From the December 2005 issue of Investment Advisor • Subscribe!

Breaking Away

Brokers are finding it easier than ever to go independent, aided by custodians and other independent advisors

Plenty of advisors today are looking to make a career move like Colin Higgins. In 2003, he left his job as a rep for a regional brokerage firm, Hoefer & Arnette in San Francisco, and started his own RIA firm. But he didn't go it alone. Four other brokers at the firm, who were working as a team with Higgins, jumped ship with him--taking $180 million in assets under management.

Needless to say, the brokerage firm wasn't happy about losing the five-member team--or the assets under management--but Higgins and his colleagues believed that leaving the brokerage firm environment was not only the best move for them, but also for their clients. "We were looking for the ability to continue to grow our business in a manner that we wanted to, and we wanted to give our clients a shift from a B/D relationship to a pure fee-based one," Higgins says. "We weren't getting the support that we wanted from the B/D," he adds, and "we realized that these are our [client] relationships, and that we could better take care of them if we went out on our own."

After jointly sending a letter with the B/D to their clients about their decision to leave, Higgins and his colleagues took 95% of their clients with them. Two years after launching their RIA firm, The Golub Group in San Mateo, California, Higgins and his team have doubled their assets under management to $360 million. They've also doubled their staff--a decision they weren't free to make at the brokerage firm--and client base.

Regional brokerage firms aren't the only ones losing advisors in droves. The wirehouses are also seeing their share of brokers breaking away (dubbed "breakaway brokers") to hang out their own shingle. Scott Dell'Orfano, executive VP of Fidelity Registered Investment Advisor Group, says more and more teams of advisors with "higher-net-worth clients and much larger books of business" are abandoning wirehouses and setting up their own shops.

It may be far too early to suggest that the wirehouse model is pass?(C)--those titans of Wall Street can still boast tens of thousands of brokers and billions of dollars in transactions and assets under management. Under Stan O'Neal, for instance, a leaner Merrill Lynch has increased both revenue and profitability. In the third quarter, Merrill's net income was $1.4 billion (up 49%) on revenues of $6.7 billion. The company's Global Private Client group, which its 14,696 "financial advisors" call home, posted record pretax profit margins of 19.8% in the quarter on net revenues that were up 9% to $7.9 billion. Yet, many brokers are leaving the wirehouse scene.

Why is that?

The Conflict of Interest Issue

Besides the fact that these brokers want to control their own destiny and that of their clients', industry officials interviewed for this article believe a big part of the reason for the increase in breakaway brokers is because of regulatory scrutiny concerning conflicts of interest, and the dispute over the Merrill Lynch rule. "A lot of the wirehouses are starting to feel defensive about their firms," says Scott MacKillop, president of U.S. Fiduciary in Houston. The wirehouses' reputations and marketing prowess, too, are suffering, and many brokers are being put in the awkward position of having to defend their wirehouses' reputations.

But Steve Gresham, executive VP at Phoenix Investment Partners in Hartford, Connecticut, says the wirehouse model will always be around in some form because not every advisor wants to be an entrepreneur. The silent generation, too, who were born before the baby boomers, have "an extraordinary interest in the safety and security of an established company," he says. Although the wirehouses have not made significant strides in attracting boomers.

To be successful at setting up their own businesses, however, Higgins says advisors must hatch a plan ahead of time. "We had a pretty smooth transition because we did a lot of planning in advance," he says, like scoping out office space, computer IT vendors, payroll providers, and banking relationships. Another crucial step is finding a custodian that's "willing to support you and help you grow your business," Higgins says. Higgins and his team are using Charles Schwab as their custodian, and are also getting technology and compliance support, among other things, from Schwab. "They've done a phenomenal job," Higgins says.

Advisors must also know that just because they may be good at managing a portfolio and client relationships, that doesn't mean they'll be good at running a business, Higgins warns. "You have to have an entrepreneurial instinct, and pay attention to detail," he says. Dell'Orfano agrees, but says he's noticed that advisors are learning from the mistakes of their peers who've already made the transition, and are "taking a lot more time to analyze what it takes to run an independent practice."

Being a Good Manager

That's good news, because the breakaway brokers who end up creating the most profitable firms are good business managers, says Philip Palaveev, a senior manager at Moss Adams who's in charge of advisor market research. Beside wanting to control their own destiny, believing that they can serve their clients better solo, and creating equity in a firm that they can sell when they retire, one of the main attractions to going independent is pulling in more money, he says, so advisors must realistically assess the challenges associated with running a business. Despite the fact that most advisors working at wirehouses are entrepreneurial by nature, when they break away from the wirehouses they "underestimate how much time they will spend managing the business," Palaveev says. At wirehouses, brokers can devote nearly all of their time to clients and relatively little time on practice management, he says. Once they go independent, they'll find they're spending from 30% to 50% of their time running the business, he says, so to free up more time with clients they should consider outsourcing some functions, or joining an existing RIA firm instead of going it alone.

Another popular option is for breakaway brokers to link up with an independent broker/dealer firm. MacKillop says many breakaway brokers are getting a significant chunk--in some cases as much as 70%--of their revenues from commissions, so they need to park their Series 7 license at a broker/dealer in order to keep collecting the commissions. That's what a former Smith Barney rep did when she decided to join U.S. Fiduciary. Like other breakaway brokers, she left Smith Barney because "she wanted to be more objective, have control over her destiny, and [control] what she was doing with her clients," MacKillop says. She's now an employee of U.S. Fiduciary's broker/dealer and its RIA practice. MacKillop points out that neither Schwab nor TD Waterhouse's transition service for breakaway brokers allows them to move their Series 7 license. "This is where the TD Waterhouse and Schwab strategy [to recruit breakaway brokers] has a hole in it," he says. "It puts the advisor in a position of either having to give up that stream of revenue or find another alternative."

Palaveev of Moss Adams says the decision of whether to go totally independent or hook up with an independent broker/dealer "is an important one," and usually depends on the size of the advisor's practice. "Many of the smaller practices aren't ready to be RIAs," he says. "Larger practices have the choice, and that's going to depend on their strategy." Many advisors, he says, actually choose both models because there's no restriction on having a broker/dealer practice and their own RIA firm. Recent research performed by Moss Adams revealed that between 25% to 35% of all RIAs have a broker/dealer relationship, he says.

Transition Training Wheels

Most of the broker/dealers and custodians like Schwab, TD Waterhouse, and Fidelity offer a transition service for breakaway brokers. When the Smith Barney rep came to U.S. Fiduciary, for instance, the firm rented office space for her, purchased office supplies, and so on. "We did a huge amount of work to get her set up and ready to go," MacKillop says. "Most of the independent B/Ds give the broker a checklist, and maybe they would provide some other help, but they don't always rent the space and put their name on the lease like us."

AIG Financial Advisors does. The brokerage firm pays for the breakaway broker's office space, as well as all of the office amenities, says Jim Childress, director of the brokerage firm's Transition Suite. AIG's transition service also refrains from charging the advisor "ticket charges or E&O insurance," he says. The transition "model will pick up most of all the expenses that they're used to having be paid at the wirehouses."

Childress says that to help eliminate the fear that most breakaway brokers have about starting their own business, AIG gives them the choice of either being independent or becoming an AIG employee. "Some advisors move [from the wirehouses] because they want to be independent, but they still want the cocoon of a corporate environment--they know the certainty of their payouts and they know there aren't any hidden charges or agendas," he says.

AIG is also noticing that many of its breakaway broker recruits have been with the wirehouses for 15 or 20 years. "Brokers who've been in the wirehouse environment for many years are realizing it's time to move," Childress says. Why? Well, consider what happened recently at Morgan Stanley. The wirehouse released 1,400 advisors for various and "sundry reasons," Childress says, but most of the firings occurred for lack of productivity. Those firings are "causing a ripple effect at the wirehouses in terms of people saying, 'Am I going to be next?'" But that begs the question, if an advisor isn't producing to suit wirehouse standards, would he do better under an independent model? Childress says yes because first, AIG's payout structure, for instance, is higher than the wirehouses'. An advisor "could be doing the same amount of business [that he was producing at the wirehouse] and earning a higher income" at AIG. Second, unlike a wirehouse, AIG doesn't charge the advisor a "haircut" on his business. "His payout is his payout," Childress says. The advisors who were cut at Morgan Stanley were producing about $225,000 or less per year in commission revenue, Childress says. "AIG doesn't have that requirement; we'd like them to produce as much as they can, but we don't have any set [production] requirements."

Charles Schwab Institutional and TD Waterhouse (soon to be TDAmeritrade) are pulling out all the stops to recruit breakaway brokers. Dell'Orfano of Fidelity Registered Investment Advisor Group says while the brokerage firm has seen a significant uptick in the number of breakaway brokers coming to Fidelity, "we're not focused on hard recruiting." In her opening speech at the Schwab Impact show in Seattle this fall, Schwab Institutional President Deborah McWhinney stated it baldly: "Independent advisors have taken market share from full-commission brokers; you are the primary advisors to high-net-worth clients," citing research from earlier this year from Cerulli Associates.

But Schwab, like many of its competitors, isn't content to simply allow those HNW folks to find their own way to independent advisors. It is actively pursuing those "full-commission brokers" and especially fee-based advisors at the wirehouses, tempting them to go the independent route by playing matchmaker between those brokers and Schwab-affiliated RIAs and by running advertisements in major media outlets like The Wall Street Journal and through direct-mail campaigns.

Bob Oros, a VP & Senior Divisional Sales Manager for SI, says Schwab is capturing brokers on the Schwab practice transition site, and through its 13 regional sales teams. Schwab also holds Webcasts where brokers contemplating a move can learn more about their options; one recent such Webcast attracted 650 brokers, Oros says. Oros reports that as of the second quarter of 2005, there was $11 billion in new client assets coming into the Schwab pipeline from breakaway brokers, which he said was double last year's new assets from brokers; he said he expects that number to double again next year.

In 2004, Dell'Orfano says 55 breakaway brokers joined Fidelity's platform as an independent RIAs; To date, 186 brokers have moved over to Fidelity to start their own shops. Dell'Orfano says more and more advisors are attracted to Fidelity's transition "roadmap," which details the steps they will need to take to ensure a smooth transition. Fidelity has "alliance partners that handle all compliance and regulatory licensing, so we connect advisors with them," Dell'Orfano says. Breakaway brokers' biggest issue when going independent is getting up to speed with compliance issues, he says. "They need a resource to walk them through filing the legal entity, the administration process, and from there it leads to hiring personnel, staffing, where do they want to be located--a whole slew of questions." (See sidebar)

Fidelity also helps advisors brand the new entity, as well as strategically position the new firm based on the business model. The Beantown broker then helps advisors set up an "organization that is going to drive scale and efficiency and help them manage the growth of their practice," he says. "We help them analyze and eventually either purchase or use technology." Then Fidelity helps them grow, he says. Fidelity tells them "how to get the word out to the centers of influence that they are now independent and what does that mean for their clients."

If you're an advisor at a wirehouse that's considering taking the leap to independence, but fear the hurdles to success are too great, as Palaveev with Moss Adams says, you can take heart in knowing that none of the advisors that have taken the leap before you have regretted their decision.

Melanie Waddell, Investment Advisor's Washington Bureau Chief, can be reached at mwaddell@investmentadvisor.com. Additional reporting for this story was done by James J. Green.

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