Private equity investors have been major players in the independent broker-dealer industry since 2005, when two top-tier managers, Hellman & Friedman and Texas & Pacific Group, now TPG, bought 60% of LPL Financial.
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Five years later, they took the company public at $30 per share. The initial public offering was an unqualified success, with LPL shares flirting with $100 per share this year before the COVID-19 pandemic sparked a market sell-off.
Other private equity managers obviously took notice, as they’ve been snatching up registered investment advisers for the past 0 years.
Although broker-dealers are larger than RIAs when it comes to assets, B-Ds are less profitable, with margins in the single digits, compared with margins of 20% to 30% for RIAs.
But after the 2016 election of President Donald Trump signaled the end of the Department of Labor’s expensive fiduciary rule for broker-dealers, private equity managers began acquiring giant broker-dealer networks with thousands of financial advisers. Those included Cetera Financial Group in 2018 and, a year later, Advisor Group and Kestra Financial.
Private equity funds typically use high levels of debt to complete their purchases, and that debt concerns some in the marketplace now that broker-dealers face a harsher economic environment.
How will they hold up as they deal with the fallout from the COVID-19 pandemic, which includes the broad market sell-off and a sharp decline in interest rates, which hurts broker-dealers’ spreads on client cash? Will the broker-dealers acquired by PE funds be able to spend as much on technology, marketing and recruiting as they had planned to do before the current bear market?
In a note from March, Moody’s Investors Service Inc. said that while it was reaffirming the credit rating for Cetera’s parent company, Aretec Group Inc., at B3, it changed the company’s outlook to negative from stable. Moody’s also cut the rating on Advisor Group’s debt to B3 from B2.
“Aretec’s negative outlook reflects a challenging macroeconomic environment which will weigh on the firm’s revenue in the form of lower asset-based and advisory fees,” according to the ratings agency. “The negative outlook also reflects the elevated debt level and the increasing probability of deterioration in debt-servicing capacity now that interest rates and market levels have declined.”
“Although Advisor Group’s revenue has benefited from macroeconomic tailwinds between 2017 and 2019, including higher interest rates and strengthened levels of client assets, Advisor Group has also engaged in debt-funded acquisitions, delaying its organic deleveraging during this favorable period,” Moody’s noted.
Such concerns weigh on broker-dealers owned by private equity managers, according to one industry observer.
“These high levels of leverage of the broker-dealers leave little margin of safety, as up to half of cash flow goes to servicing debt,” said Jonathan Henschen, head of an eponymous recruiting firm. “As a result, the growth of the business slows.”
“With the recent drop in interest rates, these broker-dealers now have very little revenue from money market sweep account revenue, which is why Moody’s dropped the rating on Advisor Group, and both Advisor Group and Cetera were put on negative credit watch,” Henschen said. “As broker-dealer revenue drops, but costs to maintain debt service remain the same, what happens to technology improvements, services and staffing levels?”
Not all private equity acquisitions are the same, industry executives and observers say. The firms that were the earliest to buy broker-dealers, before the recent market peak, are likely to be in better shape. And if private equity funds finance their deals with floating-rate debt — which has recently seen a decline as a result of the Fed’s rate cut — that helps, too.
Genstar Capital sold $1 billion in junk bonds in 2018 to help finance its acquisition of Cetera.
“Our debt payments will go down because we have a variable interest rate on the debt,” Adam Antoniades, CEO of Cetera, said in an interview last month. “That gives us a little relief.”
The firm will “absolutely” continue to invest in the business, he said, particularly its ongoing technology overhaul, but will have to be diligent during the rough time in the markets and given all the unknowns related to the coronavirus.
“All firms and advisers are feeling pain right now and have to manage their circumstances,” Antoniades said.
Another executive remains upbeat.
“Kestra Financial has the benefit of a strong balance sheet, balanced and diverse revenue streams and is financially equipped to manage through the current environment,” Kestra CEO James Poer wrote in an email.
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