Private equity funds are investing heavily in independent financial advisory firms, staking billions of dollars and injecting Wall Street business and management practices into financial planning's fastest-growing corner.
But the funds are also associated with something else, according to a recent academic paper. Advisors at registered investment advisory firms, or RIAs, with private equity stakeholders are more likely to engage in misconduct with clients.
The paper, “Private Equity and Financial Adviser Misconduct,” was
“While PE tends to choose advisory firms with less misconduct as buyout targets, there is a sharp increase in adviser misconduct measured both at the adviser and the firm levels after the PE takeover,” wrote the paper’s authors, Albert Sheen, an assistant professor, Youchang Wu, an associate professor, and Yuwen Yuan, a graduate student, all at the university’s Lundquist College of Business. “Our results suggest a tension between advisory firms’ profit motive and ethical business practices, especially when customers are financially unsophisticated.” Customers refers to a firm's retail investing clients.
The paper, which has not yet been published in a peer-reviewed journal, adds a fresh layer of scrutiny to the perennial problem of rogue brokers that plagues the financial planning industry. A revised 2018
For at least two decades, RIAs have been associated with a higher level of care for their clients. Customers of independent firms pay fees regardless of the type of investment, as opposed to commissions tied to specific investments with financial incentives for the seller. Advisors at independent firms are held to the fiduciary standard, which requires that a client’s best interest always come first and that conflicts be not only disclosed but also avoided. By contrast, advisors who work at brokerages, also known as brokers, fall under a lesser standard known as Regulation Best Interest, in which they’re required only to recommend products and services deemed “suitable” for a client. Advisors who work at independent firms that also offer brokerage services can be held to either standard, depending on the products and services they’re selling through their “hybrid” RIAs. The Oregon study covers both types of advisors.
Breaking bad
Advisors at independent firms are on average 40% “cleaner” in terms of misconduct before they sell to a private equity fund, the researchers said. But after a sale, those advisors become “on par with the industry average.”
Last year, RIAs
DeVoe’s lookback at 2021 reveals trends and surprises.
The Oregon paper examined data over 2000-2020 from the SEC, which regulates RIAs, and BrokerCheck at the Financial Industry Regulatory Authority, or FINRA, which regulates brokers, along with PE-backed merger and acquisition data from research firm Pitchbook. The researchers crunched the data through the lens of five types of disclosed misconduct events that were resolved: civil proceedings, criminal proceedings, regulatory events, customer disputes and termination. In all, 57 RIAs, each with an average 250 advisors, met the criteria for the study, meaning that it covers roughly 14,250 advisors, said Wu, one of the authors.
Private equity funds typically back large “consolidator” RIAs that in turn snap up smaller competitors. Those bigger firms are typically “hybrid” firms. The 25 largest broker-dealers with advisors control 68% of all retail client assets,
The study found that misconduct increased in firms in which a private equity fund took a stake without completely buying out top executives and partners. Malfeasance, it said, is “concentrated” in deals involving non-management buyouts, “in which the acquirers are likely less familiar with the advisory business than in the case of management.”
The paper posits that private equity can potentially be bad for an RIA — and for its clients.
“Our findings indicate that PE chooses cleaner firms in terms of misconduct as buyout targets," it said. "After PE takeover, however, firms commit more misconduct. These results suggest implications about the value of misconduct.” The paper concluded that “PE firms choose targets with untapped misconduct slack and exploit this opportunity to make profit, perhaps at the expense of customers.”
A College for Financial Planning analysis suggests encouraging aspiring planners to pursue financial designations other than the CFP could lead to more women and people of color entering the industry.
Private equity funds focus on investing in promising companies and then flipping them around five to seven years later for a profit. The industry has acquired a reputation in some instances for stripping money out of solid businesses. Anne Marie Stonich, the co-founder and managing director of Paracle Advisors in Seattle,
Some top RIA executives argue that image is misguided.
During a Dec. 16 webinar, David Barton, the M&A leader and former CEO of Mercer Advisors, a $36.5 billion RIA in Denver that’s majority owned by New York-based private equity firms Oak Hill Partners and Genstar Capital, said that “there’s this misconception that private equity is this puppeteer, pulling the strings on management. That’s not the case.” He added that “we’re the ones that manage the clients. We’re the ones that operate the business. We drive the decision-making process.”
