The first thing you learn in Economics 101 is that “there is no such thing as a free lunch.” In other words, when you get something of value, you usually give up something of value. Hopefully the exchange is equal and you know what you are giving up and what you are getting. The same is true for a recruiting bonus: You give up something of value to get that bonus, and it is important to analyze exactly what you give up. Unfortunately, too many advisors believe that broker/dealers “have gone crazy” and are paying great bonuses because they “are very competitive.” Let's take a look at what is behind those sign-on bonuses.
Why would a broker/dealer pay its advisors? Isn't it supposed to be the other way around? Simply put, the value of a client to a company is equal to the present value of the stream of future profitability from that client over the years of doing business together. In other words, if a broker/dealer is recruiting an advisor with $1 million in GDC (revenue) and the broker/dealer has a 5 percent profit margin (reasonable assumption for the average independent b/d) and the b/d expects the relationship to last 10 years, then the value of that advisory relationship equals:
$1,000,000 (revenue) × 5% (profit margin) × 10 (years) = $500,000
Let's ignore the time value of money for a moment, as well as the possible growth of the advisory relationship. In this simplistic model, the b/d might be inclined to spend $200,000 in a recruiting bonus to receive $500,000 in future profits. This makes sense.
Notice something very important here: If the company's margins decline over time, the recruiting bonus can go from being a “good deal” to being a “bad deal.” Now notice that the b/d has paid a significant portion of its future profits to get this advisor to join. This means that the future margin on this advisor will be more like 2 percent rather than 5 percent. Ask yourself what will happen if the bonuses become a common tactic? The margins will decline. With the decline in margins, the ability to offer bonuses will decline. In other words, a b/d cannot systematically use bonuses to grow. Over time, bonuses should decline, not grow, especially if they are a common practice for that specific b/d.
Now let's add the time value of money and see what that does. Let's assume that the b/d has a required rate of return on capital of 10 percent (not an unreasonable assumption for an independent b/d, but if you want to do more research you can check the interest rates paid by publicly traded firms like LPL and Raymond James). The value of the relationship becomes:
NPV (future profits) = Sum (Revenue X Growth Rate X Profit Margin)/(1+Required Rate of Return)I
I = the period in time.
If the required rate of return is 10 percent and the growth is zero, the present value of the same stream of profits is $357,228. Now a bonus of $300,000 starts looking dicey and a bonus of $400,000 is overpaying. However, if the b/d is optimistic and assumes that the advisor's practice will grow at 15 percent per year, the value increases dramatically. Now the value of the relationship becomes $693,698 and a bonus of $550,000 does not look irrational anymore.
Why are we bothering with all of this math? So you can see what the factors are that influence recruiting bonuses:
- What is the profit margin of the b/d? Clearly, the higher the margin, the more the firm will be able to offer in a recruiting bonus.
- How long will the advisor stay? The more years the advisor is expected to stay with the b/d, the larger the present value of future profits becomes.
- What is the weighted average cost of capital for the b/d? If the b/d can borrow at lower rates, they will have a lower required rate of return and therefore will have dramatically higher net present value.
- What is the b/d's expectation of how much the advisor's firm will grow? If an advisor can sell the b/d a growth story, he can get a bigger bonus.
This explains why independent b/ds have historically not offered recruiting bonuses while wirehouses have practiced this tactic for years. Independent b/ds have lower margins, higher cost of capital (and, therefore, a higher required rate of return), fewer barriers to the advisor leaving, and therefore, a shorter expected life of the relationship. This also explains why some independent b/ds are now offering bonuses: A few of them are large enough to have a lower cost of capital (LPL is public, a few others are owned by public companies or insurance companies) and regulations have made block-transfers extinct, assuring the relationships are stickier and more valuable.
This also explains why recruiting bonuses go up and down. Quite simply, management in charge of recruiting can get more or less optimistic about its growth assumptions. For example, if you increase the growth assumption from 15 percent to 20 percent (I would argue that 15 percent for 10 years straight is very aggressive), you can get to a total value of $882,309 and justify a very high bonus.
Wirehouse Math
Finally, the math for a wirehouse firm is a little different. Their profit margins are closer to 15 percent (theoretically) and that drives the value of the relationship to well over $2 million- assuming a 10 percent required rate of return and 15 percent growth rate. In other words, while the maximum bonus an advisor could get with an independent b/d profit was about 50 percent of GDC, here we can justify as much as 200 percent. Another factor at play is that wirehouses, and to some degree (lesser but still valid) independent b/ds, will generate a lot of non-commissionable revenue that is not shared with advisors. (That's why their margins are higher). Self-clearing firms can get as much as 20 to 30 cents of additional high-margin revenue from a dollar of revenue; that's where a large percent of the 15 percent profit will come from.
There might be specific factors unique to the advisor's business that allow the b/d to pay a higher bonus: those that generate non-commissionable revenue. For example, the advisor can agree to pay high ticket charges, or maintain high cash balances, or trade frequently, etc. None of these practices is good for the advisor's clients, but they will maximize the bonus offer.
This means you can reverse-engineer any bonus offer. Let's say you had $1 million in revenue and you got a 20 percent recruiting bonus offer from an independent b/d. The offer is tied to a five-year forgivable loan and a target of 20 percent growth (all disclosed in the offer). Let's now reverse calculate the profit margin of the b/d using a 10 percent required rate of return. You can simply have Excel solve what profit margin justifies this offer or you can trust me when I tell you that the b/d must have at least a 3 percent profit margin to justify this offer. A profit margin lower than 3 percent will result in the b/d losing money on the deal. What if the offer was 40 percent? (I have never heard of such a high offer from an independent b/d, but we live in strange times.) The profit margin will have to be at least 6 percent just to break even on the bonus. For most independent b/ds, this profit margin and this offer are unrealistic.
Now consider a 250 percent offer from a wirehouse tied to a 10-year loan and 15 percent growth. The implied profit margin is about 18 percent to make the math work.
Recruiting Bonuses Are Not Good for Clients
So why are recruiting bonuses negative for the industry and for clients?
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Clients pay for everything. The $1 million in commissions and fees is their money and they have the right to know the terms of the transition deal. I don't believe that recruiting bonuses are disclosed to clients. They should be. Ultimately, the clients are the ones that bear the cost, and the profit margin required to justify the bonus will be created out of their commissions and fees. All else being equal, the more the industry uses recruiting bonuses, the higher fees and commissions will have to be to finance such bonuses.
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The winner's curse. The winner in the bonus competition will be the firm with the most aggressive assumptions about growth and the length of the relationship. In a competitive market, most firms will have similar profit margins (they do) and similar cost of capital (mostly true). This means that the winner in the bonus game will be the most aggressive firm. Economists call this “the winner's curse” since the winner in a competitive bidding tends to overpay. It is no surprise that some of the most aggressive “bonus recruiters” are currently out of business or in trouble.
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Bonuses encourage bad practices. To afford even higher bonuses, firms will need higher profits. This will happen through either restricting investment choices to managers that pay the b/d, or increasing revenue sharing deals, or increasing “platform fees” and ticket charges, and a plethora of other poorly disclosed deals that ultimately come out of the investors' pockets.
So if you are an advisor getting invited to the “free lunch” and you are looking at a “bonus” to move your practice, be honest with yourself. Analyze what you are giving up to get to this bonus. There is a fine line somewhere when the recruiting money turns from a compensation for transition expenses incurred to strictly a blank check to take advantage of your clients. At some point the situation starts to resemble an old gangster movie where the guy says, “Hey kid, here's five bucks; go take a break.” I don't know where that line starts, but we are all financial people and the analysis is very basic. If it sounds like you are getting a lot, you are probably giving up a lot (or your clients are).
Philip Palaveev is the president of Fusion Advisor Network, a business management consultant to financial advisors.
