The Mating Game

Mar 1, 2009 12:00 PM, By Christina Mucciolo

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

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Squeezed

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

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

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

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

Indie Scuttlebutt

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

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

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

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

Small Fry, Big Stake

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

Broker/Dealer Revenue Breakdown by Channel, 2008

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