The Mating Game

Many small indie b/ds are feeling the margin pinch and have begun to quietly shop themselves around

The week before Christmas, at 9:30 in the morning, Marshall Leeds, CEO and president of independent b/d Summit Brokerage Services in Boca Raton, met with an advisor named Eric, whose own small, independent b/d was just barely eking out a profit. They met to talk about the possibility that Eric would sell his b/d to Summit, and they tried to hash out what that deal might look like. Summit, with 225 advisors and $4 billion in assets under management, has been in the market to acquire small b/ds for the past three years, but until recently Leeds wasn't seeing a whole lot of serious interest. After all, six months ago, the market was relatively good and many b/ds were holding out for a better deal, he says. That has changed.

Eric's five-person b/d, for example, which generates a little over $750,000 in annual gross commissions, has been flatlining as plummeting fees on assets and rising costs cut into profits. For months Eric held on, reluctant to give up the reigns of control. He had built the firm from scratch with his own savings 10 years before. But by mid-December, profits were so tight that Eric was ready to negotiate. Under the preliminary terms of their agreement, Leeds would pay Eric and his group up to 10 percent of trailing 12-months' production in cash upfront and take a 10 percent cut of all future revenues. The other 90 percent would go to Eric and his team. Eric would also offload most of his regulatory burden to Summit, which would pay roughly 90 percent of his compliance costs (or around $70,000), giving him more time to focus on clients. Meanwhile, Eric would keep his own name on the door and maintain a relationship with his clearing firm. At the end of the day, Eric's take-home pay would total around $160,000, tacking on a 30 percent pay raise.

These kinds of discussions are being held in the front offices of independent broker/dealers more and more these days as the smallest shops — loosely defined by industry experts as firms with less than $50 million in client assets — navigate the razor's edge of survival. The meetings are often kept quiet because b/d executives fear that the scent of failure will cause their advisors to panic and begin hunting for a new b/d to call home. (Indeed, Eric himself declined to talk to the magazine for this story, and didn't want his last name or firm name mentioned.)

Of course, consolidation is nothing new in the independent b/d space, where slim margins have long meant that competition is fierce and scale is imperative: With average payouts to independent reps of 80 percent to 90 percent of revenue generated, pre-tax margins are as low as 3 percent to 4 percent at some firms. But now a lot of other pressures have been added to the mix. Most brokerages' assets are down around 40 percent, says Larry Papike, president and owner of Cross-Search, a Jamul, Calif.-based recruiting firm. Revenues are down proportionately, further pinching profits — if not wiping them out. On top of that compliance costs are rising, clients are demanding more time and better service, credit is scarce and liquidity has dried up. Oh, and then there's the threat of increased litigation from clients as the market heads south. Those without a capital-rich corporate parent, or a capital cushion of their own, may need to sell out — or risk going under. “Over the next 12 to 18 months, if this market continues, you are going to see an awful lot of firms trying to find a partner that can take them out of the mess they are in,” says Papike.

Hooking Up

Falling profits and rising costs have already pushed some small b/ds into the arms of bigger players over the past two years. For example, in August, Securities America agreed to acquire Brecek & Young Advisors, an independent broker/dealer based in Folsom, Calif., with some 300 reps and $1.3 billion in assets under management. And Ladenburg Thalmann recently agreed to acquire two independent b/ds: In the fall of 2007, it struck a deal to buy Investacorp of Miami with 500 reps and $8.5 billion in assets under management; in the summer of 2008, it agreed to acquire Triad Advisors of Norcross, Ga., with its 380 advisors and $9 billion in assets under management. More recently, in December, First Allied Securities closed on a deal to buy the assets of Red Bank, N.J., First Montauk Financial Corp.

After fourth quarter losses are tallied, there may be more of these pairings to come, says Joel Marks, vice chairman and COO of Advanced Equities, parent of San Diego-based IBD First Allied. “I think there is a lot more fear for some of the smaller b/ds,” says Marks. “They know they have a good model in a good market, but they don't know how long it is going to take for that good market to return.”

Certainly, some recent buyers are already looking for more acquisitions. Securities America, for example, has admitted it would like to buy additional small firms. In fact, Jim Nagengast, President, CFO and COO of Omaha-based independent b/d Securities America estimates acquisition discussions with other b/ds occupy 50 percent of his time now — compared to 10 percent to 20 percent last year. “I feel this is a great opportunity to add some of the smaller b/ds,” says Nagengast. “We're seeing a lot of opportunity there, and I think more and more small b/ds are going to ask themselves, ‘Where do I want to focus my business and how can I partner with somebody who is very strong in this space.’” Nagengast says the firm is interested in acquiring both entire b/ds and individual b/ds' assets, but it will also be aggressively recruiting reps. In any one year, the firm may recruit 300 to 400 advisors, he says.

Securian Financial Services, based in St. Paul, Minn., with 1,500 FAs nationwide, says it's in the market to buy other b/ds, while Berthel Fisher is actively in conversations with smaller shops. Ladenburg Thalmann may also be looking to buy more firms, says Papike, though the firm wouldn't comment. Then there are regional acquirers like Summit.

There are plenty of small b/ds out there that may need a lifeline: Of a total of 5,031 broker/dealers registered with FINRA, some 91 percent are considered small — with 150 employees and $50 million in assets under management or less. A smaller slice, or 36 percent, have one to five employees, and 20 percent have six to 10 employees. (See adjacent table.) Many of these smaller independents are realizing that in order to survive they need scale. “The retail brokerage business is a scale business,” says Bernstein Research senior analyst Brad Hintz in a January report. “In the past, we have found that the larger the retail brokerage unit, the higher the operating profit margin.”

For now, there is mostly just talk, but as the market and the economy continue to sputter, the talk is growing more heated. Leeds, for example, says the number of small b/ds expressing interest in possibly selling to his firm has almost tripled in the past three months. It used to be that he would have one discussion a month with such b/ds; over the past 90 days, he has had serious discussions with eight. These firms range from micro shops with two advisors and about $100 million in assets under management to larger firms with about 800 reps and around $1 billion in assets under management. Leeds says these b/ds are weighing their options, and although most of them are not yet in dire straits, the unrelenting down market could push them to make hasty marriages with his b/d or another.

Squeezed

Not surprisingly, research shows that many IBDs think that shrinking profit margins are the biggest threat to the sustainability of their businesses. According to a survey conducted by Cerulli Associates in the summer of 2008, before the current credit crisis really began to topple the market, at least 42 percent of the IBD firms ranked shrinking profit margins as the number one threat. (Another 21.4 percent of IBD respondents voted “Other”, which was followed by “advisor defections,” at 14.3 percent.) If margins were bad before, they are seriously hurting now. The S&P 500 fell 39 percent in the 12 months ending February 12, wiping out $4.5 trillion in market capitalization. That is a big blow for indie b/ds, which, on average, get 31 percent of their revenues from fees on assets, according to Cerulli data. Meanwhile, compliance costs have been skyrocketing: Leeds estimates they have more than doubled over the past five years and over the next five years he expects them to double again.

In fact, the recent squeeze on revenues and profits has even made it difficult for some indie b/ds to keep up with the SEC's net capital requirements. Independent b/ds must maintain a debt-to-liquid capital ratio of 15 to one. In addition, all b/ds are required to maintain absolute capital minimums, equal to either a set minimum based on firm type, or a number that is calculated on a monthly basis using measures of leverage, lending and margin — whichever number is higher. Basically, firms that do little more than place orders for clients must have an absolute minimum of $5,000 in liquid capital, while those that self-clear must hold a minimum of $250,000, with several interim levels set for those b/ds that accept checks from clients, accept securities and act as market makers.

In fact, so many small IBDs were in danger of falling afoul of the net capital rules at the end of the third quarter that Stephen Distante, president of the National Association of Independent Broker/Dealers (NAIBD) and CEO of Vanderbilt Securities in Melville, N.Y., says the NAIBD was in discussions with FINRA about how to keep these firms afloat. In the end, the market rebounded enough that these discussions were put on hold. But that may be temporary.

Adding to these business pressures, investor confidence has reached an all-time low. The Conference Board said its consumer confidence index tumbled to 37.7 in January, eclipsing the prior record low of 38.6 in December — the second straight monthly decline and the lowest confidence reading since the private research firm began tracking the data in 1967. What's more, if a b/d faces arbitrations as a result of customer complaints (which always seem to pile up in down markets) these can cost a minimum of $2,000 to $3,000 each. “It is going to make it very difficult for that under $50 million b/d unless they're really well capitalized to make it in this new environment,” says Papike.

Indie Scuttlebutt

Deal valuations in the independent space fluctuate widely. While buyers may pay as little as 30 percent of annual revenue, this multiple can get as high as 70 percent for firms that do a lot of managed money, says Tom Berthel, CEO and founder of Iowa-based independent b/d and RIA, Berthel Fisher. That said, if the smaller players are desperate enough to sell, buyers might find themselves looking at some nice discounts. “Valuations are down, probably depressed 30 percent to 40 percent,” says Berthel.

Will bigger firms be able to pass these deals up? That depends. Many of the bigger indie b/ds say they are already benefitting from the flow of advisors and assets to the independent b/ds from the Wall Street firms, whose reputations have been so damaged in the recent crisis. On the other hand, many of the big firms are themselves struggling with shrinking profits and rising costs, and with credit tight, it might be difficult for them to get financing. In the meantime, many firms are still digesting fourth quarter results, 2008 audits and arbitration rulings.

There are a number of ways these deals can get done. Buying the assets outright, as First Allied did with First Montauk, is one good way for an acquiring b/d to add scale without incurring the liabilities of the acquired b/d. This strategy was addressed in a white paper published by Securities America in October called, “Small Market Broker/Dealers — The New Reality,” that covers some of the challenges facing small IBDs today. Other options often considered, according to the paper, include affiliating with a larger organization as a branch office; a stock sale, where the acquirer purchases the assets and liabilities of the b/d; a wind down of the operation with a forgivable loan based on production; and a combination of an asset and a forgivable loan purchase.

Whatever shape they take, industry executives and analysts expect many deals in the coming months. “There is no question that people are out there looking right now,” says Berthel. “I have not seen it like this since 2001 to 2003.”

Small Fry, Big Stake

Of the 5,031 FINRA b/ds, 91 percent, or 4,601, are “small” firms while 215 are considered “medium” and 187 are “large.“ Below is a breakdown.

Headcount No. of B/Ds / % of Total
1-5 1,800 or 36 percent
6-10 1,000 or 20 percent
11-20 625 or 12 percent
21-50 439 or 9 percent
51-99 301 or 6 percent
100-150 436 or 9 percent
Source: FINRA


Broker/Dealer Revenue Breakdown by Channel, 2008

Source of Revenue Independent All Advisors
Commissions 60.4% 62.5%
Asset-Based Fees 30.8 30.9
Alternative Advisor Fees (e.g. hourly fees, fees for financial plans.) 1.3 1.1
Fees Charged to Advisors (ticket charges, etc.) 2.4 1.7
Other 5.1 3.8
Source: Cerulli Associates, Cerulli Associates-Financial Services Institute Joint Surveys


Greatest Business Threat For Broker/Dealers, By Channel, 2008

Threat IBD All broker/dealers
Shrinking Margins 42.9% 36.4%
Growth of Independent RIAs 7.1 22.7
Advisor Defections 14.3 13.6
Larger, Better Capitalized Competitors 7.1 9.1
Increased Compliance Scrutiny 7.1 4.5
Other 21.4 13.6
Source: Cerulli Associates, Cerulli Associates-Financial Institute Joint Surveys


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