To consider where we, as independent registered investment advisors are going, we need to look at where we came from: The independent RIA grew out of a failure of the brokerage and insurance institutions to act consistently in the best interest of clients, and out of frustration over those same institutions' conflicts of interest. Now, as these aging RIAs begin to sell parts or all of their firms to buyers in preparation for retirement, we may see a repeat of the earlier conflict. That is, the next generation will find itself back at the same place this generation struggled to get out of. I think we may need to find a better solution.
Before the 1990s, consumers wanting help with their investments had only one real choice: someone at a regional or national brokerage house. For estate planning, they had to look to an insurance agent who had access to a limited number of products usually from the agent's employer, typically a large insurance company. For banking products and services, they could choose only from among local or regional banks. Unbiased, appropriately-constructed advice and guidance were difficult, if not impossible, to find.
While consumers may not have known what choices were possible, they were clear about a few things. They wanted their interests to come first. They wanted unbiased advice. They wanted a broader variety of products and services to choose from--and which they could understand. They also wanted a logical, thoughtful way to grow and protect their assets in light of their total financial circumstances and needs. In short, they wanted a solution that, for a long time, wasn't available to them.
At the same time, many of the brokers and bankers and insurance agents were beginning to feel constrained by the conflicts inherent in working for the very institutions which produced the products they sold to their clients. They wanted to find a way to better serve their clients.
Out of this problem grew two solutions: First came Independent Asset Managers--or Portfolio Managers-- who charged the client a fee for their advice rather than commissions on the products they recommended. They've done well and continue to grow in size and number. But many professionals concluded they wanted to take a more holistic approach than these portfolio managers typically did. So, out of this client-centered need, the Wealth Manager channel was born. Today, the wealth management segment of the industry is clearly ascendant. Consumers have realized the benefit of being served by an advisor who is loyal to the client rather than the employer, and who offers more comprehensive ways to address more of the client's needs. Today, Portfolio Managers and Wealth Managers represent most of the Independent RIA community.
To avoid any semblance of conflict of interest, both Portfolio Managers and Wealth Managers largely abstained from creating proprietary products. They chose to be service providers--not product providers. This left them free to access products from any company, free to recommend what was best for their client. And it positioned them to be able to offer advice free from the influence of those product companies.
Consumers responded by flocking to the independents. Today, independents enjoy significant market share which has been taken from the historically dominant leaders in the "Advice" and "Guidance" space. The growth of the independent channel has notably outpaced that of the banks and wirehouses. An ever- increasing number of the most affluent individuals and families seek out the conflict-free offering of successful independent RIAs for their advice and guidance needs. This trend has not escaped the notice of the institutions.
Since the fall of Glass-Steagall, large commercial banks have begun aggressively entering this space, hoping to take advantage of cross-selling opportunities. In fact, banks are now the largest buyers of RIAs.
Meanwhile, Wall Street investment banks and wirehouses struggle with the question of how to avoid continued deterioration of their market share. Certainly so-called "Private Client groups and pockets of others have been trying to compete in this arena, but the demise of the "Merrill Lynch Rule" will make it more difficult. They may adapt or change stripes entirely, but the economics of their legacy business model will likely prevent them from ever fully adopting the RIA business model.
However, commercial banks are looking to leverage their existing client base with a wealth management offering. And financial buyers, often backed by private equity funds, hope to take advantage of the attractive economics of the independents.
Their timing is good, as many of the early independents are of an age to contemplate their own retirement and a personal exit strategy--often in place of a succession plan. For many RIA principals, the ability to monetize their practice at today's lofty valuations is an attractive proposition. Given the rapid increase in acquisition activity, many RIAs are feeling compelled to contemplate this opportunity sooner than they otherwise might, lest they come too late to the party.
Hardly a day goes by without an article announcing additional M&A activity. In fact, a recent Google search for "buyers for a Registered Investment company" produced 1,890,000 results. While not all constituted good results, many were--ranging from firms offering M&A representation, to white papers on M&A transactions, to actual offers of take-out financing.
What are the implications for our industry of this wave of M&A activity? Will this trend reverse the move to independence that was responsible for so much success? To me, "Independence" means the practitioner is the owner of the organization. It is this fact that allows the professional to serve only one master--the client--and conduct business as conflict-free as possible. I worry that significant non-practitioner ownership will re-create exactly what we left behind.
The critical variable here is: Who owns the means of production? If the practitioner is beholden to an outside shareholder as well as to the client, might that not create some form of conflict? And ultimately, should that conflict arise, won't it often play out at the client's expense?
According to a recent Moss Adams report, in the first six months of 2006, there were 228 M&A transactions with firms whose revenues exceeded $1 million, and in close to 50 percent of the reported deals, the buyer was a bank. Another 10 percent of buyers were what the report calls "Consolidators," or financial buyers. In approximately 60 percent of the transactions, therefore, the acquirer is an organization that will probably alter the client's relationship with a truly independent RIA.
I'm concerned that many of the acquiring organizations do not share the same independence and conflict-free environment that helped create the success of the firms they are buying. And if I'm right, the ramifications are significant.
Banks are concerned, first and foremost, with serving their public shareholders. Not only does this create the possibility of conflicts on the surface, but as they look to expand their profits, other choices will make it ever less likely that their first loyalty will be to client needs. On the positive side, banks can and often do bring more clients to the table, which can fuel an RIA's growth. But in general, acting as an independent is not a value encouraged by most banking institutions.
Financial buyers are most often backed by private equity investors, and their goals are usually quite clear. They typically have an annual ROI expectation in excess of 20 percent; few want to remain in any investment for 10 years.
Financial buyers tend to be attracted to our business not by a passion for the business of advising clients, but because of the attractive economics and demographics. More importantly, their typical exit strategy --an IPO or strategic sale--is contrary to both the clients' and advisors' best interests.
o If the exit is an IPO, how long will it be before an ambitious CEO decides she needs to improve margins to hit the next quarterly earnings target? At that point, proprietary products may begin to look attractive. In addition, less profitable activities such as financial planning and analysis start to look disposable.
o In the case of a strategic sale, one need look no farther than the large Wall Street firms or major banks to understand the ramifications. Few are known to consistently offer client-friendly, conflict-free environments.
At the end of the day, the M&A sale would seem to be a zero-sum game. If an advisor sells a portion of her firm to a financial buyer with a return target of 20 percent or more, the selling firm must go without that same 20-plus percent. For a retiring owner whose primary focus is to monetize his interests and head for the beach, this may be quite attractive. But the RIA who is concerned about her legacy and succession at the firm she has created could find that there may not be enough financial incentive left to keep the next generation interested.
One of the principles in most professional services organizations is that after a junior or associate role is successfully completed, the associate is then rewarded with the opportunity to become a principal in the firm. This younger professional can then enjoy most, if not all, of the fruits of his/her labor. If a significant percentage of the firm has been sold to an outside party, the opportunity for reward appears to change. Will the next generation of highly motivated professionals in an "advice and guidance" organization be happy giving 100 percent of the effort for a small piece of the net reward?
My concern, then, is that the next generation of professionals working at an organization that has sold off the lion's share of its equity to outside third parties will become disenchanted with the economic reality and look to leave. My related concern is that the next generation will watch the new buyers and become disillusioned as they realize they are no longer conflict-free. There will certainly be no shortage of opportunities for these individuals, especially if they are able to take client relations with them. Let us not forget that ours is not such a capital intensive industry, and the barriers to entry are not so high.
If we look to other types of professional services organizations for guidance about how to incent the best and brightest of the next generation to stay with a firm and continue to build it, I think we'll find we must offer them a path to make it possible for them to step into the founders' shoes and carry on their client-centric work. That path must include the same independence the current owner generation worked so hard to establish.
Certainly, for some sellers who simply want to monetize their efforts, the current environment may be quite attractive. However, for those who are passionate about succession and legacy issues and the future of the profession, this newfound M&A activity presents a challenge to creating an exit strategy.
Of the many solutions to this dilemma that exist, the idea that comes to my mind centers around a larger regional or national firm owned by multiple senior partners. They would need to be willing to forego their own name on the door and undoubtedly be prepared make some practice management compromises. But they could retain their independent ownership that is so critical. As independent owners, they could ensure that their clients' interests would always come first. In a peer-review environment, they could be assured that integrity and quality of work throughout the firm remained consistently high. Such a firm would not be without its challenges, but the resources that could be applied to any issue would also be enormous.
I invite your opinions about where we, as an industry, might go from here, and what the future might look like from both the client's and professional's point of view.
Norman M. Boone, MBA, CFP, is the founder and president of Mosaic Financial Partners, Inc. a San Francisco-based fee-only financial planning and investment firm. He is also co-creator of the award-winning IPS AdvisorPro, a Web-based Investment Policy Statement software solution for advisors.