B/D or RIA? The Case for the Flexible B/D 

• Staff Writer

The financial services industry has changed radically in the past 20 years. By foreseeing the rise of fee business and building a model to accommodate it, the firm of which I serve now as founder and chairman, Cambridge Investment Research, was able to ride the wave of that change. We grew from $500,000 in revenues 15 years ago to over $250 million in revenues today by leveraging one really good idea: being the fee business experts in the independent broker/dealer space. Rep advisors can accomplish a similar outcome in the next 10 to 20 years if they see the industry clearly and build the right model. But how can you find your "Blue Ocean Strategy," as W. Chan Kim and Renée Mauborgne described in their book of the same name (Harvard Business School Press, 2005), in that uncertain future--one that separates you from the competition and makes growing your business easier and more fun and rewarding?

Developing a compelling model that separates you from the competition requires a clear vision of the future, or of at least one meaningful trend, and a focused strategy to take advantage of that trend. Where do the future opportunities lie? Why do 95% or more of companies run by bright people either fail to see the trend, ignore it, or go in the opposite direction and end up anywhere but in the "Blue Ocean" of huge, largely uncontested opportunity? Before we can answer these questions, we must first identify the trends on our horizon.

Trend 1: The Fee Trend Grows Even Stronger
Fees may have been a secret when Cambridge jumped on them 15 to 20 years ago, but not any more. Most industry experts agree that fee business is an important model, and many think it may soon be the dominant model. Within the next 10 to 15 years, it certainly would not surprise me to see fee revenue accounting for an average of 50% to 80% of total revenue for all independent broker/dealers.

The fee explosion continues for many reasons. Quality rep advisors actually make more money in a more predictable manner over the long term and their practices are worth more when they focus on their fee business. Clients can get better advice and clearer disclosure, and the regulators also seem to prefer fees for their own reasons.

With fees widely acknowledged as a major part of the future, they are no longer a true Blue Ocean strategy. Continued competition will drive down pricing, and customers will demand more value-added service. Also, as regulation follows the dollars flowing into the fee business, it will seriously impact the profitability and ease of doing fee business. However, fees will continue to be king, creating opportunities in the industry.

One obvious opportunity is for rep advisors to become fee experts. They can carve out a niche in which they do fee business better than everyone else in their area. To be a world-beater in this one area, I suggest you outsource or partner with individuals or companies who are world class in other areas such as managing money, performance reporting, or management of staff.

Your broker/dealer may be a good place to start looking for outsourcing opportunities. If your B/D is not world class, then part of your journey may be finding a better broker/dealer. I believe that in the next 10 to 20 years, numerous fee-based rep advisors who make the right choices will have practices valued at anywhere from $10 million to $100-million plus.

Trend 2: Lines Blur Between Vertical and Horizontal Channels
Over the last 30 years, channel blurring has already occurred, but that was just the warm up. Thirty years ago, retail financial rep advisors basically consisted of stockbrokers, insurance agents, banks, and CPAs--all in their separate worlds. Today, independent rep advisors typically have insurance, securities, and RIA licenses and many are CPAs. At an ownership level, many wire firms, regionals, and independents are owned by banks or insurance companies. On the product side, there is more overlapping as well. Joining the early wave of variable life, variable annuities, and index annuities are principal-protected, structured products, and separately managed accounts with downside protection (i.e., insurance).

Just as the lines between horizontal channels will continue to blur, so will the vertical lines between rep advisors, independent broker/dealers, clearing firms, and custodians. Already, some broker/dealers have acquired or "rolled up" advisory practices. LPL is a broker/dealer, a clearing firm for other broker/dealers, and is planning a fee-only institutional platform to compete in Schwab's world. Pershing and Fidelity's National Financial are clearing firms for broker/dealers, institutional platforms for fee-based rep advisors, and are also retail firms. Schwab, Pershing, and National Financial all have recently created hybrid models to serve the commission and fee-based rep advisor.

I believe that in the next 10 to 20 years, these lines will continue to blend and the leaders of the next generation will be the companies that offer the most integrated, value-added global solutions to rep advisors and their clients. These will be firms who best integrate the vertical and horizontal opportunities to create a unique, value-added proposition to their partners/clients. This does not mean being all things to all people. It does mean assembling the right pieces from across these vertical and horizontal structures in a unique and integrated way to create their own Blue Ocean strategy and culture. Rep advisors have a unique opportunity today to be a part of this restructuring rather than being on the outside looking in. The future belongs to those who see and participate in the trend.

Trend 3: Regulatory Consolidation and Levelization
As the distinctions between stockbrokers, insurance salespeople, and advisors disappear, the regulatory and licensing side will follow suit. Regulation follows business trends, though usually five to 15 years after the fact. A major consolidation of the over 100 current regulators of financial services in the U.S. is likely. The Financial Services Authority (FSA) in the U.K. serves as a model of consolidated regulation often cited by U.S. regulators and politicians as worth considering. This consolidation trend is well in motion today with the merger of the NYSE and NASD to form FINRA. The next step is likely to be the merger of the Commodity Futures Trading Commission (CFTC) with FINRA. The failure of regulators to prevent, or even seem to notice, the subprime problem until it was too late will accelerate this trend.

In 20 years, I believe a financial rep advisor may well have just one global license that covers insurance, securities, and other investment business, be it fee or commission-based. A few regulatory bodies could oversee one reasonably unified regulatory structure. Companies and rep advisors offering integrated solutions to financial planning, wealth management, investments, banking, and insurance should benefit from this development because such a trend would substantially reduce complexity and cost of regulation for companies currently struggling to comply with multiple regulatory bodies. However, for RIA-only rep advisors, this could be a negative as they are currently "under-regulated" compared to other financial firms, which brings us to our next foreseeable trend.

Trend 4: New Wave of RIA Regulation
Most industry observers see Trend 1--the further strengthening of the fee business--loud and clear. However, when everyone sees a trend and assumes an outcome is guaranteed, that outcome has a low chance of occurring, in my opinion. While I think people are right, although late, about Trend 1, most people have not considered its implications and repercussions and are missing the accompanying challenges and opportunities. Fee business in the future will not be the same as today. The trend will still be in motion but the competitive and regulatory headwinds may surprise some people.

Today, huge dollars are flowing into fee business, but in spite of recent increases in the regulation of RIAs, they are under-regulated compared to broker/dealers and other financial institutions. Granted, some regulation on broker/dealers will not apply to RIAs, such as rules regarding market making and churning. However, rep advisors who move from commissions to fees often do the same type of work with greatly reduced regulatory burdens and higher compensation. While those of us in the fee business like this outcome, this is not good news from the regulators' perspective.

Regulators see levelization of regulation as the answer, and rather than a decrease in regulation on broker/dealers this means a huge increase in RIA regulation. Therefore, along with the general call for integration of regulatory bodies, there is already a call for a self-regulatory organization (SRO) to regulate RIAs.

The SEC first proposed an SRO for RIAs in the 1990s and SIFMA resurrected the idea last year, specifically calling for FINRA to be the SRO. Treasury Secretary Paulson supported the idea including FINRA as the suggested SRO in the "Blueprint for a Modernized Financial Regulatory Structure" released in April 2008.

Regardless of whether the regulatory body turns out to be FINRA or another body, far more regulation is definitely coming. This increased regulation will create rules for advertising, disclosure, and other business practices which will look like FINRA's rules for broker/dealers. In addition, regulators will ultimately hit on pricing. When the SEC is highly focused on 25 bps paid in 12b-1s on the brokerage side, do you think they will ignore rep advisors charging 1% to 2% per year? The day of having to justify (and potentially reduce) advisory fees is not that far off.

This huge increase in regulation will mean small RIAs of the future will be challenged much like small broker/dealers have been over the past 10 years. "Super RIAs" or broker/dealer-affiliated super RIAs will be the solution for many fee-based rep advisors--just like larger, independent broker/dealers have solved the regulatory challenge for rep advisors that in the past might have formed their own broker/dealer. This will help avoid a regulatory nightmare for the regulators: Imagine the 500,000 Registered Representatives currently with a few hundred broker/dealers becoming 500,000 Investment Advisor Representatives with 250,000 separate RIAs--all with little or no supervision. This scenario for regulators would require 10 times their current resources to accomplish today's level of regulatory control and thus will never be allowed to happen. This is a challenge and an opportunity to the industry and to rep advisors. How each of us solve the problem will determine the winners and losers.

Trend 5: Maturation and Institutionalization of the Independent Channel
During the past 15 years, the independent channel, fee business, and the hybrid fee model have gone from niche markets to a huge and rapidly growing segment of the financial services industry. Over the next 10 to 20 years, the independent channel will become the major component of the retail financial services industry. Consider the table on page 66.

Twenty years ago, rep advisor practices had little or no value and even most independent broker/dealers had modest valuations. Today, rep advisory practices often have values well into the millions and some independent firms are worth over $100 million. Over the next 10 to 20 years, these valuations could grow 10 to 20 fold. Building real equity value is a reality for independent rep advisors and broker/dealers. This creates opportunities and challenges around the issues of ownership and transition of ownership.

Trend 6: Ownership and Transition of Ownership
As broker/dealers' and rep advisors' practices become valued into the millions and even possibly billions, ownership considerations loom large. The good news for rep advisors: you are rich. The challenge is maintaining your company's culture, values, entrepreneurial spirit, and dedication to servicing your clients when you are no longer there. Transitioning practices to the next generation--your trusted junior partner, son or daughter--may meet your emotional and cultural goals, but how can that generation afford to pay the big bucks that your practice is now worth? As the valuation numbers get large for broker/dealers and rep advisors, the best liquidity options from a price and speed-of-payment perspective are going public or selling to an institution. But for me at the broker/dealer level, and for many rep advisors as well, these options go against the grain of our other objectives. How broker/dealers and rep advisors resolve these continuity planning and ownership issues will be key differentiators determining the winners and losers. It is time to stop talking about these problems and start building the solutions.

Seek Out New Territory
As these six trends unfold, forward-thinking leaders of the independent channel will be rewarded as they create value and unique Blue Ocean strategies to help their clients and companies. So why do 95% of smart rep advisors and broker/dealers still fail to create a Blue Ocean strategy, but instead either ignore trends or go in the wrong direction? I believe the answer is that most of the time we prefer the status quo; we like to keep doing what we have been doing, especially if it has been working. We protect our turf rather than seek new territory.

Twenty years ago when my broker/dealer lost our two biggest offices--accounting for 75% of our revenue of the time--because they went fee-only, my first response was fear, anger, and a conclusion that the broker/dealer business was an obsolete model. A few years later, after really listening to rep advisors who wanted to do more fee-business, I embarked on the hybrid fee model and created Cambridge's unique strategy with incredible results. I am convinced that even greater opportunity exists today for rep advisors and broker/dealers. What will separate the leaders of the next 20 years from the other 95% will not be simply seeing the trends, but welcoming even the scary ones as friends, creating new strategies, and being a force of positive change in the industry and the world.

Eric Schwartz is chairman & CEO of Cambridge Investment Research, Inc. in Fairfield, Iowa, an Investment Advisor 2008 Broker/Dealer of the Year. He can be reached at eschwartz@CIR2.com.