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Regulation and Compliance > Federal Regulation > DOL

LPL ‘Baggage’ May Block Search for Buyer: Nomura Securities

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LPL Financial (LPLA) is reportedly looking at a potential sale or other financial arrangements. But when it comes to finding a buyer, the nation’s largest independent broker-dealer could be in real trouble, analysts say.

A deal with LPL “comes with too much baggage,” said Nomura Securities analyst Steven Chubak in a research note Wednesday.

While LPL’s shares closed up 7% Tuesday as the news broke, the stock was down 4.5% on Wednesday, trading near $31 (it is down about 26% so far this year).

“Early investor feedback suggests E-Trade, Charles Schwab, Raymond James or Stifel Financial could all be potential suitors…,” Chubak said, “but we see too many hurdles,” such as the DOL fiduciary standard, the company’s capital issues and its debt covenants.

Potential buyers, the analyst said, must consider “a number of complex factors,” and such risks “suggest that the deal is unlikely to be completed.”

The analyst sees the “top hurdles”—the need for capital and costs associated with DOL—“as being insurmountable, and more than offsetting any potential earnings accretion benefits (i.e., modest expense synergies, cash-sweep transfer, DOL ‘scalability),” explained Chubak. “While there has been some talk that a regional bank may emerge as the buyer, we see valuation as a significant hurdle here.”

LPL is currently valued at just under $3 billion.

With the new DOL rules, the risk tied to operating a broker-dealer in the retirement space, is greatest, “as a number of DOL-related earnings headwinds have not yet been clarified,” he said.

“Further, any potential acquirer would have to be comfortable taking on the litigation/earnings risk that will arise from the best interest contract exemption (BICE), which, with 30% of LPL’s current AUM in brokerage retirement accounts, is material,” Chubak added.

The firm’s negative tangible common equity, which was -$985 million as of June 30, “would meaningfully impact capital ratios, rendering [a] deal less attractive to regulated bank buyers,” the analyst points out, since this TCE “would result in a meaningful hit to the acquirer’s capital ratios barring a significant (and dilutive) equity raise. In our view, this could be reason enough to rule out an acquisition by any regulated bank subject to capital requirements.”

LPL’s debt covenant limits total net debt to five times adjusted EBITDA and is expected to fall to 4.75 times in the future.

“As of Q2 2016, its leverage ratio was 3.7 times, suggesting limited capacity for additional debt issuance. In our view, any potential private equity suitor would look to utilize leverage to enhance returns; this strategy appears to be dead on arrival in this circumstance,” Chubak said.

On the flip side, he noted, LPL clients keep about $29 billion of cash in their accounts, earning LPL a sweep fee of about 55 basis points. A potential bank buyer could “bring these balances on[to the] balance sheet and generate a much higher yield (e.g., 175 basis-point-reinvestment yield as quoted by E-Trade), supporting upside to net interest income,” the analysts explains. “However, this may not be enough to offset the variety of risks and hurdles associated with the factors as listed above.”

Tough Timing

Other analysts agree that the IBD is not going to have an easy time finding a partner.

“LPL has substantial negative tangible equity (~$1 billion), and any deal would likely generate significant goodwill,” said JPMorgan analysts Ken Worthington, CPA, and William Cuddy in a note on Wednesday.

“Furthermore, LPL has been built on the concept of ‘independence,’ recruiting brokers with the promise of not selling proprietary products that drive conflicts of interest,” explained the two analysts, who just downgraded their view of LPL shares to Neutral from Overweight.

“Lastly, new DOL rules bring meaningful legal liability as LPL had indicated plans to operate under the Best Interest Contract exemption. The BIC allows for class action rather than arbitration when addressing certain client complaints. We suspect that lenders looking to acquire LPL for its cash balances may be scared away by LPL’s capital, independence and legal liability risks,” the JPMorgan duo wrote.

“LPL potentially hiring Goldman could weaken investor confidence in management’s ability to navigate new DOL rules,” according to Worthington and Cuddy. “With interest rates poised to rise in December and with expectations for multiple rate increases in 2017 (which would benefit LPL), it seems an odd time for LPL management to pursue strategic alternatives.”

Though LPL will not comment on the report, the IBD’s pursuit of strategic alternatives “could suggest the pending implementation of new DOL rules early next year could have a more damaging impact on earnings than the investment community realized,” the JPMorgan analysts stated. “Thus, we see the potential for LPL’s shares to come under pressure should a sale not take place.”

To recruiter Jon Henschen, the news of a strategic move by LPL is likely to hinder its recruiting efforts.

“Just when LPL got a little breathing room with little exposure in the press over the last year regarding FINRA fines, they drop this bomb,” Henschen said.

The IBD’s moves to change owners over the past 11 years or so, including private-equity owners, he adds, begs the question, “What value can a private-equity firm add to LPL?”

Still, the recruiter points out that in light of deals like broker-dealer H.D. Vest’s acquisition by the Internet company Blucora in 2015, there are “always unexpected purchases that come from outside the usual sources.”

To keep its reps from departing during the current upheaval, Henschen says, the firm should offer them retention bonuses, for instance, “and even stock to higher producers.”

Given the fluctuations the share prices are likely to face as the rumors continue, of course, the value of such holdings could come under lots of pressure in the weeks ahead.


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