November 19, 2010

What LPL's IPO Filing Reveals About the Largest IBD, and the Industry

A unique firm whose revenue sheds light on how broker-dealers, and custodians, survive

Looking at the numbers in LPL's SEC filing for its IPO, Philip Palaveev, president of Fusion Advisor Network, says, “It’s important for everyone to understand that LPL is a relatively unique firm—the sources of revenue for LPL are unique and almost no other broker-dealer other than perhaps Raymond James has this combination of revenues." However, Palaveev says that the filing also provdes "a glimpse of what the entire industry looks like at the custodian and clearing level.”

Palaveev writes about Top Wealth Managers and practice management regularly for AdvisorOne.com.

Those numbers, he says, highlight the “magnitude and importance of secondary revenues to LPL’s business, and by reference, to everyone’s business. It shows us how important these revenues are for all broker-dealers and all custodians—for pretty much the entire independent industry.”

In an interview on Nov. 18, Palaveev prodided these insights into LPL, and the industry.

AdvisorOne: Any surprises in the LPL filing?

Palaveev: What draws my attention is that here we get a glimpse of the economics that are driving the RIA side of the business and the broker-dealer side of the business.

What is important is the fact that, at net revenues of $2.75 billion, well over $500 million, about 20% of that revenue, belongs in this category of attachment revenue: asset based fees, transactions and other fees, and interest and other revenues. That’s the revenue that is usually not in plain sight. This is the chunk of revenue that happens more behind the scenes.

AdvisorOne: So the asset based fees are custodial fees?

Palaveev: The asset based fees are fees that custodians generate and to some degree, broker-dealers as well.

AdvisorOne: The cash sweep fees?

Palaveev: Cash sweep, sponsor fees and record-keeping—those three. Cash sweep fees, generally speaking, are something that clearing and custodian firms generate—they may occasionally share some of that with broker-dealers. LPL, being self-clearing, has full access to that entire category.

Sponsorship fees are something that is driving custodian programs—custodian select manager and No Transaction Fee (NTF) programs are the source of such fees. Sponsorship fees are paid to basically belong to that program. Record-keeping is part of what brokers and custodians do. [LPL lists $273 million in "Asset Based Fees" for 2009 in its filing.]

The revenue clients pay advisors is the $2.182 billion ($1.478 billion in commissions and $704 million in advisory fees). For every dollar of commission or advisory fees, there’s 12.5 [additional] cents of such asset-based fees that are generated at the clearing firm or custodian level. The two are mixed because the firm is both a clearing and custodian firm.

AdvisorOne: This is part of investing that clients don’t see—I’m not saying it’s nefarious, but these are things that they don’t realize are part of the cost of investing.

Palaveev: It’s not easy to see—this is almost a unique page that gives you a full view of the economics and it’s not something that advisors often see themselves. I’m by no means suggesting that this is inappropriate—obviously if these revenues were not there these firms would not exist and they did not exist we would not be in business. I’m just trying to say we all have to realize that this is a very substantial part of the cost of investing for clients, and a cost of doing business, and it’s a very big part of the economics of this business.

Advisors need to pay a good amount of attention to this—the economics that drive their relationship behind the scenes, whether that’s a custodian relationship or broker-dealer relationship—because what happens in this category [of revenues] is going to drive the other categories.

LPL would not be able to offer the payout they are able to offer in the absence of these asset-based fees. Similarly, custodians would not be able to offer the custodian services they offer in the absence of these fees. This is a critical part of the economics of this industry. The payouts of the first category are about 90% and out of that they have to cover their operating costs. So a typical broker-dearer would probably not be profitable on that first category alone—advisor-driven revenue. The source of profitability of broker-dealers, if any—because not all broker-dealers are profitable—is in the asset-based fees and transactions and other fees.

Without them independent broker-dealers would not be able to offer this economic model of 85%-90% payout and be profitable. Very important, though, it’s not just broker-dealers. Custodians would not be able to offer the ticket charges and custodial fees that they charge in the absence of those fees. Remember, a lot of those revenues are advisory in nature—LPL is also a custodian; NFP is not. Clearing firms and custodian firms do have some overlap in terms of those economics.

Then you have the transaction and other fees—this is really ticket and other fees charged to clients—tickets, wire transfers, small account, statement, phone access. Some of these are charged to the advisor; some to the clients.

Again—advisors occasionally focus too much on the payout and ignore the importance of these various fees that are charged to them and their clients.  For every dollar of advisory fees and commissions, there are 11.7 cents in ticket charges and other charges.

If you ignore those, big deal that you’re getting a 95% payout; it could reduce [advisors’] net take-home payout by as much as 11% if you’re absorbing all the ticket charges and  the other client charges. If you’re passing some of those to the clients, the percentage will be smaller, but somebody pays these. 

AdvisorOne: So what a client ultimately pays depends on what’s being passed on to them and what’s netted through their advisor?

Palaveev: Yes, and the cost is not insubstantial—it may amount to as much as 11% of the advisory fees.

AdvisorOne: So if you add these together you get 24% or 25% over each dollar of commission or advisory fees?

Palaveev: [Yes], 24.2% on top of every dollar charged for commissions and advisory fees.  

That’s not what really surprises me, because anybody who has been in the industry long enough will know that, but the magnitude is significant.

This is suggesting that the economics of broker-dealers, clearing firms and custodians are really driven by asset-based fees and transaction charges that are very often overlooked by advisors in the analysis of ‘Who do I affiliate with?’ or choose as my custodian or broker-dealer: What is the total cost of investing for my clients?

Obviously custodian and other firms have to charge these fees—this is what keeps them in business—there’s nothing inappropriate about them. However if we analyse the custodian or broker-dealer relationships without this we can see how far off we’re going to be.

Today advisors have a lot more options:  who to affiliate with, how they do business with these parties. To a large degree, advisors have a lot more options today because of LPL. The entire independent industry has to say a big giant thank you to LPL for their efforts to establish the independent BD model that has opened room for many, many others, by creating positive publicity for the independent model, through pioneering the business processes that they did, through new programs and new technology.

I think LPL has kind of been the torchbearer in many directions in the industry. Because of their presence, today advisors have the ability to choose better broker-dealers, lower transaction costs for their clients and more affiliation models.

I think we all need to say congratulations, guys, and thank you.

See more articles by Philip Palaveev:

Top Wealth Managers Q2 2010: Lowered Expectations

Special Report: 2010 Top Wealth Managers

Can You Build a Business?

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