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Regulation and Compliance > Federal Regulation

Advisor Misconduct Rises After PE Buyouts: Study

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What You Need to Know

  • Before they're bought out, RIAs in these deals have below-average levels of misconduct.
  • Misconduct is stronger in firms with higher post-buyout growth in AUM per advisor, the study found.
  • The findings should give pause to advisors mulling a sale to a PE firm, Michael Finke says.

RIAs acquired by private equity firms had a 147% increase in the percentage of their advisors committing misconduct and a 200% increase in the average number of misconduct incidents after the ownership change, according to a just-released study.

The research released by the University of Oregon examined whether ownership by private equity firms encourages or deters financial misconduct.

The authors analyzed the records of individual advisors around buyouts of investment advisory firms by private equity.

“Our estimates suggest that private equity ownership leads to an increase of 147% in the percentage of the acquired firm’s financial advisers committing misconduct,” the study states.

“While the misconduct rate of the acquired firms is only about 40% of the industry average before the buyout, it becomes on par with the industry average after the buyout,” the study explains.

The increase in misconduct “is stronger in firms with higher post-buyout growth in assets under management per adviser and is concentrated in firms whose clients include retail customers,” the report states. “Our results suggest a tension between advisory firms’ profit motive and ethical business practices, especially when customers are financially unsophisticated.”

Responding to the study, Michael Finke, professor and Frank M. Engle Chair of Economic Security at The American College of Financial Services, told ThinkAdvisor in an email message that “private equity firms aren’t either ethical or unethical. They are simply smart and creative at identifying profit opportunities.

“Clients of advising firms that charge asset-based fees tend to be sticky, and there are opportunities to gather additional assets or obtain additional revenue from these clients through less ethical practices. This presents a business opportunity. A more ethical advisor builds a clientele of trusting investors that are ripe for less ethical revenue harvesting.”

The University of Oregon study, Finke continued, “finds that acquired firms are significantly less likely to commit misconduct before being acquired. In other words, their clients have a good reason to trust their advisor. This makes them more vulnerable to exploitation. Firms who have a lot of individual investor clients, who tend to be less sophisticated, are also seen as more profitable takeover targets.”

The study states that overall, its findings indicate “that PE chooses cleaner firms in terms of misconduct as buyout targets. After PE takeover, however, firms commit more misconduct.”

More on this topic

These results, the study continued, “suggest implications about the value of misconduct. If we assume PE maximizes firm value, the increased level of misconduct implies that higher misconduct is related to higher profit. PE firms choose targets with untapped ‘misconduct slack’ and exploit this opportunity to make profit, perhaps at the expense of customers.”

Maximizing Profits

“Often advisors view regulation as unnecessary because more ethical advisors are more likely to succeed,” Finke noted, “but this study suggests that in the absence of effective regulation the profit maximizing business model involves a much higher level of advisor misconduct.”

Liability and regulation, he continued, “will impact the optimal amount of misconduct, and it appears that PE firms are discovering that lower ethics produces higher profits (and that many advisors are leaving money on the table by not engaging in less ethical practices).”

The findings “should also give pause to these more ethical advisors who are considering selling their practice to a PE firm,” Finke said. “The takeover may ultimately transfer wealth from trusting clients to both the advisors and the PE firm.”

Anna Povinelli, a managing director in Kroll’s Financial Services Compliance and Regulation practice, added in a separate email that “adherence to applicable rules, regulations, and policies and procedures should be of the highest priority to fiduciaries — regardless of the ultimate ownership structure. Because of fee compression and other competitive factors, some financial advisers may feel pressure to engage in risky transactions or practices that may conflict with their disclosures and obligations to their clients.”

Povinelli added that as a general matter, “acquirers — regardless of ownership structure —must carefully assess not only the financials but also the risks related to governance, controls, and culture at acquisition targets. Thorough, risk-based due diligence should be targeted to fret out situations where managers may have placed their interests ahead of client obligations, under-resourced the compliance functions, or engaged in conflicted or undisclosed transactions or practices.”

The authors of the study note that PE firms have “shown a keen interest in the financial advisory business in recent years.”

According to research by the M&A consultant DeVoe & Co,, PE firms participated in 5% of all registered investment advisory firm merger transactions from 2013 to 2019 and accounted for 26% of the deals as measured by assets under management, the report states.

(Photo: Shutterstock)