#FA Success Ep 083: Switching To The Right Independent Broker-Dealer By Understanding Its Profit Centers With Jon Henschen

What You’ll Learn In This Podcast Episode

• An overview of Henschen & Associates and how they work. [4:30]
• How the independent broker-dealer recruiting model works. [6:51]
• The question that helps determine what makes an advisor and a broker-dealer a good fit. [17:31]
• A common misconception about RIA compliance. [27:06]
• Key factors to consider when evaluating a prospective independent broker-dealer. [31:00]
• Distinguishing characteristics between publicly-owned and privately-owned broker-dealers. [40:33]
• How broker-dealers make money. [47:25]
• How forgivable note deals work. [1:08:45]
• The dynamic for dual-registered reps and hybrids. [1:15:38]
• The differences in the dynamics between larger and smaller independent broker-dealers. [1:25:37]
• Jon’s thoughts on how the independent broker-dealer channel will play out over the next 5 – 10 years. [1:30:00]
• Advice for newer advisors coming into the industry today. [1:32:29]

Resources Featured In This Episode:

• Jon Henschen
• Henschen & Associates
• Are Broker-Dealers Drowning In Their Own Lowest Common Denominator Compliance Standards?
• Credibility Marketing: The New Challenge of Creating Your Own Expert Status Out of Thin Air by Charity Cason
• Jon Henschen on ThinkAdvisor
• Jon Henschen Podcast

Full Transcript: Switching to the Right Independent Broker-Dealer by Understanding its Profit Centers with Jon Henschen

Michael: Welcome, everyone. Welcome to the 83rd episode of the "Financial Advisor Success" podcast. My guest on today's podcast is Jon Henschen. Jon is the president of Henschen & Associates, a recruiting firm that specializes in helping advisors find and match themselves to the right independent broker-dealer when making a switch to a new platform. What's unique about Jon, though, is his willingness to be transparent in how broker-dealer recruiting really works in a segment of the industry that historically has thrived by keeping much of its compensation hidden with back-end commissions and markups.

In this episode, we talk in depth about the key factors to consider when evaluating a prospective independent broker-dealer. Why the ownership structure and whether the BD is publicly-owned or privately-owned and whether the private owner is an individual or a bank or an insurance company or a private equity firm is so important, the ways that certain broker-dealers specialize in certain types of reps, how forgivable loans work when advisors are recruited to a new independent broker-dealer, and the ways that broker-dealers have created profit centers above and beyond the payout grid, which is crucial for advisors to know so they don't unwittingly switch to a broker-dealer that may drive higher pass-through costs to their clients.

We also talk about how the independent broker-dealer recruiting model itself works. How recruiters are paid by broker-dealers to find new advisors to switch to them, what broker-dealers really spend upfront in order to attract advisors to make the switch, and how the dynamics differ when being recruited to a larger versus smaller independent broker-dealer.

And be certain to listen to the end, where Jon talks about the trends in independent broker-dealers that advisors should know when considering where to build their businesses in the long run. How the growth of the RIA channel and the fee-based business is impacting the broker-dealer model, and how different broker-dealers are taking very different positions on whether or how to support hybrid RIAs.

And so with that introduction, I hope you enjoy this episode of the "Financial Advisor Success" podcast with Jon Henschen.

Welcome, Jon Henschen, to the "Financial Advisor Success" podcast.

Jon: Thank you. It's great to be here.

Michael: I'm really excited about this podcast today because we are I think kind of kindred spirits of a certain philosophy that the industry could use a little more transparency. And you do this in a very particular way. I know you are a recruiter for independent broker-dealers. Like, not for any one. You are an independent recruiter of or for independent broker-dealers and just help that whole process of how advisors have to figure out the matchmaking of, "Here's my existing client base and my book of business and I want to switch broker-dealers and I'm not sure who to switch to based on what I do and who I serve and how I charge and what technology I use and all that." It's a very messy process for a lot of advisors. But you have, like me, this kind of philosophy around, "The industry could stand and be a little more transparent." And unfortunately, there are few areas that are more opaque, I think, than the broker-dealer model and how broker-dealers actually make money on their businesses.

And so I'm looking forward today to a discussion of just hopefully giving more insight and perspective about how all this stuff really works, how it works behind the scenes. Not because we're out to do a... this isn't meant to be a “gotcha” thing against broker-dealers. They're businesses, they provide a service, they're fully entitled to make money at what they do, but I find there's not always a healthy balance when you don't understand how they're making money, which means you can't pick the right platform for you because you have no idea if you're picking a platform that gives you reasonably priced services for what you're going to do for your clients or might really overcharge you for those services if you don't know how they charge in the first place and how they're making their money. And so it's kind of my goal for the podcast today is just unearthing a little bit of that perspective around how broker-dealers really work so you can pick the right one.

Jon: Sure.

Michael: So as a starting point, Jon, can you just tell us a little bit about Henschen & Associates, your business, and what you guys do?

Henschen & Associates and how They Work [4:30]

Jon: Yeah. Yeah, we are focused on the independent broker-dealer channel. We contract with currently at about 80 independent broker-dealers that we contract with. We were as high as 92 or so a few years ago, but there's fewer broker-dealers than there used to be, and so we've kind of pared that down now to around 80. But we are specialized where we help advisors who are at the crossroads, where they realize, "Hey, this broker-dealer isn't working out for me, for whatever reason, we need to find a new home. But there's a lot of firms out there, how do we know what would be the best firm for our particular needs and likes?" And so, we go through a research process with them of picking apart their business and having some open discussion topics. So it's our initial consultation call, which usually takes about a half hour to 45 minutes. It's more of a fact-gathering and getting-to-know-them [type call].

So once we have the information gathered, we need through that call, we go through a research process on our end with the objective of funneling down to two to four firms that best fit their profile and need. Because we realize reps like to have choices and they don't want to be pigeonholed. And so we give them some choices of firms we think that are best fit, and we talk about those firms. Then the firms they're interested in pursuing, we have those firms send their marketing material to the advisor and follow up on their end. And we're there as a resource from that point forward for the advisor. A lot of times they come to us with questions for perspective of, "The broker-dealer is telling us this, is this normal in the industry or is that unique to them?"

So we're oftentimes used as a objective sounding board because we're not married to anybody. We’re contracted with these firms, there's no cost to the rep for using our services, and the broker-dealers are more than happy to pay us a small stipend for referring quality reps that they know will be a fit for their particular model, and, just like they pay money for advertising and online ads and things like that, we’re comped out of their marketing budget. So when they use our services, it has no effect on what they get offered by the broker-dealer.

How the Independent Broker-Dealer Recruiting Model Works [6:51]

Michael: Interesting. That's a good note. They don't draw the dollars from the pool of money they're using to do rep payouts, they pull it from their marketing budgets. Their marketing and advertising budgets is, you know, "Hey, we can go sponsor a bunch of conferences or do a bunch of advertising or other things to reach prospective brokers that want to make a change, or we can use some of those dollars and pay independent recruiters like Henschen & Associates to do that matchmaking process."

Jon: Yeah. And sometimes advisors will think, "Well, would I get more upfront money if I didn't use you and went direct?" No, that's not the case. You'd be offered the same either way. As a matter of fact, broker-dealers earn forgivable note money nowadays. It's based on a matrix where they'll run their product mix, their profitability, and also they bring in things like compliance record. And so it's very cut and dry what they get offered. And whether they use me or not, it would be the same scenario as they enter that information into a matrix and it spits out a number.

Michael: Interesting. And out of curiosity, how do they set comp for independent recruiters like you then? Do they pay for introductions? Do they pay for reps that actually come over? Do they at least give you some kind of tiering, like, "Hey, if someone comes over with a half a million production, that's a better payment to the recruiter than someone that only comes over with $150,000 of GDC?" What does the system look like for them?

Jon: Yeah, we're comped off… we get a small percentage of the GDC, a total of 6%. You deal with the wirehouses and some of the larger BDs, they just pay 6% upfront on the trailing 12, but most of the firms will stagger it where you'll get about 3% of the trailing 12 upfront, and another 3% at the end of their first year.

Michael: Right, just to make sure they stick around and don't bounce, right? You've got to do a little bit of retention risk management on their end. Interesting. And, I'm just curious, is that standard across broker-dealers or is there a dynamic like when they're making...because I know across BDs, the ones that are recruiting more aggressively may have much higher forgivable notes and other things that they offer to reps to push their recruiting cycle. Do they vary in what they pay recruiters as well? Are there firms that say, "Hey, we're doing a big recruiting push so we're doing 8% offers for a while," or has the recruiter space just kind of standardized at a number that's common across the board?

Jon: It is 6% pretty much across the board. Occasionally, and I had a larger firm approach me recently saying, "Hey, any business you bring us till the end of the year, we're going to pay you 8% total." And I didn't ask for it, they offered it. Will it influence me? No. I like a level playing field, I only match up by if it's a fit or not. And frankly, I prefer it to be the same because I don't even have to think about that as something that would skew my opinion.

Michael: It's frankly kind of ironic to me that in... for all the different ways that the brokerage industry has historically tried to impact incentives with compensation, and I'm kind of amazed that their recruiting business has managed to get to such a standardized uniform number that's consistent across the board. I view that as a huge positive that when independent recruiters get paid out of marketing and not out of the rep pay and get a standard number, you can really get a healthy, objective consultant marketplace that just plays matchmaker to reps finding the best fit for wherever it is they're going. And obviously, the BD may recruit the rep harder to say yes if they really want to get the rep to switch over, but they're not distorting it at the recruiter level. I'm very happy to hear that, right?

Jon: Yeah, yeah. Largely, that's the case. It's rare I have anybody deviate from the total of 6%. They just vary how they split that up. As a matter of fact, most of the small and mid-sized BDs I deal with, my standard comp that I prefer, it's 2% upfront and 2% for two years, 2% override. And that's pretty digestible for smaller firms that don't have as deeper pockets.

Michael: Okay. And I'm sure we'll talk about this a little, but the dynamics of recruiting are very challenging and very different for some small to mid-sized broker-dealers because they just don't have the upfront dollars to do the same kinds of payments as some of the bigger ones do. They don't have access to the capital to do the cash, and it creates challenges for them and kind of a less even playing field for recruiting across the broker-dealer marketplace.

So for the 80-plus broker-dealers you work with, I mean, I know from the BD space – I forget what the exact number is from FINRA – there's something like 3,600 broker-dealers, but from a practical perspective, something like 80% or 90% of all registered reps work at roughly the top 50 or top 75. So I guess at the point of 80-something broker-dealers that you recruit for, you've got virtually everybody of any size is in the mix there? I mean, are there ones that just say, "Hey, Jon, sorry we don't work with independent recruiters," and so there's some of the top 50 that would bow out of this process with you, or is it just the list ends at about the top 80 because, by the time you get below that, they just don't have much capital, they're not doing much recruiting, they just aren't really in that game so it's kind of a moot point to go further down the line?

Jon: There's quite a few broker-dealers that fall in the category of… they're just...there's not much they bring to the table that interest me.

Michael: "I don't need to do the due diligence on you if I know you're never going to win a situation with someone I'm working with."

Jon: Yeah, I mean maybe your payouts are below normal, your expenses are above normal, your advisory administrative fees are above normal, and there's really no bells and whistles going on here. So why would I be interested? So I get approached a lot where firms will contact me wanting me to recruit to them, and I’ll say, "Well, send me over your marketing material, let me look through that. Include this particular information like your ticket charges, your payout grid, your advisory administrative fees. If you're working with alternative investments, a list of what products you work with there. So let me look over your material and I'll get back to you with questions."

And so I'll do the research. I'll go on the SEC website and look at their financials… if they're profitable or not, how much net capital do they have. And then I'll look on FINRA to see what's going on there, if there's problematic situations there. And for smaller BDs, I'll even scan and look at their reps' records and scan their reps on FINRA to see if they have a lot of reps with multiple marks on their record. So I go through my own due diligence and determination whether I'm interested. This last year I've cut some firms out, mostly concentrated in the east that are more stock jock-focused, that have a lot of problematic reps. And so I'm kind of phasing those out. There's far fewer of these stock churners today than there used to be. And thank God for that.

Michael: Yeah. I feel like that's part of the industry. The stockbroker model has been kind of dying for 20 years now, once the internet showed up and people could just buy them online. And we all shifted to mutual funds and managed money and all these other models. But I guess the flip side is it's amazing how long some broker-dealers have managed to remain stock jocks and keep going for a model that's been declining for 20 odd years now, that just... old businesses die hard I guess.

Jon: Well, FINRA hates that model. And so if you have that model, you're going to have FINRA camped out at your firm. I remember Newport Coast Securities out of Newport, California, and the president was sharing with me how FINRA had been auditing them for eight months. They were there for eight months.

Michael: Which at a small to mid-sized broker-dealer, I mean, that is just...that's staff-intensive. I mean, not even just the actual stress of having FINRA set up camp in your office, but just...

Jon: Well, they had a hard time just recruiting, yeah, because they were totally tied up. Yeah.

Michael: You're going to do due diligence visit, "This is FINRA's office. They live here, but no, no, no, it's okay," right?

Jon: Well, the regional FINRA office was just down the street from them, so they blamed it on that. So their answer to feeling like they're getting picked on because they were just down the street was to move their home office to New York City. And so – they got a new president – the president and the compliance head were based out of New York City, otherwise, everything else was still over at Newport Beach. And so they thought, "Hey, this will help us get lost in the forest of broker-dealers in New York City." And yeah, they ended up closing and selling, and their reps moved over to Madison Street Securities probably about two years after that.

Michael: Oh, man.

Jon: Yeah, they were dying from too much litigation.

Michael: Yeah. So when we get into, you know, call it the top 50, top 100 broker-dealers, which I know generally have moved away from that business, they are at least since the more modern models of mutual funds and managed accounts and the array of services modern broker-dealers provide today. So when you think about this from a matchmaking perspective, you said you're going through an intro call with an advisor or you're kind of picking apart their business, and you ask, "What's your GDC? What kinds of stuff do you use? Are you doing a bunch of annuities? Are you doing a bunch of managed money? Are you trading a bunch of funds?" When you think about how to then start making the introductions to particular broker-dealers and lining it up, what are the factors that drive it for you? What are the matchmaker matching criteria that tend to either make a broker-dealer a particularly good fit or another one a particularly bad fit?

The Question that Helps Determine what Makes an Advisor and a Broker-Dealer a Good Fit [17:31]

Jon: Yeah. Well, from the information we gather in our initial consultation call, that pretty much helps me to narrow down to what's a fit. And one of the open-ended questions we talk about is, "If you had a perfect world in a broker-dealer, how would that look to you? What are you looking for that your current broker-dealer isn't providing you that would put you in a better place?" And so that one question helps whittle down a lot of issues for what they like and dislike. And I also will get into details about, you know, "Do you have an aversion to insurance-owned broker-dealers or private equity-owned broker-dealers or bank broker-dealers, or what region of the country the firm is based in? Is any of that dogmatic for you? Let me know."

And I do a pretty broad range of types of broker-dealers as well. I don't want to have all the BDs having a focus on just the financial planning approach. I have some firms that are cachet broker-dealers that are really good with institutional business because you still have reps that are doing institutional, and I have some broker-dealers that have a lot of depth and breadth in the alternative investments and REITs and BDC arena. Reps that are still into the endowment model, even though that hasn't been working out too well over the last two years or so, but they still are believers.

And then advisors who have been very busy over the last two years with a big focus on the hybrid model and firms that are friendly to the hybrid approach, where they want to work with TD Ameritrade or Schwab or Fidelity. And that could be under the broker-dealer's RIA or it could be under their own RIA. Some reps want to work with TD but they don't want the hassle of having their own RIA. So, there's firms that will accommodate that. And then also if they're going to be heavily focused on fee-based, what about those expenses? And so there too we'll drill down and try to get them away from the firms that charge too much in those areas.

But here's the other dichotomy: Are you needing a firm that brings value-added things to the table or are you pretty self-sufficient? If you're self-sufficient, don't go to a firm that ultimately you're going to be paying for a lot of those bells and whistles they provide. But if you need those bells and whistles, we need to look at some of these value-added broker-dealers that have things like practice management, marketing help, you know, all those things that help them to grow their book. That technology varies from rep to rep. Your higher end reps tend to be more focused on technology than are reps that are doing say funds and annuities held direct, all they need is a consolidated client statement and they're content, whereas the advisors that are doing a lot of advisory and have higher end clients, they'll be more focused on technology.

Michael: So you raised to me some really interesting items there. The first is just, you said you start with this question around, "What is the ideal you would get from your broker-dealer that you're not getting now?" So aside from the obvious, "I wish my broker-dealer was less of a pain in the butt about compliance," which I feel like comes across in pretty much all broker-dealers everywhere, once you get beyond that, what kinds of things do people say? What are the typical pain points or searching points that someone puts on the table and says, "I just can't take ‘blank’ anymore, this is why I'm switching, so you've got to make sure my new broker-dealer is better at this?" What sorts of triggers are common?

Jon: Yeah, yeah. Actually, one that's been more common over the last year or so are reps that are offended at the compliance department in how they're treated during audits or when they get called by compliance, where compliance is just a bull in a china shop and the reps say, "I don't want to be here after the way I was treated." So they're not being treated very well by compliance departments. And so that's been a major one. But I get it, advisors oftentimes [get to] where they feel like they've just outgrown their firm – they feel like they're just not a fit anymore. I do get reps that are moving because they're in a compliance situation and their firm asked them to leave over it.

Michael: Okay.

Jon: Yeah, done. And those are becoming harder to place. Five years ago, placing somebody that had been suspended for a period of time was not a problem, but now suspensions are getting increasingly difficult to place if they have multiple marks, say three or more marks. So that's become a huge deal over the last year.

Michael: And that's part of FINRA cracking down on problematic rep recidivism and repeat offenses. I know there was the study that came out a few years ago that found this relatively small number of highly repeat offender-registered reps that tend to gravitate to a small number of firms that have been particularly open arms to them, and FINRA it seems is just trying to completely crack down on the repeat offenses.

Jon: They'll threaten broker-dealers and say, "Hey, you're above the industry average on your assessment report for reps with multiple marks, and so either you stop bringing on reps with multiple marks or get rid of some of them or we're going to make your life more difficult and audit you more frequently, and probably spend more time here," which is the last thing a broker-dealer wants to hear. To give you a perspective as far as a firm that's in good standing with FINRA, they'll be audited every other year. And then a firm that's not in good standing with FINRA, they'll be getting audited every year. And when FINRA does audit them, they might be there for a long period of time. So that's what firms want to avoid is getting more attention from FINRA. You want to be invisible with FINRA because it just means problems.

Michael: And I remain fascinated by the compliance dynamic in particular. I get that broker-dealers have a compliance oversight obligation. The fact that there are so many bad sales and transactions that happen out there is effectively why we need the compliance oversight that we do, but it struck me – and I still remember it from my days when I was on the BD side before I switched to the RIA channel – that there's this effect with BD compliance that I call the lowest common denominator problem. And it's that compliance departments – and it seems to get worse as the broker-dealer gets larger – the compliance departments always make rules for the lowest common denominator. So whatever the one biggest knucklehead in your entire broker-dealer organization could possibly do that screws something up and basically gets the chief compliance officer in trouble for failure to oversee, whatever the one biggest idiot in the organization can do, everybody is then subject to compliance rules based on that one lowest common denominator threshold.

And so we get this sort of perverse challenge that in theory, the larger the broker-dealer, the more efficient their economies of scale should be and the more efficient they should be at doing compliance. And in practice, at least what I hear, I'm curious if there's a different view, that in general, the larger the dealer, the more problematic compliance is because you get more distant, right? Like a small broker-dealer, that chief compliance officer might actually know virtually every rep. You get into a large BD, they don't know you, they don't know who's who, they just have to make rules for the lowest common denominator, because that's what keeps them from getting fired from the compliance department, and all of the good reps get dragged down to what the one worst rep either does or conceivably could do. Do you see that trend as well? Is that shifting or are we kind of stuck with it?

Jon: I think it's just the nature of larger broker-dealers. If you're an advisor who wants to put together a nice Ponzi scheme or do a outside business activity that isn't approved, it'd be much easier to get away with it for a longer period of time at a larger broker-dealer as you basically are getting lost in the forest of other advisors at that firm than at smaller firms. The only time I've heard firms catch reps at the early stage of Ponzi schemes were at small and mid-sized broker-dealers. With larger firms, it's usually been going on for a long time before it's uncovered.

Michael: And just to be clear, we're not literally advocating any podcast listeners to set up their Ponzi scheme shops based on the size of the broker-dealer. Just kind of pointing out the dynamic.

Jon: Your chances of getting away with it are better at a larger firm than at a smaller mid-sized because as you said, they know – just as clients should know – brokers should know their clients, broker-dealers should know their advisors. And it's harder for a larger broker-dealer to know and track their advisors well.

A Common Misconception About RIA Compliance [27:06]

Michael: I get asked a lot of questions about compliance in the broker-dealer versus the RIA side, and I think there's this prevailing view out there that compliance is just easier and less stringent and less painful on the RIA side than the broker-dealer side. And I think that's largely true in practice having lived on both sides, both channels myself and seen it for a lot of others. But it's not like RIA compliance is just easier and less stringent. Frankly, the standard is higher because the SEC scrutinizes some of the fiduciary obligations even more, but the difference is just the size of organization, right? Large RIAs might have $1 billion or few under management, 50 to 100 employees, and 1 or 2 or 3 dozen advisors at the most. And, that means a huge RIA is like a miniscule broker-dealer by comparison. Even the huge RIAs are not the size of mid-sized broker-dealers, much less large broker-dealers.

And so even as I look at it in a firm like ours, we're almost 60 employees at our RIA, but I've been there for 15 years, I've worked with our partners for 15 years, and so the nature of trust and depth with the compliance officer is very different when I'm a co-owner in the business and have worked with them for 15 years and they know what I do and what I don't do and my ability to know where the lines are on the regulatory end, versus if I was in a large firm and the person who has to oversee me has never met me, has no idea who I am, has no idea of my character because we've never worked together and is trying to write lowest-common-denominator compliance rules.

So I think there's a mistake sometimes that's made of, "RIA compliance is easier than broker-dealers’," versus what's more of just an organizational size effect that compliance in many ways is just easier to run at a smaller firm. If you're too small, you don't have the staff infrastructure and it gets a little harder again. But it's just easier to appropriately match the compliance to the advisor when you're not in a mega-firm environment. That's just what I see in practice in our advisor marketplace.

Jon: Yeah, one area with the RIA that's been kind of missing as far as checks and balances is with the smaller RIAs under $100 million who are audited by their state. I've known some RIAs that had been RIAs for 10 years and they were never audited. And there's some of these states that are just way understaffed for being able to accommodate doing the audits of the under $100 million advisors in their state.

Michael: Which I know to some extent now are starting to follow the custodians. I know regulators are looking a little bit more to the RIA custodians to say, "Well, what are your controls and oversights to make sure that people aren't doing illegal stuff on your platform?" Which I don't think was necessarily part of the business that custodian signed up for to say, "We have to do oversight on independent RIAs that we don't have compliance oversight into, but we hold the clients' money and we can see what's going in the accounts."  And when [the state] can't audit every small RIA, it seems like there is a little bit more focus now on, "Well, we can at least make sure the custodian has good anti-money laundering protocols and good oversight protocols in place to make sure inappropriate things aren't happening." So you even see custodians flag advisory fees that are unusually high as a percentage of the account. Normally, that would be an internal firm compliance function, but the custodians kind of feel an obligation or some pressure from the regulators to insert themselves a little into that process as well.

Key Factors to Consider when Evaluating a Prospective Independent Broker-Dealer [31:00]

So you noted a couple of other pieces of ways to distinguish amongst broker-dealers. I think that area is not commonly discussed. You raised, kind of, BD ownership. "As a rep that's changing, do you care if your broker-dealer is insurance-owned or bank-owned or private equity-owned?" And I think for a lot of advisors who've never been through that environment, the answer is, "Well, I don't know. Should I care?"

Jon: Well, I just ask them. I have my own opinions, but I just ask them because I don't want to mismatch where I didn't ask the question and they tell me, "Well, I don't want insurance BDs.” So I need to bring that out to see what their opinion is.

Michael: So can you give us any color to it, though? Aside from, "Hey, I came from the insurance world and I've got a chip on my shoulder about insurance BDs so I don't want to be there.” Aside from those scenarios, I mean, are there distinguishing characteristics about …. I can sort of come up with four or five different ways that BDs get owned. There's bank-owned, there's private equity-owned, there's insurance-owned, there's just privately-owned by some founder, including big ones like Commonwealth, and then there's public market-owned like LPL. So, how should we think about the ownership of the BD and whether or why or how that matters?

Jon: Well, I'll run through them. The insurance-owned, well, we have far fewer insurance BDs than we used to.

Michael: Well, a lot of them gotten sold off and pumped out over the past couple of years, NPC and Advisor Group and all those.

Jon: Yeah, they commonly talk about how there were a lot of these insurance companies that got burned on their variable annuities offering too rich living benefit on the variable annuities they offered, but really, what's been the plight of the insurance BDs has been the low interest rate environment has been brutal for insurance companies' books. And that's been for the last 10 years. And so back when interest rates were more attractive, we saw the '80s and '90s were the go-go years for insurance companies diversifying and buying broker-dealers or starting up broker-dealers, and now we're in consolidation where they're shedding and sticking to their core business, which is just insurance product. And now it's spreading over to the captive insurance BDs, as we saw with MetLife and now Signator.

So yeah, a big concern reps have now with insurance BDs is, "Is this firm going to be selling in the next couple years?" So there's an underlying fear that they may not be around. And so it's a big job for recruiting departments and insurance BDs to assure them that, "We're in here for the long haul, and this is why." So it's a sales job for them right now.

Michael: And the risk from the rep's end is just…. I mean, when Signator got spun out or NPH or the rest, it's not like the broker-dealers got shut down and suddenly you don't have a platform anymore, you just got sold and now you've got a different owner and you're going to find out what the solutions are.

Jon: Yeah. It brings out unknowns. Yeah, I mean, the downside to the insurance BDs used to be because there was product pressures but they really don't...they can't do that anymore. But they do... you talk about compliance that caters to the lowest denominator, and that's the epitome of insurance BDs. They are very much like that. And the ownership, the insurance company is always drilling down with the broker-dealer management to cut costs. I know the former head of NPC, he would – the more recent one, John Johnson – he would share with the recruiter there about how, at the conference, he's going to serve generic booze and home office should be really happy with him because he's saving money by serving generic booze at their conference. So yeah, they're always trying to dream up ways to cut corners and save money. And so that's another downside to the insurance BDs.

The private equity ownership, I have mixed feelings on. I've seen good examples of it like with Kestra, where when Madison Dearborn owned them, they invested $20 million into their technology. And their current owners, which is also a private equity firm… they're not going in there and slashing costs and doing all this financial engineering to flip them a short time later. And so the current ownership has been very supportive as well, and they've been maintaining a high-quality broker-dealer.

But I've seen some instances in the past like when Lovell Minnick owned First Allied. Within less than a month of owning them, they did layoffs, and they did two or three more layoffs after that. And they owned them for under two years and then sold them to Danny Schorsch. And during that period, less than 2 years they owned them, they went from 300 back office people to around 200. And a lot of the brain trust, which was what originally attracted reps to that firm, were gone. So they kind of just gutted the firm.

Michael: Right. Because when you come in and cut staff, it's not even just that you're cutting staff, which can reduce response times and make the queues longer for reaching the people you want in various departments, but you don't tend to cut the cheap entry-level people, you cut the expensive ones that have been there for a long time and as you said, and kill the brain trust in the process.

Jon: Yeah, they had a really good brain trust at that firm, and yeah, they just either left or were asked to leave. But as I said, after two years, that firm was kind of a shell of their former self. A lot of the advisors stayed, but as far as the things that attracted them to coming there, it was a much different story.

Michael: Right. And unfortunately, I think they're a good example of the way they bounced around, right? Because they went from Lovell Minnick to Schorsch, Schorsch had them for a limited time. Then, I'm trying to remember, they got sold to Cetera or tucked into Cetera when Schorsch also bought Cetera? They ended out with multiple corporate ownership changes in a relatively short period of time after what had been stability for a long time.

Jon: Yeah, before Lovell Minnick, they were owned by Advanced Equities, which was a private equity firm out of Chicago. Advanced Equities was kind of using First Allied as their piggy bank. And where most firms that are owned have a deep pocket parent, the parent company is a financial support and they funnel money into them for growth, it was the opposite with Advanced Equities. They were draining money from them.

Michael: But again, as you said, then there's the Kestra scenario where Madison Dearborn plowed money in, gave them dollars for tech, made the platform better, so it's just kind of a wild card. I guess realistically, what it comes down to is there's – and it's not always apparent upfront –  but there's private equity that basically buys for cash flow and tends to do a strip cost, hunker down and then try to flip it with better margins not long thereafter. And that doesn't tend to be as good from the end rep level in the support services you get. And then there's private equity that comes and says, "No, no, we view this as a growth story. We want to come in and buy and put money in and our goal is to make this much larger and more valuable because there's still a business profit interest." But they're much more interested in putting cash in to build the equity value as opposed to taking cash out as a business strategy with this BD asset they just bought known.

Jon: Yeah. Yeah, I mean, my issue with private equity is ultimately, they're into risk transfer, not ownership. So eventually, there's going to be a point where they either flip it to a new buyer or they go public and they bow out at that time once they make their money on the stock. So they're there for a season. A couple years, maybe five, but usually not much longer than that.

Michael: Right. So what about some of the other categories like bank-owned broker-dealers?

Jon: Yeah, bank-owned, very bureaucratic. Very slow, not rep-driven, typically very corporate. Kind of the same reason why reps want to leave wirehouses because they're very corporate, very bureaucratic, so they'll favor, say a regional firm like Jefferies or...what's that one out of St. Louis?

Michael: Sterne Agee?

Jon: Not Sterne Agee, the one out of St. Louis that has been doing quite well. As I said, it's not my niche. I don't do the regionals or wirehouse. I am focused on the independent. But yeah, they'll go from a wirehouse to a regional or perhaps go RIA or independent. I will say that there's been more activity recently with the wirehouse going independent than say over the last few years. But since about 2012 or so, the wirehouse activity to independent has been mostly concentrated to just a couple firms like LPL, Raymond James, maybe Voya, three of them. They look for name branding, and so they'll tend to gravitate too. And they also look for a lot of upfront money because that's their nature. I have a lot of firms that are small, that have wirehouse reps, but these are reps that joined them back in the '90s and the '80s, not more recently.

Distinctions Between Publicly-Owned and Privately-Owned Broker-Dealers [40:33]

Michael: Okay. And then, how do you think about public-owned versus private-owned? I feel like the quintessential is sort of Commonwealth being this giant privately-owned firm versus a company like LPL that's publicly-owned on the public markets.

Jon: I like privately-owned I think is the ideal. My issue with publicly-owned is there's another mouth to feed, which is the shareholder. So by nature they're… granted, they're going to have scale, but a lot of those benefits to scale go to the shareholder. And the first person they want to please is the shareholder, and the advisor comes after that. And so I tend to find the wirehouse – or not the wirehouse, but the publicly traded like LPL – they'll give more forgivable note money but their service level is worse. And, you know, since they went public, they were dealing with a lot of litigation. A lot of their profits went to litigation and paying FINRA fines, and a couple years ago, it was getting very bad in that regard. They kind of have bounced back from that and the litigation has diminished quite a bit.

But here again, as you know with larger broker-dealers, they'll often boast, "Well, we have deep pockets." It's like, "Well, good, you're going to need them because on a proportional basis, you pay much more in fines and reps get away with things for a longer period of time because you just don't know them and have a harder time keeping track of them because you have so many reps."

Michael: And I guess the caveat on the privately-owned if you want to gravitate that way is just privately-owned at the end of the day becomes at least potentially reliant on what is the ownership succession plan of the founder who's got all these dollars tied up? Like Cadaret Grant was private forever until Mr. Grant sold it, and now it's private equity-owned by Atria. So we'll see whether that's the good version of the private equity growth story like Kestra or the more problematic version of the private equity. But I guess your risk… or at least your question on privately-owned is, what ultimately is going to be the exit strategy of the owner/founder, or at least over what time horizon so you can understand like, "Could this business have a change in ownership and liquidity event that I may or may not be happy with?"

Jon: Yeah. And that's the sales job for the privately-owned is, you know, do they have a solid succession plan? Does it look like they're... if the story is flaky, the chances of them selling out to somebody go up quite a bit. Frankly, a lot of the sales for those firms that were vulnerable to selling, I think a lot of them did back like when Schorsch was offering unusually high amounts to buy broker-dealers.

Michael: So anybody that wanted their liquidity moment, that was kind of the peak of the market right there?

Jon: Yeah, it was a peak of the market. I think for Cetera, he paid 100% of trailing 12 revenue. And so that's when stupid amounts of money...I mean, it used to be 40% of trailing 12. I remember when Multi-Financial sold to ING and the Diachok family, they were thrilled, they got 40%. And those were great numbers back then. Some firms were selling for around 30%. So 40% was good, but then Schorsch came along and the numbers went up as high as 100% of trailing 12. And actually, I think probably the highest I saw was when Blucora bought HD Vest and their...I think it was 200% but part of that was stock. So I think that was probably the richest deal I saw was Blucora buying HD Vest.

Michael: Oh, boy, I know Blucora had some unique strategic value because HD Vest historically was a very tax-centric broker-dealer, CPA-oriented broker-dealer. And Blucora actually owns as well, I think it's TaxAct, the tax software.

Jon: Yeah, the online tax service. Yeah.

Michael: Yeah. So you can kind of envision this like, "I know what's coming. Blucora is going to start putting recommendations in TaxAct, 'If you need an advisor, talk to one of our HD Vest advisors. There are CPAs who do financial advising.'" And, "Yeah, I get why there was probably a strategic value premium on that one in particular."

But those numbers, though, still are just fascinating to me that Schorsch was a peak of the market paying 100% of trailing 12. Deals used to be 40%. I think the NPH deal to LPL was in the middle. It was something like 70% of trailing revenue if they hit their retention bonus target. But I contrast that with the RIA space where you're seeing RIA firms getting sold for... a low-end RIA deal gets sold for one and a half times revenue. A lot of them get done for 2X, and some of the larger ones with scale get sold for even more. So I don't know if you have any perspective. How do we end out with this monster gap that RIAs can get sold for 2X revenue or more and BDs are getting sold as low as 0.4 and maybe a good deal is 0.7?

Jon: Well, yeah, good question.

Michael: Is it just a function of the marketplace. The investor dollars voting with their feet to say, "No, no, this is recurring revenue?"

Jon: Well, I think the difference is that the RIA owns that book, the broker-dealer doesn't own these books. They're just caretakers of books. So that's the difference.

Michael: So the BD isn't actually getting sold for the revenue per se, they're getting sold on the fact that they're a revenue intermediary, which means that they get a slice of that revenue until and unless a rep decides to leave and then they don't. And they're not very captive because they're generally independent contractors and not employees since, and the rep can pull the client with them and it just limits their business value?

Jon: Yeah, I think the fact that they don't actually own the books is what drives the price down.

Michael: So you talked about the other part of this, the matchmaking process is around, "Are you doing more mutual fund products? Are you doing more fee-based business? Are you deeper in alts?" And I know some of that is just product...just sheer product lineup. If you like doing lots of SMAs it would be nice to be at a broker-dealer that has a good variety of SMAs on the shelf, on the platform for you. But I know some of this is a cost dynamic as well. As you said, some firms charge more and you want to minimize exposure to firms that charge too much in those areas.

How Broker-Dealers Make Money [47:25]

So I'm wondering… I feel like this is a good time maybe to just talk about the mechanics of how stuff is priced at broker-dealers. Which I guess basically is another way of saying like how broker-dealers make their money. Most of us know the obvious one, which is there's some gross dealer concession. I get paid a percentage of that as a payout, so the broker-dealer keeps the slice of my revenue for providing the platform. And that's how it works. But there are other ways that broker-dealers either make money as a broker-dealer, which means impact cost to the advisor or the end client besides just that rep payout percentage. It's the one we focus on the most, but isn't the only one in the mix.

So can you talk a little bit about how else do broker-dealers make money and what should advisors be watching out for? Again, not because we're trying to play "gotcha" that broker-dealer shouldn't be entitled to make money, but just, you should know how they're making money off of you because that may impact some of the decisions about who you work with or what solutions you use at the platform level.

Jon: Yeah, it's interesting because a lot of reps think, "Well, the grid, the 10% I'm giving up to the broker-dealer, that's where they make their money." And it's like, "No." I had one rep term it as, for a rep, the pie is 100%, but for broker-dealers, the pie is 120%. And there's some truth to that. Besides the payout grid, they have many other profit centers. For example, mutual funds and variable annuities, broker-dealers will negotiate with vendors to earn basis points on assets or sales of products their reps sell.

Michael: Basically, overrides, or… extra payments that don't hit the grid.

Jon: Yeah. Broker-dealers typically make 1 to 10 basis points on either assets or sales of products, with small firms making only 1 to 2 basis points, and larger firms making 8 or more basis points because they could leverage for more because of their scale. But larger firms have ability to make these basis points on both assets and sales as they leverage their scale to obtain more.

Michael: That's across investment to managed accounts? So that's specifically in the annuity space.

Jon: This is for mutual funds and variable annuities I'm speaking.

Michael: Okay.

Jon: And then on REITs and alternative investments, broker-dealers are in between 1% and 1.5% extra in commissions on the products their reps sell, which is a huge profit center. And then they also get a marketing reallowance on top of that. Like that 1 to 10 basis points that we mentioned, it's probably more in the 5 to 10.

Michael: So I see what you mean. These costs, like, they're baked into the products. It is what it is, it's not like...

Jon: These are invisible to the rep and they have no say in it basically. Yeah.

Michael: Right. But it kind of illustrates the point that at the rep level, we get... there's 100% of our GDC, and then we get some payout and the broker-dealer keeps the rest, but the broker-dealer's pie really is more like 110%, 120%. So if I take a mutual fund as an example, a sizable BD… I do a load-waived A-share for sizable client, there's a 25 basis point 12b-1 fee. I'm going to get my 12b-1 fee minus the payout. So 25 bips is paid, maybe I get 20 to 22 of them depending on what my payout level is. But, in addition to the fact that the BD is getting 3 to 5 basis points off the payout grid from me, they could be getting 3, 5, 7, 10 bips more on the back end directly from the company, and I'm not participating in that payout ratio.

Jon: They can be getting another eight basis points on the assets and the mutual fund or variable annuity and another eight basis points on the sale. And then on a REIT sale, you might have been paid a 6% commission and a broker-dealer made another 1% commission off the assets you had bought.

Michael: So the truth for a lot of the companies at the company level –  like the product manufacturers – is their budget for call it commissions compensation and distribution is larger than what we necessarily see at the advisor level, at the rep level. There's a carving up process that happens of what goes directly to the BD versus what goes down to the rep and even hits the grid in the first place, and then we fight about the payouts at the grid level.

So part of the effect of that then is… you can start to imagine how this plays out. I go to broker-dealer number one that says, "We'll give you a 90% payout on your non-traded REITs and BDCs," and the other one says, "No, no, no, we only give you an 80% payout." But the problem is the firm that gives you a 90% payout is only putting 5% commission on the table because they took the other 2 on the back end, and the firm that's paying 80% is putting 6% or 6.5% on the table because they don't take a big back-end.

Jon: Well, no. Actually, the broker-dealer is paying the full commission that the rep is offering. It's just they pay an additional invisible commission amount of 1% to 1.5% to the broker-dealer. That's just figured in as additional revenue, and it's basically an encouragement for the broker-dealer to sell their product.

Another big expense for the BDs are broker-dealer conferences, where the product vendors spend a lot of money on being sponsored and having speaking engagements at their conferences. And that's another very large expense for the BDs. And the alternative investment REIT companies have been having a lion's share of presence at a lot of the broker-dealer conferences over the... not as much recently, but over the last say five years, they were the main ones spending money on these broker-dealer conferences where the fund companies and VA companies had kind of pulled back and were cutting their expenses.

Michael: So will you actually see differences on products across broker-dealers because they negotiate these things differently? "We give higher payouts, but we're also taking more on the back end." Or, "We give higher payouts across our product mix, but the BDCs and REITs, we actually give you lower commissions than anyone else because we're taking a bigger chunk of it on that end. We give a full payout on this, but….”

Jon: No, the commissions don't vary in the independent channel. The amount the rep gets paid doesn't vary. It's just the payouts could vary. The main thing with a rep that does a lot of REITs and alts is some firms offer a lot more product in that area than others. There's quite a few firms over the last couple years that have pulled back their selection in those areas because they want to avoid the risk and the potential litigation with those products. There's been a lot of litigation with REITs and TICs because they were repriced at lower prices and clients didn't get what they had anticipated out of it. So securities attorneys concentrated in those areas.

Michael: So if the commission rates are all set and standardized across the firms then does it change my decision to know or find out what else the firms are getting or negotiating on the back end or is it at the end of the day like, "Hey, the commissions are standardized across the products so I can really just look at what my payout grid is." And it may or may not bother me to know how much my BD is getting on the back end as well, but it doesn't change the net dollar to me no matter what BD I choose. I can just look at, "What's the payout rate?" Because the commission structure is going to be standardized across all of them, and if you're big and negotiate more on the back end, bully to you.

Jon: Yeah, for the alts and REITs arena, at least, yeah, the commissions are the same. They're going to be more focused on the selection of product that the firm has to offer. It will be the... and also potentially, ability to add product. And there again, your larger firms, much harder to get product added, small and mid-sized firms, much easier to get product added.

Yeah, I mean, the other areas of profit centers, you have ticket charges, you know, the net cost to a broker-dealer is probably in the $7 to $9 range, and then they mark that up to $15 to $20 typically. So that's been a long-standing profit center for broker-dealers. Money markets, that used to account for a larger part of broker-dealer's overall, but since money market rates have been so low, that's been...you know, broker-dealers would love to see interest rates go up. Let me put it that way.

Michael: You can't make a margin on a money market when current rates minus your expense ratio would take the yield to zero or negative. I guess that's the good news of even the rate increases that we've had already from the Fed in this cycle is at least now there's a little bit of room for broker-dealers, custodians and the rest to start actually generating some additional revenue from their money market funds in a way that they haven't been able to do for the better part of 10 years now.

Jon: Yeah, exactly. And then the other area that I've mentioned in the advisory arena, their markups on administration fees on rep-directed advisory platforms like an unbundled account where the administration fee pays for billing and performance reporting, their net costs, say at NFS is 3, 4 basis points, and they mark it up to 15 to 25 basis points for their profit center. And if you're in an all-inclusive account where ticket charges are covered as well as the billing and performance reporting, those tend to run about 25 to 40 basis points, and there the net cost to the broker-dealer is perhaps around 10 to 15 basis points. So yeah, those are sacred cows for the broker-dealer.

And it's interesting because this year, one of the phenomena was broker-dealers lowering the – on advisory accounts – lowering the ticket charges to their net costs in anticipation of DOL rules. And so they were only charging $7, $8 ticket charge in the advisory accounts. And so they lost that profit center. So to make it up, they were raising the administration fees by about five basis points, which was typical. So I had one larger broker-dealer that charged...their starting point on the administration fees was 20 basis points, now they're charging 25. So it's kind of a profit center shell game, "Oh, we've got to take away from here, well, we'll add over here." In the long-run, we're at a break-even. But for reps that are not active traders, that administration fee cost them more than if they had to pay the higher ticket charge since they're not doing active trading. So yeah, it's a lose situation for some of the reps with that higher administration fee.

Michael: Yeah. And now it starts to get clearer about what the matchmaking process looks like from these questions about, "What stuff do you use and what's your revenue mix?" So if you're doing mostly direct mutual fund business and variable annuities, go ahead and choose a BD with a 25 basis point administrative fee on their advisory accounts, you're not doing advisory accounts, you can let other advisors pay that fee and just focus on this piece. If you're doing a lot of alts then make sure you've got a good product selection.

If you're doing a bunch of managed money and advisory accounts, now you care about the administration fee a whole lot, but then there's still a question of, "Well, are you a DFA-style buy-and-hold advisory account, in which case you might find a platform with the lower administration fee and a higher ticket charge because you don't actually care about the ticket charge since you're not going to trade much?" Or if you're a rep that actually does a lot more active trading and you've got your own strategies that you're running then you might care a whole lot more about those ticket charges and balancing them out with the administrative fee that the platform is charging.

Jon: That brings up another point is from the broker-dealer's perspective: what's a fit for them? I can go to a firm like Commonwealth, for instance, and they like reps who are doing about $250,000 or more. They don't like reps that have a lot of variable annuity business. If they're, say over 25% variable annuities, they'll say, "Yeah, that's not a fit for us." "Oh, and they do fixed index annuities as well." "Yeah, we don't like that product. We're not interested."

They like the reps doing a lot of fee-based, maybe a few alternative investments with a lot of brokerage accounts at NFS. That's very profitable for them. And they've been around a long time. They have very high average production per rep, and I guess they can afford to be that picky. But they are picky. And as a matter of fact, they have to like the rep. They even have a like factor. If they don't like the person and they rub them the wrong way, they'll just say no. But a growing trend we've seen over the last year are firms increasingly hostile towards reps that have direct fund and annuity business because that's less profitable for broker-dealers than if those assets were held in brokerage accounts.

Michael: Because if it's held in brokerage, there's a sub-transfer agent fee that's getting paid that the broker-dealer can get a piece of?

Jon: Well, that, and they make money on the.... There's charges. With mutual funds in a brokerage account, there's charges for systematic withdrawals and deposit, dollar cost averaging. They charge for IRA custodial fees, inactive account fees. So there's just many more opportunities for the broker-dealer to make profits off brokerage account business than if it's held direct where they don't make anything off of it. They don't miss out on all those gouging opportunities I guess I could put it. But yeah, so there's a lot of firms now focused on wanting reps that have brokerage account business because it's more profitable for them.

It's like Kestra, for instance. They've been...yeah, they have a wealth platform geared towards wirehouse reps. And they like the wirehouse advisors because they have all brokerage account business. And that's very attractive to them. And they typically do quite a bit of fee-based, which is very profitable. And one thing they're not interested in are advisors that have a lot of direct fund and annuity business held away with very few brokerage accounts. That's not of much interest to them. So there's BDs that will accommodate that, but there's also broker-dealers that aren't interested in that model.

That used to be a very common model, but there's fewer places that are friendly to that model nowadays, even though in some respects, you take a client with $100,000 invested in an advisory versus mutual funds with just 25 basis points. I've known a lot of advisors with that mutual fund model showing the growth over 10 years and it came out quite a bit ahead of the advisory model. But nonetheless, our industry seems to be embracing the advisory model.

Michael: So, it starts to become more and more clear about what the challenges around this matchmaking dynamic now that there's a piece here that's just, "What are your pain points in your broker-dealer? What do you not like about your current one that you would rather find in a different one?" There's questions around how the BD is owned and what that implies about their long-term trajectory. There's a lot around just, "Where do they make their money? Or is this a BD that mostly makes its money on annuities and funds or the override on alts? Or are they ticket charge-based? Or are they more about their markups on their administration fees?"

So that you can match the nature of the business that you do to whatever it is that... well, I guess ideally, you kind of want to...you want to not match their maximal profit centers where they're trying to make the most money. Let them make the high margin on other reps. You want to pick the one that has the least cost in that area. But with dozens and dozens and dozens of broker-dealers, it's hard to keep track of which is which and who's hiring what type and which ones like wirehouse reps and which ones like high production and which ones like managed money and which ones like reps doing alts, which is essentially where the independent recruiter marketplace comes in is, "We'll help you do that matchmaking and figure it out."

Jon: Well, yeah, where the advisor will be in good company. You don't want to be the odd man out, where you're the only guy, your broker-dealer, with this particular business model, because they could come to pass a year later or so where the firm says, "Yeah, you're just not a fit for how our other reps are doing business, so why don't you find a new home."

Another factor too is, are you the only rep at your broker-dealer in your state? Because I've had reps in New York, for instance, where broker-dealers only had a couple reps in New York and they decided, "You know, New York City is a huge pain in the keister, we're going to pull out of here." And they call the reps and say, "Go find a new home, we don't want to be in New York anymore." So yeah, there's a downside to being the only rep in your state or just a handful of reps in your state.

Another thing I do quite a bit of is succession planning help, where advisors will call me and say, "Hey, I'm the only rep in my state with my broker-dealer," or, "We only have a couple others, and I'm 60 years old, I need a junior rep to come in. And they're not helping me or have anybody else in my area." So I hook them up with a broker-dealer which is rich with advisors and choices for succession plans in their geography so that when they do decide to retire, there's somebody to take over their book.

Michael: So you're not necessarily going out to recruit a junior advisor to be their successor, you are helping them move to a broker-dealer that has a deeper pool of succession opportunities based on the size of the BD, the ages of the reps at the BD, the geographic dispersion to make sure there are reps in the area that you could potentially merge into or sell into as a way to facilitate the succession plan or at least up the odds, you get a good succession plan.

Jon: Exactly. Yep.

Michael: Okay. And so how else does kind of the marketplace get carved up when you're either trying to differentiate broker-dealers or try to differentiate yourself as a rep finding a broker-dealer? Like, you mentioned at least Commonwealth just targets reps at a certain level of GDC, like, that's a clearing threshold for them. So how much does production level matter in the first place, and are there certain inflection points? "If you're above this number, here are the things you should be looking at. If you're below this number, here's the stuff you're going to have to deal with."

Jon: Yeah, some firms are friendly to the advisors under $200,000 because there's a lot of firms where if you're under $200,000, you're looked upon as a marginal producer. So, there's a large segment of our industry that's in the $100,000 to $200,000 production range. So there are firms that are friendly to that segment. If you are $1 million-plus producer, there's firms where you can leverage more out of some of these firms where you might have firms that cap out at 90%, but I have some firms where if you're at $1 million of production, you can get a 96% payout. If you have a lot of advisory assets, some of these firms base the amount of administration fee on how much you have in overall advisory assets. So if you have $100 million or $200 million of advisory assets, you can get your advisory administrative fees down quite a bit.

Michael: So that actually raises an interesting question since we talked about all these different profit center areas, some of which hit the grid, some don't, some which are paid by the advisor and some not. What pieces are actually realistically negotiable, right? I'm not going to renegotiate the 1 to 10 basis points they get on mutual funds in the back end because I don't participate in that anyways. I can't renegotiate their money market fund rates because they are what they are. Is it ticket charges and fee-based administration fees the primary areas I get to negotiate or are there other things as well?

Jon: Yeah, possibly payout. Yeah, the main areas that have potential for negotiation is that some firms not at all, other firms possibly. But payout is possibly negotiable, advisory administrative fees and ticket charges. Those are probably the main ones there. And also forgivable note money is also a negotiable point.

How Forgivable Note Deals Work [1:08:45]

Michael: So can you explain just that whole system and how it works? If you change BDs once, you've gone through the forgivable note world, and if you haven't, you haven't. So can you explain that whole system? What's the forgivable note deal? How does this work?

Jon: Yeah, it's money they give you upfront when you join the firm. It's a forgivable note and it's typically for a five-year period. Some of the larger notes may go for seven, but we'll go with the five-year note period. And so if you join a firm, let's say you're a $1 million producer, they're going to offer you say a 30% forgivable note. You'll $300,000 upfront. It used to be they would have production tied to those notes, but over the last year and a half, a lot of firms have gotten rid of that policy because FINRA frowned on that because they perceive that as a potential conflict of interest.

Michael: Well, and DOL took a really...DOL fiduciary before it went away took a really big swipe at production requirements tied to forgivable notes, at least for the IRA portion of the business that they had scope of.

Jon: Yeah. So there were multiple reasons why they grudgingly got rid of that. No, I'll tell you, it was really grudgingly that they did it. There's actually still a few firms that still have it. I believe last I knew Cambridge still had it. And I was kind of surprised at that. Yeah. So now they're just based on time. So you stick around for five years. If you leave after two and a half years, you're going to owe half that note money back. And so at the end of five years, you're free and clear. You don't owe anything back.

So yeah, the note amounts. I mean, the normal amount for firms that offer forgivable notes is in the 10% to 20% range. There's some firms that'll pay in the 20% to 40% range. Then there's Ameriprise and Wells Fargo FiNet and such, where you can get up into 100% range with those firms, 100%, 80% to 100% of trailing 12. And there again, it's dependent on… you need to have a lot of advisory business to get those higher amounts. If you're more transactional and doing transactional stock and bond business and funds and annuities, you won't get those higher amounts. Say at FiNet where you would cap out at a max of 110%, a transactional book may only get say 60% or 70%.

Michael: And what's going on in the dynamics that most BDs are paying 10% or 20% and some larger ones are paying 20% to 40%, oh, except FiNet and Ameriprise that are going up to 100%? That just feels so drastically different. Is that because it's just only eligible to a really narrow range of reps that most others and most won't qualify it or is this like because they make money in other ways and they're paying you more upfront but they're going to make more on the back end because the math has to work? How do you get that big of a disparity?

Jon: More profit centers.

Michael: Okay.

Jon: Yeah, everything has to be in a brokerage account. On third-party managers you owe bigger markups on the management fees, on the advisory platforms you typically pay higher amounts. I know at Ameriprise, the administration fees on their advisory platforms are high – 25 basis points-plus. So yeah, there's no free lunch, as Milton Friedman would say. And if you're offered something, is it too good to be true? Well, if you're being offered substantially more than the industry average, they're going to make it up somewhere. And it may be something you see, it may be something you don't see, but it'll be made up for.

Yeah, some firms are just being more aggressive. LPL recently was doing 50 basis points on assets, which was unusually high. And to pay on basis points rather than production was also unusual because advisory it makes sense, but to pay basis points on commission business, which can be dead money, like a variable annuity, it just doesn't make sense to have that type of pricing. But yeah, it's just some are more aggressive than others. I would think for the LPL advisor – they're spending all this money to bring new blood in, but they're not doing much to keep the people that are already there happy, I would think that that would be an issue for them.

Michael: Well, and I know that's always been the challenge for broker-dealers going through growth. I mean, I don't envy the position that BDs are in. From the business perspective, if you're not growing, you don't have room to give people new opportunities, which makes it harder to attract good home office staff. You're not getting higher economies of scale that give your business model more efficiencies or give you better bargaining and negotiating power. But the moment you start putting resources towards growth then all of the existing reps say, "What about reinvesting into existing systems? Why do you keep having to put all the money towards growth?" And you're kind of stuck between a rock and a hard place. Some managing that better than others.

Jon: Well, I think, Commonwealth is a good example of a firm that's more focused on organic growth. And they do recruit but they're very particular when they bring in. And if recruiting slows down, they don't panic, they just stay the course. And that's one thing I like about private-owned broker-dealers is they could think long-term and they're less reactive, versus say an LPL, they have a bad quarter and they flinch and make all these policy changes to accommodate what they just made a big FINRA fine on. And oh, yeah, they're more reactive, and the publicly traded broker-dealers think short term.

Michael: Yeah. And I'll say public market scrutiny. They're taking calls from analysts on Wall Street, they're trying to explain their profits for the quarters and what they're doing to turn it around. And just, there is the pressure.

Jon: Yeah. So instead of thinking five years out, they're thinking one quarter out. And, "How do we please the shareholders this next quarter?"

Michael: All right. And just one other question on forgivable notes: How does tax treatment work for them? Is this income when I get my $300,000 upfront as a $1 million producer? Do I pay the taxes as the note is forgiven and is vested over time or is this just non-taxable loan money? How does it work?

Jon: It's typically spread out over the five years.

Michael: Okay, so I don't get taxed on the $300k, I get taxed on the whatever, $60k a year as it gets forgiven to me, and that's when it officially vests, so that's when it's income that I've got to pay taxes on. All right, so at least I get to amortize my tax impact a little bit.

The Dynamic for Dual-Registered Reps and Hybrids [1:15:38]

So can you talk to us a little bit about the dynamic for dual registered reps and hybrids? I feel like this is an area that just has become a huge focus over the past 10 years. We didn't see very many hybrid reps until FPA won their lawsuit against the SEC and got the broker-dealer exemption struck down for fee-based accounts. And all of a sudden if you were going to do all this advisory work, you really had to be under an RIA. And off went the hybrid movement starting in 2008, a year after the lawsuit. And I think I've seen one stat that something like 80% or 90% of the reps in the top 50 broker-dealers were hybrids or had a hybrid option or something. This astonishingly high number of dual registrants now, obviously to varying degrees about how much they use it, but it's out there.

Jon: Well, that term hybrid, I think it's misused. You can have a firm like Raymond James and Commonwealth will say they're hybrid, which is true in the sense that they let advisors have their own RIA. And there's a lot of reps that have their own RIA for say doing financial plan work. And so they do that on their own, the BD doesn't have involvement when they have their own RIA. There's no haircut on that, although some firms have started to do that as well for-profit centers.

But in my mind, a true hybrid is: you can not only have your own RIA, but you can custody those assets away from the broker-dealer at say Schwab or TD or Fidelity IWS, but like at Commonwealth and Raymond James, you have to custody those assets in their clearing, in Raymond James clearing or at NFS because that's where their profit centers are. They don't want those assets held away at Schwab or TD because that's less profitable for them. So in my mind, a full hybrid model is one where you can not only have your own RIA, but you have the option of custodying those assets away if you choose as well. And there's far fewer firms nowadays that are open to that than there used to be.

Michael: And now they don't allow it just because it grew too well, there's too much money, they're not getting a piece of now, so they need the profit center and they're trying to pull it back in? Is it that simple?

Jon: It's that simple. Yeah, I mean, there's firms like Cambridge which basically got their start as being the hybrid-friendly broker-dealer but they more and more are focusing on encouraging reps holding those assets away less in that direction and more in advisors holding their assets in their proprietary advisory platforms because it's so much more profitable for the broker-dealer. And they'll offer some freebies like, "If you have X amount of assets in our internally managed platform, you'll get free Albridge." They'll throw Albridge at them for free as an enticement to have those assets in their bigger profit center.

And then some of the...what I couldn't make sense of because it doesn't happen all the time, it's kind of hit and miss, for some reps that would hold their assets away at say Schwab or TD, you get some reps who would have a platform fee charged of like 10 basis points. And well, what's the BD doing for that? Nothing. They're just doing that because they want to make up the profit loss that they are missing out on with those assets being held away versus held with them.

Michael: Is there a niche forming for broker-dealers that are actually willing to stand up and say, "I'll just take the BD business, y’all can do whatever you want with the outside RIA business. We're not trying to make that a profit center. In fact, we'll welcome the people that want to keep that separation?"

Jon: Yeah, there's that niche of firms that are friendly to that, and then there's another handful of broker-dealers that pay 100% on the RIA side. They don't take any haircut on that, they only take a haircut on the commission side. There's only about six or seven firms that have that model. PKS is probably the largest. They have around...I think they're at about 1,300, 1,400 now. They've grown quite quickly, and they have a nice referral source of attorneys that refer reps to them. But yeah, they'll pay 100% on any of the RIA business.

Michael: Because they've got other profit centers? Because they're...

Jon: Well, yeah, they just make money on the commission side.

Michael: Okay.

Jon: Yeah. I mean, the downside with that model is: you have a rep with $200 million in advisory and maybe $200,000 of commission business, which is decreasing as time goes on. It's just maybe some trails, and they may do an occasional REIT or mutual fund for a smaller client, but it's definitely kind of the afterthought of their overall book. Their main focus is the fee-based. But the problem with that model is the broker-dealer is basically getting the crumbs of the rep's overall production. They're not making anything off the main thrust of their focus, which is advisory.

Michael: Well, the industry shift to fee-based is sort of... it seems like this inevitable shift at this point and more and more money flows that way over time, but it just fundamentally doesn't fit the traditional broker-dealer business model. And it seems like they're all still struggling in their own various ways to figure out how to contend with that. You can say you're supportive to reps that do lots of fee-based or have an outside RIA but the problem is the reps that are doing that tend to be focused on just gathering assets and building their RIA bigger. The commission-based business tends to either be stable, low volume, or just run off trails.

So I guess as the BD, you can make some money on that for some period of time, but when your organic growth rate is going to be zero or negative on all of that business on the core commission business, this is not good for you in the long run. So they've tried to shift over to all of these administrative fees on advisory accounts. And I get it, they've got to make their money somehow, but then I see more and more reps that are mostly advisory that are paying these 15, 20, 25 basis point fees to brokerage platforms. And at some point, they say, "I can just go direct to an RIA custodian and pay zero. I mean, I've got to go buy my own billing and portfolio performance reporting software, but if I'm large enough, most of that software is charged on a fixed dollar basis, not a basis point basis. So if I get large enough, flat fee software is a lot cheaper than broker-dealer administrative platform fees and basis points."

Are you seeing them figure out how to reinvent themselves in a way that stems this flow or the broker-dealer is just going to keep bleeding off the advisory business as reps shift to it and then grow larger and then get large enough that they say, "Wait, why am I with my BD? I can just run my own RIA separately with the custodian with more scale."

Jon: Yeah, at this point in time, the biggest competition to the independent and the wirehouse, for that matter, is advisors going fee-only. And the wirehouse and the independent channel, they're going to have to figure out how they could bring more value to the table to justify advisors to stay. At this point, I don't think they've figured it out.

Michael: It's a striking balance to me because, while the early days the RIA space was frankly a lot of pioneers that went out into the wilderness and blazed their own trails, there wasn't much technology, there wasn't much support structure, there wasn't much ecosystem besides just a couple of large RIA custodians that did the core custody and clearing business. And so you had to be really stubbornly independent-minded to go and blaze that trail. Now we see this subset of RIA platform plays that have begun to emerge, like HighTower and Dynasty Financial, and I'd even kind of put our XY Planning Network in this category although we serve a very different marketplace, where we say, "Look, you don't have to go into the RIA space and be there on your own, here's a platform business that will support your RIA and will help you get the technology, and will help you figure out the compliance, and will help you do some of the back-end office stuff so you can focus on your clients."

And I feel like the RIA side of the industry is basically reinventing the broker-dealer model while broker-dealers figure out how to flip over to the fee-based side, right? We're all converging in this space, which is, there's a subset of advisors that just love to be so independent, they're going to build everything themselves no matter what, and most people are not wired like that. They would like a little bit more infrastructure and system, and they just want to focus on their clients and growing their business but not running all this back-end stuff. And so there's a need for advisor support systems.

We just end out with this convergence where there's platforms like Dynasty that build from scratch and try to build up to the capabilities that reps need when they switch over, and then you've got broker-dealers that are trying to reinvent their own platforms to get to the same place. And the bad news for the startups is you've got to build from scratch, the bad news for the broker-dealers is you've got to build around all your legacy infrastructure and all the legacy costs. And we're just kind of in a race to see who builds a viable platform first as they both come at it from their opposite sides.

Jon: Exactly.

Michael: So when you look at IBDs, I mean are there...is there a point now where you look at some of them and say, "Yeah, I don't know if I would tell an advisor to go there because I'm not sure these guys are going to be around in 3 or 5 or 10 years because they don't seem to be making this shift very well?" Do you see that at your level?

The Different Dynamics Between Larger and Smaller Independent Broker-Dealers [1:25:37]

Jon: Yeah. I mean, there's some firms out there like National Securities where they did have a company invest in them that kind of gave them the capital they needed, but they're firm believers that the transactional stock and bond model is here to stay. Well, I think the jury is still out on that. Because if you ask FINRA, they would disagree with that. Talk to securities attorneys, they would disagree with that. So they're kind of swimming against the currents. Firms under 100, I think it's a tough go for them. There's some very good firms that are smaller but...

Michael: Meaning firms under 100 reps?

Jon: Yeah, firms under 100 reps… the advisors at those firms feel insecure. And they're like, "Hey, is my firm going to be able to hack it?" If you're under...especially if you're under say $25 million of revenue as a broker-dealer, the cost of compliance has taken about a 30% bite out of their profits over the last couple of years. It's disproportional, the amount of compliance cost is definitely disproportional to a big BD versus a small BD. And then any advisor they're courting, they're going to feel insecure about their being small, they're going to want transition money, which they can't do. It's just a tough sell for them. They could sell the high service level, high-touch, flexibility… all those things, but – and I do have reps that seek that out, where they could be a big fish in a little pond – but overall, it's an increasingly tough sell for those smaller BDs and even the bigger.

I mean, a sweet spot for me personally with broker-dealers is when they hit $100 million of revenue. I look at that as kind of a safety plateau where I don't have to be as concerned with their financial viability and their being able to survive going forward.

Michael: It's a striking thing to me how the recruiting dynamics are changing the landscape. I feel like I've watched over the past couple of years, the reps that are going upmarket and more fee-based are demanding more services, demanding more payouts. They're able to get it from some larger firms that are willing to negotiate and do that. And so the higher production, more fee-based reps seem to be gravitating to call it like top 50 broker-dealers because of that competitive dynamic. And that means if you're a smaller broker-dealer and you want to recruit, you're struggling to get those people, which means if you're going to recruit, you've kind of got to take what you can get. And what you can get tends to be more transactionally-based.

And that it seems like we're getting this divergence where larger broker-dealers are very disproportionately more fee-based than smaller broker-dealers, which if you think the future is heading towards more fiduciary and more fee-based, that ultimately doesn't bode well for small broker-dealers. And not because small broker-dealers can't do fee-based or can't exist with reasonable scale, but just they can't recruit the reps. They're not moving in that direction.

Jon: Well, yeah, the smaller broker-dealers have to take more risks yet they're the very audience that cannot afford more risk. The bigger firms can. Yeah, so they're between a rock and a hard place where they have to... you know, if they want reps, they have to be willing to take reps that might have more compliance marks on their record. Not always. As I said, there's exceptions to this. There's a firm like Prospera which has 100 reps, and they have good compliance records largely at that firm, and their average production per rep is over $400,000. So they've made it work, but there's a lot of firms that are smaller under 100 that they're just between a rock and a hard place in being able to attract reps. And when they do get a rep, they've got to have more flexibility in taking the higher risk reps or having a marketing niche that might be higher risk such as having a niche with REITs and BDCs and alternative investments, which have much higher litigation rate.

Jon’s Thoughts on How the Independent Broker-Dealer Channel Will Play Out Over the Next 5 - 10 Years [1:30:00]

Michael: It's an interesting dynamic. So, I mean, you live this space, you've lived this space for the better part of 20 years. So, as someone that's in the business of recruiting into the independent broker-dealer channel, what is your outlook on the independent broker-dealer channel? Like, how does this play out over the next 5 to 10 years?

Jon: Well, we might see more wirehouse reps coming to our channel, more the captive insurance reps coming to the independent channel, but more of this channel going RIA. So it could end up being a break-even, potentially bleeding more numbers out to the RIA. But that could change. It has been kind of a two-tier compliance, with FINRA policing us, whereas RIAs are left to the states. I know FINRA has been eager to want to...wanting to do the supervision of RIAs but RIAs cringe at that thought. But if it gets tougher to have your own RIA where they're under more scrutiny, maybe something similar to what broker-dealers have with FINRA, we could see some RIAs not wanting to have their own RIA and joining broker-dealers. We could see some backpedaling in that regard. I've actually had cases where reps had their RIA and they didn't want to hassle with it anymore and they wanted to be with a broker-dealer. It's an exception, but I've had that happening a bit more frequently over the last couple years than I had prior.

Michael: Interesting. So you kind of see this dynamic where the independent channel maybe does okay because they can pull enough from wirehouses and captive insurance reps to replace what's bleeding out to the RIA channel. Which I guess is also a nice way of saying the net losers that are more challenged are the captive insurance reps and the wirehouses themselves that don't seem to be having much luck recruiting from independent broker-dealers or from RIAs. They are just largely seeing net outflows. Net outflows from a big base. There's 50,000 in wirehouses alone.

Jon: Yeah, I think for the wirehouse, it's about culture and that the reps just are growing tired of their bureaucratic culture. And it's just not a warm fuzzy for them. They want to go to greener pastures where they can be the master of their domain and choose what they do and how they do it and have more autonomy and not be dictated to it so much.

Advice for Newer Advisors Coming into the Industry Today [1:32:29]

Michael: So flipping it around, what advice would you give younger and newer advisors coming into the industry today as they're trying to figure out what platforms to be affiliated with?

Jon: Well, yeah, if you're starting out, it's all about marketing, so perhaps a broker-dealer that is marketing-focused with helping advisors to grow. So organic growth. Marketing platforms, practice management, a lot of training tools. So the value-added broker-dealers would be good for them.

Michael: And how do you find who are the players there, or how do you find that? Because you're new, you have no revenue. You can't engage recruiting services and get bonus payouts and all that when you're starting from zero and there's no revenue, there's no trailing 12, there's no GDC yet.

Jon: Well, they can ask the broker-dealer, "Do you guys have anything in place to help advisors to build their book and grow it?" And see what they offer. Because some firms don't.. they offer very little, and then others are robust. So it varies.

Michael: So as we wrap up, this is a podcast about success, and one of the things that always comes up is just the nature of success and what people are trying for means different things to different people, sometimes different things to us at different stages of our own lives. So we've talked about this from the perspective of consulting with advisors and how to help them make decisions about broker-dealer platforms, but I'm just curious, at a personal level for you, how do you define the success path for yourself and your business?

Jon: Success for me is to be able to work but it's not work. It's I enjoy it, I look forward to it. So it's not work for me. So to be able to go and do your job and it not be so much work but something you enjoy doing day-to-day, I think that that's very much a blessing to have that. And so I appreciate that I have that.

And I'm always fine-tuning things. I started writing articles back in 2005. And that was motivated by the fact that...I read a book called "Credibility Marketing," and they talked about writing articles as among one of numerous things for building credibility. So I read that in, like, 2004, and I started writing articles in 2005. And I've just built on that since. And so that's been just one form. I've added a new form, recently I've started doing podcasts on my website. And I talk to reporters on a regular basis.

My objective originally with that credibility marketing was to not... I hate cold-calling, for instance, so what could I do to not cold-call? And so focusing on credibility marketing was part of that. And I haven't cold-called since 2006. And in 2005, I did some cold-calling for a producer group that had a turnkey marketing program. And so I placed about 15 advisors with them over about a year and a half period. But since then, I haven't cold-called. And I enjoy not cold-calling. So that was part of my motive in writing articles was to change the way I do business to where I wouldn't have to cold-call.

Michael: Very cool. I'll admit a lot of the path towards blogging and writing was the same for me. I'm an introvert. I started on the cold-calling side. I don't like it. I'm not very good at it. So let's find a way to reach people where there's a pathway for this to come to you so you don't have to cold-call your way to the business.

We’ll make sure we get links out to some of this as well. So for folks that are listening, this is episode 83, so if you go to kitces.com/83, we'll have links out for Jon's podcast recordings up on his website. Jon, I know you have a column on ThinkAdvisor as well, which was how I first became familiar with some of your work. So credibility marketing works. And thank you for joining us and going through this conversation about the broker-dealer landscape and how it works and what's going on out there these days.

Jon: I appreciate your contact. And this was an enjoyable experience.

Michael: Likewise. Thank you. Have a good day.

Jon: Thanks. Take care.