Executive Summary
Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with a striking new projection from Cerulli that direct-to-investor platforms are projected to grow to over $9 trillion of assets by 2022... driven not by robo-advisors, but by the existing leading direct-to-consumer platforms (primarily Fidelity, Vanguard, Schwab, and TD Ameritrade, that collectively own 84% of the direct-to-investor marketplace) that are increasingly competing with financial advisors by launching their own in-house advisory solutions for investors.
From there, we have a number of other notable industry news articles this week, including the news that Schwab, Fidelity, and TD Ameritrade (along with 6 other banks, brokerage firms, and trading firms) are launching a new alternative stock exchange that will be known as MEMX (Members Exchange) to try to undercut trading and data costs of the "traditional" stock exchanges like NYSE and Nasdaq, a discussion of how Schwab is working with the Investment Advisers Association to try to roll back the repeal of the advisory fee deduction and allow financial advisors to be eligible for the 20% QBI deduction as insurance agents are (though progress is not likely until after the 2020 election at best), and a preview of how the CFP Board is getting ready to "beef up" its disciplinary and enforcement capabilities in advance of its new higher fiduciary standard taking effect later this year.
We also have several articles on the theme of mergers and acquisitions of advisory firms, from tips for RIAs that want to be acquired about how to better position themselves, how RIA deals are becoming so lucrative they're beginning to mirror the wirehouse recruiting deals of old (which in turn may be further accelerating the wirehouse breakaway broker trend), some technical issues to consider for those evaluating a merger (from entity structure to compensation policies and decision-making processes), the significance of cultural fit in a merger and how to assess it, and why the key to being a successful acquirer isn't just about offering the right price but scaling the firm's own operational capabilities to truly be able to take the load off the shoulders of advisors who want to sell (often to simply get back to the client-facing advisory work they enjoy the most).
We wrap up with three interesting articles, all around the theme of how technology in general (and FinTech in particular) is evolving: the first looks at how, while platforms like Facebook become popular because of their ability to facilitate connections and sharing of information, their success has created platforms so cluttered with information that it "forces" the companies to create algorithms to manage the newsfeed (which is now leading to other unintended consequences); the second explores how platforms like Google have become so dominant that it's in their interests to not be biased in any way (that might open up half the marketplace to a competitor) but the longer they succeed, the more they may unwittingly stifle innovation anyway; and the last is a fascinating look at the rise of Ant Financial in China, a "FinTech" digital financial services firm that has been so successful, it may have already achieved what many advisors fear Google or Amazon will attempt here in the US (using their technology brands to compete in a wide range of financial services products)... even as, ironically, Ant Financial is now facing a regulatory backlash because of its success and is trying to reposition itself as not being a financial services firm but "just" a technology firm, which may help to explain why companies like Amazon and Google have been content to not directly enter the highly-regulated world of investments and financial advisors themselves, either.
Enjoy the "light" reading, and Happy New Year!
Direct-to-Investor Platforms to Grow to Over $9 Trillion by 2022 (Emily Zulz, ThinkAdvisor) - Robo-advisors were predicted to trigger a disintermediation of human advisors by going directly to consumers who could simply use the technology to implement their own portfolios. Yet while robo-advisor growth rates have slowed dramatically, industry tracker Cerulli suggests that the direct-to-investor channel is still on track to grow from $7 trillion today to more than $9 trillion by 2022... driven not by the growth of robo-advisors, but by "traditional" direct-to-consumer platforms, such as Fidelity, Vanguard, Charles Schwab, and TD Ameritrade (which now includes its Scottrade acquisition). In fact, those four firms alone account for a whopping 84% of the entire direct-to-consumer channel and continue to increase their market share by both expediting rollovers by deepening their affiliations with retirement plan recordkeepers and launching their own internal advisory services to provide more than "just" self-directed technology to do-it-yourself investors. Which helps to explain why competitors like Blackrock have begun to invest so heavily in technology as a distribution channel to reach consumers (given how competitive the other players are in the traditional direct-to-consumer channel). Of course, human financial advisors are arguably still best fit for consumers that want to fully delegate to a holistic financial advisor (rather than use self-directed technology and on-demand human advice)... but the more that the existing direct-to-consumer companies continue to grow and move "upmarket" in their services, the more channel conflict will likely emerge between independent RIAs and the platforms that serve them while also competing against them in the retail investor marketplace.
Fidelity, Schwab, & TDA Join Consortium Launching New Equities Exchange (Alexander Osipovich, Wall Street Journal) - This week, a group of major financial services firms, including the top 3 RIA custodians (Schwab, Fidelity, and TD Ameritrade) announced their plans to launch a new low-cost stock exchange to challenge the NYSE and Nasdaq. Known as MEMX (short for "Members Exchange"), the new exchange will be controlled by the nine banks, brokerage firms, and high-frequency trading firms funding it (including not only the leading RIA custodians, but also E*Trade, Morgan Stanley, Merrill Lynch, UBS, Citadel, and Virtu), effectively reviving the "old" world of stock exchanges that are/were owned by their members. Notably, the process of seeking and obtaining exchange status is a long drawn-out process that can take more than a year, so MEMX likely will not be up-and-running until 2020 at best. But the core purpose of MEMX is simply to introduce new competition into the exchange marketplace, with the founding firms anticipating that they can run a new exchange at a fraction of the cost of what incumbents charge today, allowing their collective members-only exchange to have substantially reduced trading costs for clients, and mimicking other recent start-up independent exchanges like IEX. Even as there is also rising scrutiny against the three primary exchange groups that some allege already hold too much concentrated power over the pricing of everything from trade execution to the data feeds necessary to engage in markets in the first place.
Adviser Advocates Seek Tax Breaks For Advisory Fees And Business Revenue (Mark Schoeff, Investment News) - When the Tax Cuts and Jobs Act was passed in late 2017, it happened so quickly that lobbyists had very limited time to influence the legislation, resulting in a number of "surprise" impacts to various industries... including financial advisors, who saw their investment advisory fee deduction eliminated (even as commission remain pre-tax), and a limitation that prevents many advisory firms from claiming the new Qualified Business Income (QBI) deduction. But now, Charles Schwab is working in conjunction with the Investment Adviser Association to provide relief for RIAs, advocating for both a return of the miscellaneous itemized deduction for advisory fees, and that the QBI deduction should be permitted for financial advisors (given that engineers, architects, insurance brokers, and mortgage brokers qualify). However, the reality is that there's little appetite for tax law changes in Congress at this point, with Senate Finance Committee Chair Chuck Grassley stating that there will likely be little more than perhaps some Technical Corrections in the coming year... which means, at best, reform may not come until after the 2020 election. Nonetheless, the IAA is aiming to set the foundation for relief now, with campaign contributions to members of tax-writing committees of both the House Ways and Means Committee and the Senate Finance Committee.
CFP Board 'Beefing Up' Disciplinary Arm (Ann Marsh, Financial Planning) - With its new higher fiduciary standard for CFP certificants rolling out on October 1st, the CFP Board is anticipating an uptick in disciplinary cases in the coming year... and as a result, has been "beefing up" its disciplinary committees and scheduling additional dates for disciplinary hearings in 2020. And while incoming CFP Board Chair Susan John is a former NAPFA Chair who operates a fee-only practice, she cautions that the scope of CFP Board's scrutiny will go beyond just compensation methodology, and focus on whether the advice provided or the products implemented enhanced the client's financial well-being. Though at the same time, the reality is that the CFP Board is not legally a regulator, and as a result has limitations on its power to investigate complaints (e.g., it does not have subpoena powers). To help bridge the gap, the CFP Board is updating its own Disciplinary Rules and Procedures, and is instead building relationships with state regulators, in the hopes of at least learning about other investigations from other state or Federal regulatory bodies more quickly, to take its own conforming actions against those who are CFP certificants as well. Though notably, John indicates that the CFP Board is not looking to only enforce against practitioners, but also to more proactively scrutinize the oversight practices of larger firms - particularly larger firms where managers themselves are CFP certificants - to ensure that the CFP certificant's fiduciary duties to the client are upheld, and that firms are creating a proper environment that allows those CFP certificants to deliver on their fiduciary duty in the first place.
Four Tips For RIAs Looking To Be Acquired (Gabriel Garcia, Advisor Perspectives) - According to Echelon Partners, since 2010 the growth of the RIA channel (combined with rising markets) has led the average RIA to nearly triple its revenues, and as advisory firms seek to sustain growth on an ever-larger denominator of assets under management, there is a growing hunger for firms to acquire (or to tuck in and be acquired) in order to achieve better advisory firm economies of scale. Which are occurring at an ever-higher volume thanks not only to a desire for consolidation, but also the increased flow of outside capital that is making it easier for firms to secure financing for deals in the first place. So how should advisory firms position themselves if they want to be acquired and tuck into a larger firm (and get a good valuation in the process)? Garcia offers up four tips: 1) Set clear goals for the acquisition in the first place (besides just getting a good price), to ensure you find the right buyer (e.g., the "right" partner to help the firm expand capabilities into a critical new market is different than the "right" partner to simply expand capacity, or to access new technology capabilities); 2) don't forget the importance of cultural alignment, as if the firms don't take a similar investment and planning approach with clients and don't have similar employee/team cultures, the deal may fall apart even if it otherwise looks good on paper; 3) don't assume the deal will be "done" when it closes, as the post-merger integration phase is actually when most acquisitions fall apart or fail to produce the desired results; and 4) the stronger the business and the more differentiated its client experience, the more appealing it is to an acquirer (which, ironically, means the businesses most likely to be sought out for acquisition are the ones that may be least in need of being acquired in the first place!?).
RIA Deals Starting To Mirror Excesses Of Wirehouse World (Danny Sarch, Investment News) - The ongoing trend of breakaway brokers leaving wirehouses is the culmination of years of both "push" factors (wirehouses driving their brokers away with annual payout changes, multiple reorganizations, failure to customize compliance to the experience of the broker, etc.) and also some "pull" factors (towards the desire of being independent, and building a practice you actually own and can someday sell). For many years, the willingness to break away was limited by the fact that merely switching wirehouses could produce very substantial "recruiting" payouts that were akin to (and in some cases, higher than) the payday from selling an RIA anyway (as high as 400% of trailing revenue at its peak, when RIAs "just" typically sell for 2X revenue instead). But more recently, wirehouse recruiting packages are on the decline, while an abundance of acquirers in the RIA channel is driving those prices higher (at least for larger firms with greater scale). As a result, highly profitable RIA firms that sell for 8X free cash flow can come close to the same valuations that were once being paid from wirehouses (at 3X or 4X trailing 12-month revenue). Which means there is an increasing "pull" for wirehouse brokers, who now have the potential for substantively similar payouts for selling their firm as an RIA as they would have been recruited to another wirehouse but with the independence and control that comes from being an RIA. Yet Sarch suggests that in the near-frothiness of RIA acquisitions, there's a risk that RIA acquirers will begin to replicate many of the woes of the outsized wirehouse recruiting deals, including that throwing "too much" money at the deal risks convincing the seller to agree to a transaction that's good for the seller but not necessarily the clients, that some turns may turn south if the price ends out being too high to be justified by the underlying revenue, and that some firms have grown large enough that even with buyers they may still struggle to sell simply because of a shortage of successors to take over the clients after the sale anyway?
8 Considerations For Your Merger Strategy (FP Transitions) - The terms "mergers" and "acquisitions" often get used somewhat interchangeably, but functionally they are substantively different transactions; with an acquisition, one firm acquires another and the latter is eliminated or dissolved, while with a merger, two separate businesses are truly integrated into a single surviving entity. And it's the "integration" aspect of a merger - as opposed to the more assimilative approach of an acquisition - that makes it especially complex and challenging to navigate. As in the case of a merger, it's not merely about saying that the two firms are coming together to work on shared clients with shared leadership, but truly about integrating a number of key legal, technical, and management aspects of the business (all of which should be discussed and determined in advance), including: 1) entity type, as advisory firms are often formed as sole proprietorships, partnerships, LLCs, and S corporations, but each type has its own tax and legal nuances, and businesses that are of different types will have to agree on the final entity structure they will merge themselves in to; 2) merger type, which can be Type A (a statutory merger or consolidation where shares of one company are exchanged for shares of another or shares of both are exchanged into a new common entity), Type B (where the acquired firm is purchased and remains a subsidiary of the acquirer), or Type C (where the acquirer purchases the assets of the firm being merged and assimilates them into its core); 3) tax implications (as each of the different entity types and merger types has their own tax consequences); 4) post-merger relative ownership and value (which doesn't necessarily have to split evenly amongst the current equity holders, but obviously must be discussed and determined in advance); 5) post-merger compensation policies (not only for all the new owners/partners of the new entity, but also how staff compensation of the separate entities will be consolidated into one); 6) post-merger management, as larger firms increasingly tend to separate ownership from management, which makes it important to understand not only who will be an owner of the newly merged entity but who will (or won't) have management control; 7) how decisions will be made (and disputes will be resolved) between the new owners of the merged entity; and 8) what the succession/exit plan is, in case the deal doesn't work out, or even if it does but something untimely happens to one of the owners of the newly merged entity.
Does Culture Really Matter In M&A (Mark Tibergien, Investment Adviser) - Although "culture fit" is often discussed as a key ingredient in mergers and acquisitions, Tibergien notes that, in practice, such considerations often fall to the wayside in the deal-making process as the financial terms and economics take hold (which in turn are usually the only parts of a deal discussed in the financial press). Similarly, mergers and acquisitions are also often driven by prospective "synergies" (e.g., cost savings by eliminating redundant positions or overlapping technology)... but these, too, are often not thoroughly discussed in advance. Of course, a certain unwillingness to discuss such issues is not unreasonable, given that sellers often believe they have created something unique and don't want to see it substantively changed, while buyers don't necessarily want to upset the apple cart by pushing such issues "prematurely" with the seller. So what should buyers do if they do want to get a better understanding of real synergy opportunities, and to truly evaluate cultural fit? Tibergien suggests focusing on four key areas: 1) the human capital experience (is the firm financially driven by serving existing clients but still disproportionately exalting rainmakers who contribute less and less to the bottom line, and is the firm proactive about ensuring the right match of people and jobs?); 2) pricing philosophy (as the proliferation of different types of fee models means there are often necessary changes to billing practices and fee schedules, and differences in fee structure can also be an indicator of a more fundamental difference in firm value proposition); 3) compensation philosophy (as firms that still use revenue-based compensation for "production" may have trouble assimilating into a more salary-plus-bonus-based environment, and vice versa if a production-oriented firm acquires a salary-oriented firm); and 4) what is the firm's decision-making process, and to what extent have employees been empowered to make decisions (which provides some indication of how capable they'll be of continuing to make decisions, or not, when the founder is gone).
Harnessing RIA M&A Strategies For Growth (Matt Sonnen, Investment News) - Advisory firms are increasingly pursuing mergers and acquisitions to achieve economies of scale, as organic growth alone is becoming increasingly competitive and can't always come in fast enough to sustain an advisory firm's growth needs. Yet at the same time, inorganic growth strategies are often more difficult than they appear to execute well, and "buying badly" has the risk to further derail a firm's growth rather than accelerate it. Consequently, Sonnen suggests that the starting point for an effective M&A strategy is for the advisory firm to get its own house in order first, which means strong technology systems and back-office infrastructure, clear workflows, and a well-established service model for clients, along with the management and operational capacity to be able to scale and effectively integrate an acquired firm (both its clients and its employees). In fact, because it takes so much to execute inorganic growth well - and systematically - Sonnen notes that the most successful firms end out becoming "serial acquirers" or "professional buyers," and tend to formulate a consistent set of differentiators to make them compelling to sellers, including a focus on their own centralized infrastructure, family office services, tax expertise, professional management, investment solutions, and their own capitalization and access to additional capital as needed. Because in practice, while some advisors are looking to sell simply because they're ready to retire, it's increasingly common to acquire advisory firms because the founder simply doesn't want to run the operations and day-to-day business anymore, and instead wants to get back to simply being a financial advisor with clients... which means for the acquirer, having a strong back-office and operational infrastructure to take the load off the acquired advisor is an absolutely essential capability to prove in order to close the deal.
The Death Of The Newsfeed (Benedict Evans) - While early on, the appeal of social media platforms like Facebook was the ability to connect with a few friends and family and keep up to date on their latest personal announcements and select news they shared, over time, most people "friend" more and more others on Facebook (until they have a few hundred), each of whom has tended to share more and more on Facebook as they engaged more deeply with the platform... such that now, the average Facebook user is eligible to see at least 1,500(!) items each day on their Facebook news feed, which is far more than anyone has time for. Which means, ironically, even as Facebook has pushed to make us more engaged with Facebook, it also struggles to figure out how to filter more noise out of its newsfeed so people can see what would actually be of most interest to them. And since most people can't handle the volume, and won't realistically file and sort the news themselves, Facebook had no choice but to make the "algorithmic feed" instead (where Facebook tries to figure out for you which items from your newsfeed will be of most interest). Which in turn is difficult, because it's hard to know what people will really like, sampling them to find out is naturally limiting, and it's hard to judge the outcomes because people still only see a sample of their own newsfeed as well. The newsfeed overwhelm helps to explain the popularity of alternative apps like Snapchat and WhatsApp, which have succeeded in part by re-creating the smaller "Group Chat" environment where Facebook started. Except for an ever-growing number of group chats on those platforms are similarly creating overwhelm on those platforms. And is also creating new problems - such as viral fake news that Facebook at least can kill once it identifies it as fake, but private group chat systems are private and consequently don't have filters even when they might really be needed.
The State Of Technology At The End Of 2018 (Ben Thompson, Stratechery) - The rise of "fake news" and political polarization has taken a perhaps unexpected toll on high-profile technology companies over the past year, from a growing backlash against Facebook, to questions at a recent Congressional hearing about whether Google is manipulating its search results in a biased manner against conservatives. Google, in particular, has emphasized that it does not manipulate search results, nor even that its employees can do so in such a targeted manner (given the company's size and scale and the complexity of its search algorithms), and Thompson points out that doing so would likely be self-destructive for Google anyway... as creating a more "partisan" search engine that alienates nearly half the population would just invite a competitor to make an alternative search engine that favors them, splitting the market that Google already dominates (and has already enjoyed years of positive feedback loops on). Yet the concern remains that many technology companies are becoming so successful at being dominant marketplaces or platforms that it may be edging out competition, which at least raises (or amplifies) antitrust concerns and the danger that such companies could more substantively manipulate results and outcomes (not to mention stifling competition that fears it can't take on platforms like Google and Facebook and thus doesn't even try). Which means, while the large-scale enterprise technology market is thriving, Thompson suggests that the consumer market is increasingly stagnating, dominated by the "innovations" of the large behemoths that control our core platforms but little else. And unfortunately, it's not clear when/whether that will change any time soon, as regulators and legislators aren't even sure what to do, and while such dominant periods have occurred in the past (e.g., Microsoft in their near-monopoly PC business), it's not clear what technology or industry shift even could unseat Google at this point (as cloud computing and mobile ultimately did to Microsoft's PC business). Of course, it's important not to underestimate the "inevitability" (and unpredictability) of innovation and paradigm shifts... though the concern remains about how much foregone innovation and political dysfunction may occur in the meantime?
Jack Ma's Giant Financial Startup Is Shaking The Chinese Banking System (Stella Yifan Xie, Wall Street Journal) - In recent years, the financial services industry has grown increasingly concerned about the potential that a major technology firm like Amazon or Google might begin to compete as a robo-advisor or similar digital financial services company... even though the firms thus far have focused at best only on the simplest of financial products (e.g., mortgages and credit cards) and not more complex investment or holistic financial advice. Yet in China, a digital financial services "FinTech" mega-company has emerged: Ant Financial, which last year handled more payments than Mastercard, controls the world's largest money market fund, and facilitated loans to tens of millions of people (serving as a marketplace but not the lender itself), while its online payments platform completed more than $8 trillion of transactions last year (twice Germany's entire GDP!). In fact, Ant Financial has been so successful, it's siphoning away deposits from banks (causing them to pay higher interest rates to compete for cash and leading them to close branches and ATMs), and Chinese regulators are beginning to put limits on the company to try to contain its overwhelming success (e.g., blocking Ant's attempt to build a national credit-scoring system in China by telling institutions they couldn't use Ant's ratings to make loans). In fact, out of concern of the adverse impact of regulation, Ant is increasingly trying to position itself as "just" a FinTech firm and not a financial conglomerate - notwithstanding its massive $150B valuation (on revenue of "just" $15B and pre-tax profits of $2B) that clearly anticipates Ant will continue to grow rapidly with more financial services solutions. A striking parallel to the US, where similarly many have suggested that, in the end, companies like Google and Amazon won't fully enter financial services because, as tech companies, they don't want to be subject to financial services regulations, either.
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
In the meantime, if you're interested in more news and information regarding advisor technology, I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors as well.
