The Essence of Independence

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: