Joel Marks is in a race to get big before he gets crushed. Marks, vice chairman and COO of independent broker/dealer Advanced Equities in Atlanta, more than tripled the size of his independent advisor force with two acquisitions in the past year. That brings him to 600 reps and assets of $14 billion. In the coming year, he expects to nab another two or three b/ds, and by 2007 he hopes to double revenue again to at least $300 million with additional acquisitions.

Sure Marks, who sold a previous b/d to First Union (now part of Wachovia) in 2000, is ambitious — he figures he can take Advanced Equities public if his acquisition strategy works. But he's also motivated by fear: Like other small b/ds, Advanced Equities is fighting for survival in what has become a hostile environment. “Scale really does matter in this business right now,” says Marks. “In fact, every year the size that you have to be to compete seems to be growing.”

The High Price of Being Small

Small independents like Advanced Equities are in the middle of a classic squeeze between soaring costs and falling revenue. The price of compliance, technology and talent has gone way up — several b/d executives agreed that for some these costs have cut pretax net margins by 20 percent to 40 percent. But the real killer has been the crackdown on payments between fund distributors and brokerages, which have been a critical source of revenue for independents, says Steve Pierson, managing director at investment bank Putnam Lovell NBF.

“What margin was there was often provided by the rebates the fund companies offered to broker/dealers,” he says. “Once those became improper, it really cut a major source of profits.” Because independents generally pay between 70 percent and 90 percent of commissions to their producers, after fixed costs are accounted for, there isn't a lot of revenue left. In many cases, revenue sharing accounted for 100 percent of margins, Pierson says.

Which means that for small b/ds, the drill is to get big or get gone. “For the most part, independent businesses that don't have north of multi-thousand brokers, those that are not the size of a Linsco/Private Ledger, aren't capable of being profitable,” says Pierson. That leaves a lot of firms in the lurch: Of the 5,300 firms that the NASD regulates, 92 percent have 150 or fewer reps.

For some firms, adding higher-margin business lines has helped. Leonard Sokolow, president and chief executive officer of vFinance, which has $27 million in revenue and $1 billion in assets under management, says his b/d has picked up wholesale trading and market-making, as well as investment banking operations. These revenue streams, he says, have allowed the small company to stay afloat. But he's also looking for growth through acquisition. The company has picked up six b/ds over the past five years. “We think you have to have critical mass as well as diversity,” he says. And, he adds: “We're not adverse to being the minnow and being swallowed by the whale.”

Tough Sell

The problem is, there aren't a ton of buyers in today's market. Most of the midsized b/ds were swallowed up in previous waves of consolidation. And, the small fries aren't interesting enough for the biggest players to bother with. “Today you have five really giant broker/dealers,” says Dick Miles, managing director New York-based private investment bank Berkshire Capital. “A.G. Edwards, the next largest, is about half their size. You might expect that the next tier firms are going to be acquired at some time, but you could have made that speculation three to four years ago and nothing has happened,” he says. “The only firms that one of those top five could buy would be an A.G. Edwards or Edward Jones or Raymond James.”

Those firms are fiercely independent and have distinct cultures that would be hard to mesh with a giant like Merrill; there would be a risk of large-scale defections.

“Even if you acquire a broker/dealer, your assets have wingtips,” says Danny Sarch, a recruiter at Leitner & Sarch in White Plains, N.Y. “What makes you think the brokers are going to want to stay at a Merrill Lynch? In these mergers, keeping the talent is the most crucial thing.”

Even the banks and insurance companies, which spent the past decade snapping up b/ds and other organizations that could give them heft and help distribute a range of products, seem to have lost their enthusiasm — at least for the moment.

It's not that big b/ds like Merrill Lynch or Wachovia don't want or need to grow. Indeed, they are under tremendous pressure to do so after many years of declining profits, say analysts. In fact, a number of firms have publicly said that they are on the acquisition hunt, including Merrill Lynch and Legg Mason (see related story on page 67).

But for now, it seems, recruitment is the most likely growth engine for independent b/ds. Even organizations the size of Linsco/Private Ledger are more likely to grow by attracting more and better brokers than by buying other b/ds. “They're better off paying big signing bonuses and going after the cream of the crop,” says Larry Roth, also managing director at Berkshire Capital.

To get the best often requires “team liftout” — buying a multi-advisor group or an entire branch. There are a number of recruiters who specialize in cherry-picking top offices. These tend to be groups of 10 to 30 brokers who have a market niche and have identified themselves as a quality group.

Rolling it Up

For now, companies like Advanced Equities and vFinance are free to shop around for the little b/ds that, for them, could make a big difference. They're small enough that smaller acquisitions are attractive and they have stable sources of capital to invest. Advanced Equities has a late-stage private equity arm that it is partly using to finance its growth, while vFinance is publicly traded. The firm has used its common stock, warrants or options to pay for deals.

It's not that the deals require a tremendous amount of capital. Most independents with high-producing advisors are valued at between 20 percent and 40 percent of revenues. Typically, not all of that is paid upfront — a portion is paid at closing and then there's an earn-out over one to three years. Still, a lot of the smaller b/ds will have to grow slowly, through mergers of equals or the financial backing of a private equity firm or a bank.

Advanced Equities says it has high standards for its acquisition targets, but that hasn't been an obstacle yet. The firm is on the prowl for businesses with $10 million to $100 million in revenues and reps that serve high-net-worth individuals — those with say, $25 million in assets and $250,000 in annual production. “We're not having any trouble,” Marks says. “There are plenty of attractive targets out there. It all comes down to price and personality at the end of the day.”

But other buyers have found that, despite the difficulties of the current environment, some small firms are reluctant to sell even when approached. “It's a very difficult process,” says Sokolow. “It's hard for principals to give up control of their firms. Some of them tend to wait until the last minute. It's usually precipitated by an event.”

Ben Plotkin, president and CEO of New Jersey-based b/d Ryan Beck, which has $245 million in revenues and 500 reps, says his job requires patience. “We see ourselves being an acquirer of choice — people like our culture, our compensation and our sense of autonomy,” he says. “But being a good acquirer — you need to have capital and a platform — but you also need the patience to realize that companies will decide to sell when they want to sell.”

Broker/Dealer Bait

The hottest merchandise on the block these days, particularly for larger broker/dealers, are wealth management shops, such as family offices, trust companies, financial planning firms and private client businesses. Already, a number of b/ds have begun to buy up shops in this space. Wachovia Wealth Management, which has been expanding aggressively over the past few years, completed its purchase of Waltham, Mass.-based multifamily office Tanager Financial Services in September. Legg Mason acquired several offices of Scudder Private Investment Council from Deutsche Bank in November. UBS signed an agreement to buy Julius Baer's wealth management business in December. And CSFB Private Client Services has said it plans to double the size of its operation — now nine offices and 250 advisors — over the next three to five years.

In fact, Berkshire Capital called wealth management the “hottest” consolidation segment for the second year running in 2004, accounting for 48 percent of all deals in the asset management industry and 20 percent of value last year. Berkshire Capital expects similar deal volume this year, and even more interest on the part of b/ds.

“What firms like Legg Mason have found out is that the market rewards a constant income stream more than the commission-based ups and downs,” says Elizabeth Nesvold, managing director at Berkshire Capital. (Since Legg Mason acquired Scudder on Nov. 14, 2004, its stock has risen 11 percent.) It's often easier to make that switch by acquiring a wealth management firm than by reshaping the firm's business internally, she says. Several analysts speculated that Merrill Lynch might be a potential acquirer in the wealth management space. “The firm has been migrating away from transaction-based business, so it might buy a firm that is well entrenched in the fee-based or managed money side,” says Matt Bienfang, an analyst with Boston-based financial services consulting and research firm TowerGroup.

UBS is a possible buyer too, says Nesvold. “They brought in a couple of high-powered folks on the wealth management side to build the business — no one brings in high-priced talent if they're going to do it organically.” In fact, rumors abound that UBS could be interested in acquiring U.S. Trust, Schwab's wealth management arm. UBS declined to comment.

One stumbling block for b/ds on the wealth management front is that they're used to paying for a book of business, says Nesvold. But that's a function of the margins of the b/d business. Whereas net margins for b/ds can hover between 10 percent and 20 percent, wealth management firms tend to reap margins of between 35 percent and 40 percent. In valuing a wealth management firm, one tends to either look at price to earnings and EBIDTA or a percentage of client assets. Lehman Brothers' paid 4 percent of assets under management for Neuberger Berman. “That's not cheap,” says Jeffrey Harte, managing director of equity research who covers b/ds for investment banking firm Sandler O'Neill. “It's in-line with historically where they've been.”

Still, as deal activity in the space heats up, b/ds may get smarter about how to value these deals pretty quick.
Kristen French