Executive Summary
Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with the ongoing chatter about the fallout of the announced Schwab acquisition of TD Ameritrade, from Schwab relocating its headquarters to Dallas, the uncertain fate of TDA's VEO, how Schwab will handle smaller RIAs that, in the past, may have joined TDA specifically because they didn't meet Schwab minimums, and whether it will be necessary to repaper accounts as a part of the merger (which could put all the RIAs on TDA's platform 'in play' for competing custodians).
Also in the news this week is a newly proposed rule from the SEC that would potentially limit the use of leveraged and inverse exchange-traded products as regulators grow increasingly concerned about inappropriate uses of such vehicles and whether investors (whether clients of a broker-dealer or an RIA) truly understand the risks involved.
From there, we have several tax planning articles, including new Final Regulations from the Treasury clarifying that there will not be a 'clawback' of gift and estate taxes even if the Tax Cuts and Jobs Act lapses in 2025 and the current $11.4M estate tax exemption falls back to lower levels, a look at how states are becoming increasingly aggressive on "residency audits" to determine whether those claiming to have relocated (to avoid the state's high income tax rates) really changed their state of residence or not, and a reminder from IRA guru Ed Slott that with the beginning of a new year fast approaching the once-per-year 60-day rollover rule for IRAs does not reset and is still based on a rolling-365-day blackout period (but trustee-to-trustee transfers remain safe either way!).
We also have a few articles on advisory firm mergers and acquisitions, including a reminder of the key levers that drive the valuation of an advisory firm beyond just its revenue (as two firms with the same revenue may still have a drastically different valuation based on the stability and profitability of that revenue), the rise of bank funding options for RIAs that want to sell internally but not seller-finance the transaction, tips from successful acquirers of what it takes to close on a transaction (and get the seller to pick your firm as the chosen buyer), and some interesting research on the realities of today's M&A market for advisory firms that is increasingly driven by large firms that are paying ever-higher levels of upfront cash or in-kind stock exchanges as a part of the transaction.
We wrap up with three interesting articles, all around the theme of customer/client service and interacting with clients: the first explores the concept of "aesthetic intelligence", and that how an advisory firm and its services are aesthetically staged can have a significant impact on the client experience; the second explores how, amongst the affluent, human contact that eschews screens and computers is becoming a form of 'luxury good'; and the last is a powerful reminder that at some point spending money as a business on good customer service isn't just an overhead expense but a 'marketing' expense that drives word of mouth (and that it's important to be strategic in how you allocate resources to client service recognizing its potential marketing impact).
Enjoy the 'light' reading!
Schwab-TD Ameritrade Deal Fallout Ahead (Jessica Mathews, Financial Planning) - While last week's industry-grabbing headline was the announcement that Charles Schwab is acquiring TD Ameritrade, the news has continued to ripple through the industry this week as everyone continues to size up the consequences and ramifications of the prospective deal. Notably, the deal itself is not expected to close until the second half of 2020, and Schwab CEO Walt Bettinger has pointed out that the subsequent integration will likely take another 18 to 36 months, such that the dust on the Schwab-TDA merger may not have fully settled until the end of 2023. Still, though, some planned changes are already being announced, including that Schwab plans to relocate its own headquarters from San Francisco to the Westlake suburb of Dallas (where both Schwab and TDA already have existing facilities), and that there will be potentially sizable layoffs from TD Ameritrade after the deal closes in positions that are "overlapping and duplicative" in the merged entity. For larger RIAs, the merger may actually result in a simplification - where it's common for RIAs to be multi-custodial across both Schwab and TDA, which will now be consolidated to a single relationship - though significant questions have emerged about what may happen to the smaller RIAs that, in the past, went to TD Ameritrade precisely because they couldn't meet Schwab's higher AUM minimums, with competitors like TradePMR (which serves small-to-mid-sized growth-oriented RIAs) and Shareholders Service Group (SSG, which has a reputation for taking and supporting all RIAs regardless of asset minimums) already seeing a burst of inquiries from concerned small RIAs. Also up in the air is whether Schwab will maintain the popular VEO open architecture approach to advisor technology, or whether it may ultimately wind down the platform into Schwab's less-open framework (which, in turn, may have a chilling effect on AdvisorTech startups). The biggest question for most TDA advisors, though, is simply whether it will be necessary to repaper accounts to Schwab after the merger closes (or if it will be done with a negative consent letter instead), which could both create a major hassle for RIAs on the platform, and a natural opportunity for those RIAs to look to other RIA custodian alternatives (since they'll have to repaper either way). And even Schwab has acknowledged (though apparently doesn't appear to be very concerned) that there may well be some RIA attrition as the deal closes and integration gets underway. For the time being, though, both companies emphasize that it is still "business as usual" for now, in part because the deal still won't close for 6 months... and there's still some possibility that the FTC could block the merger on anti-trust grounds (especially in the context of the RIA custodial business, where the combined "Schwabitrade" may control as much as 70% of the independent RIA custodial market after the deal closes).
SEC Proposes Tougher Sales Rule For [Leveraged And Inverse] Exchange-Traded Products (Greg Iacurci, Investment News) - This week, the SEC proposed a new rule that would limit advisors at RIAs and broker-dealers from using leveraged or inverse exchange-traded products with clients unless the advisor had "a reasonable basis to believe the client is capable of evaluating the [unique] risks associated with these products", in addition to gathering the other Know Your Client (KYC) requirements such as the client's investment objectives and time horizon, investment experience, and financial situation. The concern from the SEC is that the level of volatility in such products, along with their common use of debt leverage or derivatives to amplify returns, may be more than what most clients bargained for. In fact, even providers of such products often note that they are only for "sophisticated investors" and that they shouldn't be held for any extended period more than a day at a time, which in practice would mean such products are beyond the use of most longer-term-oriented advisors anyway. Notably, the proposed rules would apply equally for RIAs and broker-dealers - despite their otherwise different fiduciary versus suitability standards - akin to FINRA's rules limiting the use of option trading for clients. And the new rule would also impose additional requirements for most robust risk management programs from companies offering such products. Ultimately, the SEC's proposal will be open for a 60-day comment period in December (once the proposed rule is published in the Federal Register), with a final rule anticipated sometime in 2020.
IRS Issues Final Regulations On Gift And Estate Tax Exclusion In The Event Of 2025 Lapse (Melanie Waddell, ThinkAdvisor) - This week, the Treasury Department issued Final Regulations to clarify the treatment of gift or estate taxes after 2025 if the currently-increased estate tax exemption until the Tax Cuts and Jobs Act is allowed to lapse. The specific concern was what might happen if someone made lifetime gifts up to the current maximum exemption amount ($11.4M in 2019, and increasing annually for inflation), and then in the future the estate tax exemption lapsed back to the 'old' $5M (indexed for inflation) exemption threshold, given that estate taxes are calculated using a unified schedule for gift and estate taxes - which could potentially cause prior gifts above the $5M exemption that weren't gift-taxable at the time to become estate taxable if the exemption was later reduced. In its guidance, the Treasury and IRS effectively cleared the way for proactive gifting strategies for estate planning purposes all the way up to the current $11.4M exemption amount, clarifying that even in the event that TCJA lapses after 2025 and the exemption decreases a clawback will not occur, and by providing a special rule that will permit the estate to compute its exposure based on the higher of the Basic Exclusion Amount applicable at death or the Exclusion Amount that was in effect when gifts were made during life.
Moving Away From A High-Tax State? Be Prepared For A Residency Audit! (Sandy Weinberg, Financial Planning) - The difference in state income tax rates has long been an incentive for affluent individuals to move from high-tax-rate states to those with lower state income tax rates (or no income taxes at all in the case of Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming), and the introduction of a $10,000 cap on State And Local Tax (SALT) deductions under the Tax Cuts and Jobs Act has only further accelerated interest in switching states to reduce income tax burdens (particular for high-rate states like California and New York). However, the burden to officially change one's state of residency is significant, as states - wise to the fact that people may claim to live in another state, just to avoid income tax burdens - are increasingly scrutinizing whether those who claim to have moved to another state have truly done so; in fact, in the past 5 years, the New York State Department of Taxation has initiated over 3,000 residency audits on high-income individuals, collecting an average of $140,000 per taxpayer, and nearly $1B of tax revenue cumulatively from such residency audits. The core issue is determining whether the claiming-to-be-former resident meets either the domicile or 183-day statutory residency test to claim their new state (and not their old state) as their state of residence. And recent court cases have affirmed that it is possible for more than one state to claim an individual is a resident at the same time, such that the failure to terminate residency with a prior state could result in double taxation in the new state and the old one. Of course, for those who are unequivocally leaving their old state and moving to the new, substantiating a change in residency is fairly straightforward. But for those who will keep a property in the prior/original state as well, it's important to either be prepared to document they avoided 183 days in the old state (saving documentation or even using a day-counting app), or engage a tax expert to help ensure that all the tests for domicile in the new state are satisfied (and that they are not also satisfied in the prior state as well!).
Watch Out For The New Year IRA Rollover Tax Trap (Ed Slott, Investment News) - One of the standard rules for IRAs is that when a distribution is taken from an account, it can be rolled over (re-deposited) into another IRA within 60 days... but such indirect 60-day rollovers can only be done once in a 12-month period (i.e., not just once per calendar year, but only once every 365 days, such that if a distribution is taken on December 20th of 2019, any distribution before December 20th of 2020 will not be eligible for rollover). Notably, the once-per-12-months rollover rule only applies to rollovers where the IRA owner actually takes possession of the money and rolls it over, and does not apply to any trustee-to-trustee transfer (and only applies to rollovers from an IRA and to an IRA, not from a 401(k) plan). Still, though, the rule is important to be aware of, because if a second/subsequent IRA distribution is taken within 12 months of the first, it will be deemed irrevocably distributed (i.e., there is no way to even request an exception for a mistake!), and attempting to re-contribute it as a rollover anyway can just cause a 6% excess contribution penalty tax on top of the tax consequences of the ineligible-for-rollover IRA distribution itself. The key concern at the end of the year, though, is that consumers often confuse the once-per-year rollover rule to be based on a calendar year - such that their window resets as of the January 1st New Year - when in reality it does not. So for any clients doing late-year rollovers, be certain they realize that no other distributions for the next 12 months will be eligible for rollover. Or better yet, just always do a trustee-to-trustee transfer when moving IRA funds, which isn't subject to the limitation in the first place.
Three Drivers That Maximize Practice Value (Todd Doherty, Advisor Perspectives) - While there are popular valuation rules-of-thumb for advisory firms (e.g., selling a practice for 2X revenue), in reality, not all advisory firms generate the same revenue sell for the same multiple of revenue. Key factors that impact valuation positively also include the percentage of the revenue that is recurring (as one-time transactional revenue that may or may not repeat in the future is not worth nearly as much as client relationships that pay an ongoing steady fee), the percentage of high-net-worth clients the practice services (recognizing that more affluent clients that generate a higher revenue/client tend to drive a disproportionate share of a practice's total profits given that clients paying twice the fees usually don't quite require twice the work), and the operating profit of the practice (as firms that have significantly higher costs to generate the same revenue typically won't be worth as much to the buyer because the business won't actually generate as much in future profits. Other factors that impact valuation - to the downside - include the number of low-value clients being served (that may be a drag on the viability or profitability of the practice because they don't pay enough to be profitable or sometimes even to carry even their share of the business overhead), the average age of clients (as the older the clientele, particularly above age 70, the more likely they are to be taking withdrawals instead of making contributions, and the higher the risk they pass away and are no longer a paying client), and the number of professionals it takes to service the clients (as again staff-heavy firms with poor staff/client productivity ratios will tend to generate less in profits for the buyer, reducing the value of the firm). When combined together, the end result is that a firm with $70M of AUM might be worth anywhere from $1M to $1.7M, depending on the various factors. Notably, though, for firm owners who plan to sell in the future but still have a few years remaining, it's important to recognize that these metrics can be actively managed to improve the financial health (and ultimately financial valuation) of the advisory firm over a period of several years!
Funding Secured: How RIAs Can Woo Banks Into Lending Them Money (Michael Thrasher, RIAIntel) - Industry data from Cerulli estimates that the average financial advisor is 52 years old and that 40% are expected to retire in the next 10 years, and of those the overwhelming majority (92% accordingly to one recent Schwab RIA Benchmarking Study) plan to sell internally to one or more employees. Which, for advisory firms of any size, will necessitate some form of financing for the transaction. In the past, founders who were selling would typically "seller-finance" such transactions (receiving payments over time, and retaining the risk if the buyer wasn't subsequently successful), but the rise of bank lending for advisor M&As is increasingly making it feasible for internal succession plans to take advantage of external financing (with the benefit for the seller that they receive most of their cash up front, financed by the bank, where the buyers then repay the bank over time instead). The caveat, however, is finding a bank that is willing to lend to a business that has little to nothing in the way of hard collateral (as most of the value of an advisory firm is in the goodwill of clients, not factories and equipment). Accordingly, it's often a good idea to establish a relationship with a local bank, not just for the convenience of local banking, but to begin to form a relationship between the business and the bank that can support potential borrowing in the future (as it's easier for the bank to lend when it's already intimately familiar with the business' cash flow and finances). Alternatively, platforms like SkyView Partners have emerged that help to match advisory firms to banks that are willing and interested to lend into financial advisory businesses.
Successful Acquirers Explain How They Made An Acquisition Work (Karen DeMasters, Financial Advisor) - While acquisitions are becoming an increasingly popular way for advisory firms to grow in an era of increasingly difficult organic growth, the reality is that acquisitions still present their own challenges, not only in finding the prospective firms to acquire but also in the process of actually integrating them into the existing business. Even the structure of acquisitions can vary, depending on the prospective seller and their goals. For instance, in some cases the goal of the seller is not actually to retire and exit, but simply to get out of the day-to-day responsibilities of running the business, in which case the "acquisition" is more of a "fold-in", and is often done as a cashless transaction (and instead exchanging all the stock of the seller's firm for an appropriate portion of shares in the buyer's firm). In a crowded acquisition environment, though - with some estimating as much as 50 buyers for every seller - it's also necessary for buyers themselves to present a compelling option to the prospective seller, which tends to focus on having a clear strategic direction, up-to-date-technology, and a strong operational infrastructure to handle the day-to-day management issues of the business... including hiring up in advance to be able to handle the work of doing such mergers and acquisitions in the first place. In a recent whitepaper entitled "Becoming A Professional Buyer: Harnessing RIA M&A Strategies For Growth", PFI Advisors suggests that it's also important to have clear compensation structures, and a strong culture, that the potential seller can "see themselves in" (if they're going to continue with the newly merged firm). Though notably, cultural alignment is equally important for buyers to vet as well... otherwise, the acquired firm and its clients don't tend to fit well after the deal closes, leading to higher attrition and turnover thereafter.
6 Realities For RIA Buyers And Sellers In Today's Market (Ginger Szala, ThinkAdvisor) - A recent "RIA Deal Room" report by Advisor Growth Strategies explores the current landscape for mergers and acquisitions in advisory firms, and how RIA dealmaking has changed in recent years. Overall, the biggest trend is that the largest buyers of advisory firms are now setting the pace for the whole industry - having completed 42% of the reported transactions from 2016 to 2018 - coming to the table with "turnkey offerings" for acquisition, and a clear understanding of their ideal market for acquisitions and strong discipline in how deals are negotiated and structured. In fact, overall, just 5% of the (largest) advisory firms now control 63% of the AUM (as of the end of 2017), creating an increasingly split landscape where behemoths compete on price and scale, while smaller firms are forced to stick to a boutique niche approach to differentiate. The hunger for deals from large firms, though, is also changing the typical structure and terms of deals, with sellers now often able to command as much as 60% in cash consideration at closing (though those who are willing to stretch payments a bit further may command a slightly better valuation). However, the focus on cash deals is also driving a focus on cash profitability of the seller's firm in the first place, with valuation multiples increasingly being driven by earnings (EBITDA) and not just a multiple of revenue alone. On the other hand, cash deals are actually primarily the domain of "small" firm acquisitions, while in the case of larger firms being acquired (where the seller, or at least most of the other employees, doesn't leave the business but instead folds into the buyer's firm), an average of 40% of the price of a transaction is paid in the form of the acquiring firm's equity (which in turn means the acquirer needs to be able to demonstrate a future path to liquidity and a repeatable growth engine). Ultimately, though, the sheer demand for acquisitions means that valuations have likely gone about as high as they can - with competitive bidding having now set the market rate - though specific valuation multiples can still vary from one acquisition to the next based both on the underlying economics of the firm, and the exact deal terms and structure.
To Truly Delight Customers [Or Clients], You Need Aesthetic Intelligence (Pauline Brown, Harvard Business Review) - In her recent new book "Aesthetic Intelligence: How To Boost It And Use It In Business And Beyond", Pauline Brown (former chairwoman of luxury goods brand company LVMH) makes the case that in addition to traditional and emotional intelligence, great leaders need to develop "aesthetic intelligence", and be able to think about how the firm's services or products stimulate all five senses to create delight. For instance, a successful restaurant has to offer great food, but the best restaurants also pay attention to the design, the ambiance, the acoustics, and even the choice of utensils and how they interact with the food being eaten. The context is especially important for companies like LVMH (which owns a number of premium luxury brands like Tiffany's, Christian Dior, Dom Pérignon, and Louis Vuitton), which, as providers of 'luxury' goods that not anyone actually needs, consequently must excel at providing services and experiences around what they actually offer to elicit delight. But the phenomenon isn't unique to luxury brands; it exists for tech companies (think Steve Jobs and how Apple designed the Mac and the iPhone to be aesthetically distinct), and even commoditized goods (e.g., what Howard Shultz did with Starbucks to sell coffee for a premium) and commoditized businesses (Brown suggests it's no coincidence that even though Craigslist was posting homes for rent a decade before Airbnb, the latter was able to succeed in part because its founders were graduates of the Rhode Island School of Design [not 'techies'] and took a strong aesthetic focus to how they listed and presented properties available to rent). In the context of advisory firms, such 'aesthetic intelligence' might be applied to everything from the furniture and design of the office space, the art and the kind of table in the conference room, and even the way that a financial plan itself is constructed and delivered. Which starts by creating a clear vision around what the aesthetics of the firm should feel like, and then developing guidelines that everyone in the firm can adopt and use.
Human Contact Is Now A Luxury Good (Nellie Bowles, New York Times) - Recently a new startup called Care.Coach launched a service where individuals who need help in (self-)managing their chronic conditions can engage a virtual coach in the form of a virtual pet dog or cat, that appears on a tablet, and are controlled by remote employees around the world who, through the dog/cat avatar, can provide caring support and feedback. The launch of Care.Coach is arguably part of a broader trend, though, where computers, tablets, and smartphones make it increasingly feasible to use our screens to access what previously were purely "human" engagements, from ordering food (online) to getting coaching for self-care of chronic health conditions. Yet at the same time, a counter-trend is emerging, especially amongst the affluent, to send children to 'tech-free' private schools, eschew video game systems for playing with blocks, and engage in "conspicuous human interaction" (e.g., flaunting the act of living without a phone for a day, quitting social media, or not answering email, as a new form of status symbol). In fact, research from the Luxury Institute finds that increasingly the affluent want to spend on "anything human", where human engagement itself is becoming a luxury good. In part, the trend is seen in luxury spending on leisure travel and dining outpacing spending on luxury goods, though with growing research questioning whether "too much" screen time may impair childhood development, eschewing screens is taking on a tone of more than just luxury services. Yet at the same time, adoption of services like Care.Coach has thrived in part because sometimes local human systems and communities fail, as the interaction between humans in-person and humans through-the-screen can involve increasingly complex relationships to balance in the modern world.
Your Customer Service Strategy (Seth Godin, Seth's Blog) - Advisory firms know perhaps better than most businesses that customer service isn't just a time-consuming 'obligation' to clients, but a strategic investment into marketing to help generate word-of-mouth referrals. Examples of such customer service success aren't unique to advisory firms, though; Zappos is famous for having heavily invested into its customer service, with agents who may spend hours on the phone with customers, creating memorable interactions that ultimately led to a billion-dollar shoe store. On the other hand, it's notable that the strategic decision about customer service can go both ways, as Google was famous, when launching their search engine, for making it virtually impossible to contact them and setting an expectation that there would be no human customer support. For most, though, investing into customer service remains an opportunity, from FedEx cementing its relationships with busy businesspeople in the early years by being known for always answering the phone on the first ring every time, Apple challenging the Microsoft empire in part by installing experts at their "Genius bars" in Apple stores to humanize a traditionally inhuman customer service interaction, and Ford and GM deciding strategically to price high-quality service at a low cost, voluntarily making no profit from their service and viewing the foregone profits as a (cheaper-than-TV-ads) marketing expense. Unfortunately, though, without the ongoing strategic focus that such customer service investments are in part a marketing expense, it's difficult not to succumb to the temptation to manage and cut customer service 'overhead' expense over time (thus why it's now often 2 minutes to reach FedEx and not 2 seconds anymore, and Apple increasingly takes flack for declining customer service quality). In turn, though, such declines in customer service across so many industries only increases the opportunity to stand out and differentiate by using customer service as a growth strategy - but only by delivering consistently above and beyond the 'accepted norms' of the industry.
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.
