What Morgan Stanley's E-Trade Deal Means for RIAs

It's here — another mega-merger.

Morgan Stanley said early Thursday that it is buying discount broker E-Trade Financial for $13 billion in stock, creating a firm that could have over $3 trillion in client assets.

"WOA. Big @WSJ news in financial advisor world this morning – Morgan Stanley Is Buying E*Trade!" said Michael Kitces, popular blogger and planner, on Twitter.

The news comes three months after Charles Schwab said it was acquiring TD Ameritrade for $26 billion. That merger, now going through antitrust review, would potentially lead to a combined firm with $5 trillion in assets.

Kitces and others industry thought leaders discussed a variety of opinions on the deal's significance for the brokerage, wealth management, workplace and related businesses.

Overall, the consensus view is that this deal is not good news for RIAs as it further limits their choice for custodial services; it's also bad news for Charles Schwab, seeking to overcome antitrust hurdles associated with its planned merger with TD Ameritrade. The development is, though, good news for Morgan Stanley.

"That's a business obviously E-trade started a few years ago and I think it's relatively small," Morgan Stanley CEO James Gorman said on a conference call Thursday morning.

"The RIA channel is obviously an interesting channel. It was a referral type program. So that's something that again obviously wasn't the primary motivator of the transaction … but we respect, and the RIA business we understand a little bit. And we'll just play that out over time," Gorman explained.

RIA Custody, Corporate Stock Plans

"The E*Trade deal brings 5M retail clients and $360B of platform assets to Morgan Stanley. Looks like this is basically Morgan Stanley's response to rapid growth of Merrill Edge – their own "low-end" small client online brokerage solution (perhaps with call-center CFPs someday?)," Kitces tweeted.

And there's more.

"It's not only about the retail opportunity, though. E*Trade also has a big business doing corporate stock plans for companies… which becomes a funnel to E*Trade retail when corporate share lock-ups end and liquidations occur," he continued.

Last year, E-Trade considered offering corporate-stock-liquidating clients as prospects for big RIAs. "Now, however, it appears more likely that Morgan Stanley is going to try to capture those clients directly, and in fact last year bought Solium which competes in the same corporate-stock-plan space," Kitces said.

"For advisors, significance is that E*Trade will no longer have referrals for large firms? And may not even remain a custodial RIA platform for small firms… which either way, won't likely want to affiliate with Morgan-Stanley- owned E*Trade custody & its blatant channel conflict," he added.

When E-Trade bought Trust Company of America (or TCA) about two years ago, it looked like it would then compete with Schwab.

"In fact, Morgan Stanley acquisition of E*Trade and potential loss of E*Trade Advisor Services as a viable RIA custody competitor puts even MORE pressure on the #Schwabitrade deal," according to Kitces. "Only a coterie of small-RIA custody options left, and even fewer competitive choices for large RIAs."

It's possible E-Trade could spin off the RIA custody operations, but that business would have trouble surviving alone, he adds, noting that RIAs may not accept a custody deal that ties them to Morgan Stanley — leaving the fate of this business unclear.

"Although frankly, that may be WHY Morgan Stanley timed the deal now. They get E*Trade retail to go online downmarket, a crack at its corporate employee stock business to upsell to upmarket wealth management, and 'collateral damage' is more DoJ scrutiny of #Schwabitrade now?" Kitces asked.

His conclusion: "Overall, just incredible what a destabilizing effect Schwab's ZeroCom announcement was last fall. The ripples and reverberations are still being felt. Yet the irony here is that what set up the #Schwabitrade deal may have rippled far enough now to threaten it further? (/end)"

'Smart Transaction'

Dynasty Financial Partners CEO Shirl Penney says that in an industry with declining margins, "You can still make money by scaling up via consolidation. There are some revenue synergies with this deal, such as Morgan Stanley 'upselling' loans, asset management and other products to E-Trade clients."

Looking at the corporate finance involved, "It seems like a smart transaction," he explained in an interview with ThinkAdvisor. "Morgan Stanley stock was up like 25% last year, while E-Trade sold off by about that amount due to [the trend of] zero commissions. It's an all-stock deal and a strategic acquisition that appears to make sense."

Gorman, then co-president of Morgan Stanley, helped strike the Smith Barney deal in 2009. "It was brilliant, and this one could be, too," Penney said, noting that Gorman "is an investment banker."

It's the stock-plan piece of the deal that Penney really likes. "These are two of the top companies in [corporate] stock plans," he said.

According to Morgan Stanley, they would be the industry's third-biggest player in stock-plan administration after the merger — with about $580 billion in assets and some 4.6 million participants.

"When you think of these plans for executives, even if you get a fraction of that business, it's a huge win," Penney said.

The clients can work with client relationship managers for many accounts and with financial advisors on the biggest accounts. "This is big," said Penney.

On the broader retail side of the business, the wirehouse can "upsell" its model portfolios and other products to E-Trade's clients, which have some $350 billion in assets.

"Morgan Stanley gets [higher] spreads on the cash as interest rates rise and that is material over time. And they get this direct-to-consumer business," Penney said.

"Time will tell when it comes to this wirehouse getting into the RIA space," he said. "Maybe they do it like Goldman Sachs … , by distributing products." (Goldman used its prime brokerage group to do this in the past, with an emphasis on sales of lending and structured products from its investment bank, according to Penney.)

"This could become part of Morgan Stanley's institutional business — to provide a suite of products — asset management, mutual funds, structured products, lending — to the RIA channel," he explained.

As for the RIA-custodian side of the deal, "E-Trade has a small RIA presence, so we will see if Morgan Stanley invests in the space and learns about it. But RIA custodial work was not ever the DNA of E-Trade," according to Penney.

For Morgan Stanley, the deal "could be significantly accretive, even if the wirehouse doesn't go into the RIA custodial space," he said. "They could let it go."

In general, the wirehouses "fear cannibalization and thus don't want their employee advisors to move to the independent side of the house" — since this is where the wirehouses make less money but the advisors tend to make more, Penney pointed out.

Another One Down …

"I agree with Michael [Kitces] on the antitrust issue," said Tim Welsh, head of the consultancy Nexus Strategy, in an interview. "Most independent advisors despise Wall Street and do not want to feed the beast they compete with."

He believes Morgan Stanley will not invest in the RIA custodial business "as it competes with its financial advisors." As a result, "E-Trade is going off the table as a competitor. No advisors will want to custody there," Welsh said.

"How long will it be until 'Morgan Stanley' goes into the E-Trade website to search for RIA clients? There won't be flows going to RIAs from E-Trade —those will be redirected to Morgan Stanley advisors — and the retail client base can easily transfer to Morgan Stanley," he explained.

According to Welsh: "It's a non-starter and the exact opposite of what Schwab wants, since it limits the competition even more."

For RIAs, especially smaller ones, it's more bad news. Larger RIAs that work with multiple custodians have some leverage, he said. But the smaller ones "will not consider E-Trade, leaving them with Schwab, Fidelity and Pershing. E-Trade is being completely eliminated."

The E-Trade-affiliated RIAs are not likely to go to the indie/RIA channels at Wells Fargo, LPL Financial or other broker-dealers, he adds. "They've left a broker-dealer and don't want to go back. … They are independent for a reason and need an independent custodian for a reason."

As for the zero commissions investors pay in the DIY channel, that should remain after the merger is wrapped up. "Morgan Stanley is not going to mess with that, as clients can move anywhere with all the zero trades available — and they don't want to lose clients to Merrill Edge," Welsh said.

As for the Morgan Stanley advisors, "Most of these assets are held in separately managed accounts. The money is tied up … and trading is included" in these programs, "so no trade-fee cut is needed," he added.

But the deal does open up an opportunity for Morgan Stanley, as DIY clients with sizable retirement assets — of $1 million, for instance — are likely to want some extra help and decide to go to the wirehouse rather than to the referred RIA.

"The bottom line is that one more custodian bites the dust," he said.

Schwab 'Thrilled'?

Robb Baldwin, CEO of Trade PMR, which provides RIAs with custodial and other services, sees the anti-trust issue differently from Kitces and Welsh. In fact, he thinks Schwab must be "thrilled" that a big brand like Morgan Stanley is entering the RIA space

"I think it eases the Department of Justice's concerns with the Schwab-TD Ameritrade merger a bit, since there is now another major player involved in the RIA custodial space … ," he explained in an interview.

The deal was "no surprise" given that E-Trade had been giving out signals about its interest in a possible acquisition for the past six months or so, Baldwin says. (Goldman Sachs passed on it, according to CNBC.)

"Morgan Stanley was a surprise, though. The wirehouses have been on the losing edge of RIAs and discount stock brokerages for 20 years. This is their chance to get back into the growing business," he added.

"The smart ones are going to do this without upsetting the normal revenue-generating model of the wirehouse reps," said Baldwin, a former advisor. "Figuring out how to do it without upsetting the apple cart and their main revenue source [means] they can grow and compete with the Schwabs of the world."

Morgan Stanley will need to keep the E-Trade affiliated RIAs and the DIY investor clients happy, too. "But the main goal is to keep the wirehouse reps happy and intact, so they don't flee to the RIA space," he stated.

For the TCA-affiliated RIAs, they've had to go through the initial conversion steps with E-Trade, "and now have to buckle up for the Morgan Stanley conversion in, say, 24 months," Baldwin said. "Firms do not buy firms to leave them alone but to monetize them."

Large firms today, especially banks, have to be strategic giving options to clients and advisors, he added: "The different channels have not gone out to capture assets — they're more of a pure retention plan."

Joel Bruckenstein, head of Technology Tools for Today, backed up Baldwin's take on the antitrust issue facing the Schwabitrade deal via Twitter, saying: "I agree with Robb Baldwin on this one. I certainly do not think the ETrade deal makes it less likely that the Schwab/TDA deal goes through. If anything, it helps Schwab make their argument ."