandon them a little easier.

The recruiting bonuses available for advisors who switch between wirehouses may dry up. The bonuses were at record levels before this shock but it is difficult to see where the cash will come from since all firms are looking to improve liquidity.

The turmoil may affect entire offices. Historically, advisors left on their own and swam against the current created by contracts, branch manager supervision, and colleagues' relationships. Today we may see entire offices, sometimes including the branch manager, planning for transitions or making outright changes.

Clients are the first priority. First and foremost advisors will deal with clients and make sure that clients are comfortable with the changes in the market. Once that task of reassuring the clients is complete, we will see advisors take decisive steps towards independence.

Will my clients follow me?

This is a true test of the relationship created by the advisor. Typically, 80% or more of the assets follow the advisor. However, several factors can slow down or hinder the process. Advisors who struggle in transitioning clients to the new firm tend to be:

Advisors who have serviced their clients in a transactional manner and have not established a good relationship; who were part of a team and the rest of the team did not break away with the advisor; who "received" the clients from the firm and were not the original source of the relationship; who do not break cleanly with the previous firm and as a result become mired in legal issues or, even worse, privacy and compliance issues; who have had a product orientation and struggle to find the product on the independent side.

The relationship with a client is usually more personal than institutional, especially if the advisor has been the face of the firm for the client over the years. The transfer track record of advisors going independent is a very good one, but it should not be taken for granted, especially in the presence of the factors mentioned above.

How will you make money as independent?

To put it very simply but accurately, the income of an independent advisor will be equal to all revenues less all expenses. Both terms require some definition, however, since they are different than what advisors see in a wirehouse.

Revenue for an independent firm is equal to all fees and or commissions paid by the client less any broker/dealer haircut (ranging from 5% to 15% depending on the size of the practice and sometimes the type of revenue). It is very important to understand that inside independent firms, advisors are not compensated on 12b-1 fees in fee-based platforms (those are, however, paid out inside brokerage accounts), ticket charges, account fees, interest on cash positions, margin interest, or custodial fees. Some of these items may vary for some broker/dealers but generally this means a 5% to 10% reduction in revenue for a typical wirehouse practice since some of these items are "comped" in those firms.

Expenses in independent firms simply means all expenses: every single thing. This includes (in order of size) compensation to assistants and other staff, rent and utilities, software and hardware, taxes and licenses (including E&O insurance), marketing, and others. Generally these expenses should be between 25% to 35% of the net revenue. So a $500,000 in revenue practice should have expenses between $100,000 to $175,000. Practices with more than $1 million in revenue will generally have a more complex structure due to possibly multiple owners and also employee advisors in the practice. As a rule of thumb, the personal pre-tax income to the advisor should be between 50% and 65% of the revenue for practices under $1,000,000 and between 40% and 50% for the owners of larger firms. The lower percent of the much bigger number is due to increased investment in employees and infrastructure that pays off in the form of added capacity. The largest of the large firms (more than $5 million in revenue) will see a full institutional income statement with profits to the owners averaging 25% plus a significant professional compensation.

Do I need a broker/dealer?

There are three primary reasons why advisors may need a broker/dealer: 1) trail commissions; 2) a strategic need for using commission-based products; and 3) the value added services offered. Of course advisors can choose to be registered with a broker/dealer and have their own RIA–a hybrid model that is increasingly being supported among IBDs. The August 2008 edition of Investment Advisor has a number of articles describing the reasons to choose various models and what services are offered by broker/dealers. As a rule of thumb, any trails under $50,000 are not worth the added cost and challenge of being dually registered. I should probably note that no broker/dealer enjoys being merely a facility for trail commissions.

How do I pick a custodian?

The first point about picking a custodian is to understand that the custodian relationship is not exclusive. The question actually is: Who do I pick as my primary custodian? Most firms end up doing business with two to three custodians, but the primary custodian usually has 80% of the assets. Most of all, your workflow will be created around the services and technology of the primary custodian.

The four major custodians are Schwab, Fidelity, TD Ameritrade, and Pershing. Others are Bear Stearns, Raymond James, and soon, LPL. I would suggest that firms take their time and examine offers from at least three of these firms. It is best to prepare a scorecard that you use to compare in apples-to-apples fashion the features of the custodial platforms. The areas of evaluation could be along the lines of:

Specific capabilities in the area of investment focus for your practice (maximum 25 points). For example, if you mostly use mutual funds, there is no point in evaluating the individual securities trading capabilities of the custodian, or if you rarely use separate account managers it is not that important what the SMA platform is like.

How the service process is structured (15 points). What service tier do you fall into (most custodians have at least two tiers of service depending on size), amd what is your level of comfort and familiarity with the service process?

Technology (15 points). This should cover the custodian interface, the integration with the performance reporting system of your choice, the ability to use trading software (if you plan to do so), and any other features that will be integral to your firm.

Value added services (15 points). What are the consultative capabilities of the firm? Will you have access to consultants and how often? What resources are available and what is their quality? Can you access third-party services at a discount?

Client pricing (25 points). You have an obligation to the client to find the best combination of services and pricing. To really compare apples to apples though, you will have to consider several client profiles and create spreadsheets that you use to compare the trading and other costs of each custodian, given assumptions about the size of the account, the frequency of trading, the typical cash balance, and other variables.

The Team (5 points). What is your sense of the people that will service your relationship and your ability to establish rapport with them?

There is absolutely no science of statistics behind this scoring system and it is merely meant as an example. You could, and perhaps should, modify the categories and the weight of the individual issues. My point here is that you should evaluate in depth three firms and compare them in a systematic manner.

What technology do I need for my office?

The one major technology acquisition that every practice will make is the performance reporting system. This will be the most expensive and the most difficult to maintain technology in an independent office. Those advisors that go to a broker/dealer can actually benefit significantly by using the performance reporting of the broker/dealer's corporate RIA, which is usually well worth the 10 to 15 basis points or so charged (varies by firm and size of the advisory assets). Otherwise, Advent and Schwab Performance Technologies (Centerpiece) lead the market for performance reporting with other systems such as Albridge and DbCAMS having a significant client base. The initial cost of system acquisition can be between $10,000 to $20,000, depending on the system and the number of users, with annual maintenance updates ranging from $2,000 to $10,000. There are also outsourcing solutions that allow the firm to free itself from the need to manage reporting. The cost of such systems ranges from $20,000 to $40,000 in the first year and $10,000 to $25,000 in subsequent years, varying by the number of custodians and the number of accounts. Both Schwab and Fidelity offer such outsourcing with a number of third-party systems also being available.

Trading and rebalancing engines usually work in conjunction with the reporting system and allow for batch trading and automatic rebalancing of model portfolios. Tamarac and iRebal are two of the more popular ones. The cost ranges from $10,000 to $15,000.

In order of cost and priority other systems include financial planning software, CRM, paperless office, research software, Web site setup, mail and file servers, and others.

Will I find the investment options I need?

All of the large mutual fund companies and investment managers are available on the custodian and broker/dealer platforms. Where there may be some discrepancies is in the area of alternative investments–some of the asset classes are simply not available inside custodian accounts as they are not liquid. Most can be found on broker/dealer platforms but the lineup will not be nearly as long as those of the Wall Street firms. Of course, that may actually be a good thing.

Advisors who use separate account managers a lot may also not find all of them in the custodian or broker/dealer platform of their choice. Last but not least, most of the credit products that wirehouses have will not be there: mortgages and personal loans are generally not a feature on the independent platforms (again not such a bad thing right now) but there have been discussions of developing some of them or creating alliances with banks who can offer them.

While the products are there, the pricing may be different from what the advisors are used to. On the advisory side of the business, advisors may be used to an all-inclusive wrap fee that combines all ticket charges, custodial fees, investment management fees, and advisory fees in one number. In contrast, each is likely to be priced and paid separately by the client. In addition, the pricing can vary from one platform to another as all broker/dealers and custodians strike their own deals with the managers and with each other.

What's the equity value vs. recruiting bonus?

I am not sure what the status of recruiting bonuses is after the crisis. The equity value of a practice can be approximated (very roughly) to be somewhere between 1.5 X revenue to 2.5 X revenue depending on the revenue mix (the more fees the higher), the size of the practice (the larger, the better), the nature of the client base (the younger the better and the larger the accounts the better), and other factors. The value is ultimately a function of what is the expected future cash flow from the practice, but since most advisors who are just starting to think about independence struggle to approximate the cash flow, we are using very rough revenue multiples.

The recruiting bonuses at one point in time were reaching over 200% of trailing twelve month's revenue, almost rivaling the equity values we are discussing above, but several points must be made:

Recruiting bonuses will be taxed as ordinary income, whereas in many situations the equity value will be eligible for capital gains treatment (consult with a CPA or tax expert)

A large portion of the recruiting bonuses–50% or more–would usually be in the form of deferred revenue, meaning that the present value will need to be discounted for the time value effect. A significant portion of the deferred revenues were also invested in company stock.

Ultimately the issue of control, while not necessarily financial, is important to consider, too. An equity value allows for partial transactions such as the sale of a minority interest, partial retirement, and so on. A recruiting bonus does not offer such flexibility.

How long does it take?

Experienced compliance attorneys and consultants can complete the registrations and the preparation for the move within 30 days and can advise on the best ways to stay within compliance of the non-compete, non-solicitation, and privacy regulations. The actual process of discussing the changes with clients and initiating the asset transfers is more of a marketing project than an operations one. The question really is how proactive you can be in contacting clients. If you can call all clients as soon as you move, you can probably initiate most of the transfers within 60 to 90 days and complete most within a total of 90 to 120 days since leaving the firm. However, if you are prohibited from contacting clients and you are essentially waiting to see if clients will come to your firm, the process can be as long as a year.

Good luck.

Philip Palaveev is president of Fusion Advisor Network. He can be reached at [email protected].

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