$17B gone: The biggest-ever advisory team exit and the bank that lost it

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It’s a historic week in wealth management. No bank, regardless of size, has ever watched anything close to $17 billion in clients assets walk out the door. Given that this misfortune befell a relatively small one this week, the blow — at first blush — appears especially severe for First Republic Bank.

Nearly 50 members of its wealth management division have left, following the five top advisors on their team. Those $17 billion in client assets are expected to evaporate with them. If it were classed as a breakaway, which typically refers to brokers who bust out of their wirehouse firms, it would be the largest in history.

Equally extraordinary: the largest breakaway hit not Morgan Stanley with its nearly $2.4 trillion in client assets or Wells Fargo with its $1.6 trillion, but First Republic, a bicoastal piker with $140 billion. If all that wasn't enough, only seven years have elapsed since the bank paid a groundbreaking $125 million to the advisors to acquire the RIA, Luminous Capital.

“It is definitely a case study for a bank-RIA acquisition that went wrong,” says Alois Pirker, research director for Aite Group’s wealth management practice. Or as consultant and investment banker David DeVoe says: “The pain index is likely somewhere between excruciating and traumatic.”

That $125 million price tag of 2012 — a jaw-dropping sum at a time before M&A in the RIA space began booming — makes it look like First Republic got a raw deal.

But did it?

"I don't think First Republic is as dumb as people are making them out to be," one source close to the original deal and the exiting advisors told Financial Planning.

Viewed over a longer time horizon, the Luminous purchase helped set First Republic on a path of fast growth that, helped by its wealth management division, has propelled the bank itself to new heights on Wall Street. It also set the stage for its own subsequent wave of sustained and often-large wealth management acquisitions.

Moreover, industrywide, it served as a bellwether for all RIAs. It did so by galvanizing the then-barely four-year-old breakaway movement of wirehouse brokers to independence and by grabbing the attention of outside investors, including private equity money, seeking big kills in the RIA space. In other words, a small bank with offices in a handful of states now has been involved in two landmark deals, one willingly and the other presumably not, with wide implications for all breakaways.

That's according to industry experts, including insiders who were part of First Republic's Luminous acquisition, and its founders' departure from Merrill Lynch. Constrained by confidentiality agreements, some spoke only on condition of anonymity.

Before going independent, David Hou and Mark Sear, the best known of the five Luminous team members, worked for Merrill — First Republic's former owner — when they joined the vanguard of the first breakaways in 2008. The breakaway movement they joined began that year and the next, during and following the economic downturn. Thanks to the market crash and the subsequent draining of their employers' coffers, some wirehouse advisors realized they could make more money on their own.

Four years later, First Republic electrified the market with its premium for Luminous, which was managing $5.5 billion in AUM at the time.

"It was the pivotal moment for the industry to say, 'My god, I could leave this big institution to go build this franchise opportunity,' " says investment banker Liz Nesvold, who represented First Republic's side of the buyout through her investment bank, Silver Lane Advisors, now owned by Raymond James’ investment banking division. "There have been some marquee deals, but there are very few that have gotten so much traction so quickly coming out of a big financial institution."

According to recruiter Louis Diamond, who funnels talent to First Republic and many other firms, "It kind of became the template for the reasons why a big wirehouse team would start an RIA, versus taking a big check from Morgan Stanley: Take it out, build it out and sell it to make a ton of money and, in this case, sell it again down the line."

Hou and Sear have formed their second RIA, Evoke Wealth based in Los Angeles, while their other three partners have started their own, IEQ Capital in Palo Alto, California, as first reported by RIABiz.

As for First Republic, its acquisition of Luminous transformed the way the Street looked at it. “It has been incredibly synergistic for the bank," Nesvold says.

One of First Republic’s paths to growth has been its focus on high-net-worth clients (though its business in low- and middle-income communities is also growing). By first drawing them into the wealth management division, it then provides banking service to a demographic that, by definition, comes with a multitude of complex financial needs, she says. (First Republic declined to comment on this characterization.)

"There is a correlation between the two," Nesvold says, referring to the banking and wealth management sides of First Republic. "They have been very successful with their clients, cross selling. I think the average client has something like nine or 10 services and products with First Republic and, so, it's a lot." (It’s a practice that’s not without peril, at least when practiced by banks like Wells Fargo, which emphasized the goal of selling eight accounts per retail client, a strategy that gave rise to its notorious fake accounts fraud.)

The numbers tell the story.

A year after First Republic bought Luminous, client assets in its wealth management division stood at $41.6 billion in December 2013. That sum more than tripled to $140 billion in assets under management or administration by March of this year, growing between 11% and 35% a year, according to public filings.

"First Republic has benefited enormously from our partnership over the past almost seven years," Hou tells Financial Planning. "The growth of the wealth management business was really jump-started with our help and we are sure First Republic will continue to prosper.

"We love First Republic Bank," he added. " We just want a more entrepreneurial endeavor to close out our careers over the next, hopefully, 20-plus years."

The bank's stock has rocketed, too, more than quadrupling from $22.87 on Dec. 1, 2010, to $98.51 on Wednesday, better than the S&P 500 Banks index.

That’s quite a track record for a venture founded in 1985 as a small thrift that went on to become part of Merrill Lynch, and then Bank of America, after the latter bought the former in 2007. In their do-si-do with captive ownership, it also may be worth noting that Hou and Sear went independent a year after a giant bank bought their employer, Merrill. Three years later, First Republic became a kind of reverse-breakaway itself. Two private equity firms, one of which (Colony Capital) is still led by a former (and current) bank board member Thomas Barrack, bought out half of its assets and restored the First Republic brand.

A newly independent First Republic, guided by its growth-minded PE owners and original founder, then landed Luminous two years later and began moving aggressively into wealth management. From $34 billion at the end of 2013, the bank's own assets have tripled to $101.8 billion this year.

Those figures are partly correlated to the bank's wealth management assets, Nesvold says.

Despite losing the wealth management business run by Hou and Sear, First Republic is expected to retain much of its lucrative banking services — such as mortgage and commercial lending — for its clients.

Indeed, Hou said he and his partners "will continue to refer clients to [First Republic] for banking, loans and trust services."

As for him and Sear, in quitting the bank, they are splitting from their other three top partners to form the two successor RIAs.

IEQ Capital has 27 employees thus far, according to employees' LinkedIn profiles, and Evoke Wealth has 20 employees, 10 of whom work in advisory roles, according to its Form ADV, filed with the SEC.

In addition to Hou and Sear, the five leaders of the Luminous team at First Republic included Robert Skinner, Alan Zafran and Eric Harrison. This year, Barron’s reported the assets they each advise on: $4.2 billion for Hou, $2.9 billion for Sear, $4.08 billion for Skinner, $3.8 billion for Zafran and $1.9 billion for Harrison.

Hou and Sear serve as Evoke’s two managing partners, alongside six other partners: Peter Chang, Scott Doré, Kim Ip, Dan Kelso, Jason Lefton and Monika Mugg, according to its website. Skinner, Zafran and Harrison are all listed as co-CEOs of IEQ on their respective LinkedIn profiles.

While the four others did not respond to attempts to reach them, Hou confirmed key details about the departure and new firms.

The timing for a return to independence was right, sources say. The advisors' contracts with First Republic expired recently, and First Republic remains in the Broker Protocol, which should allow for an easier exit than if the group were quitting a firm that is no longer a signatory. The protocol facilitates the smooth movement of advisors and clients between firms, but has been eroded lately by the exit of large signatories, such as Morgan Stanley. This ups the ante for some advisors interested in moving, but concerned their own employers could follow Morgan's lead and start fighting departures.

The exit "probably is not even an indictment of First Republic," Diamond thinks, but an opportunity Hou and his colleagues just couldn’t pass up.

Most of the 50 team members who left First Republic are relatively new to the industry, according to their LinkedIn profiles. It can be hard to hold onto young talent when running a group inside a large public company, Nesvold says.

"It's a tough thing to try and keep people highly incented when you integrate them into another company and, so, invariably you see people from time to time split out and form other businesses," she says. By running their own firms, the Evoke and IEQ founders could dole out equity as needed to instill loyalty, she says.

That's an issue that both First Republic and Luminous could — and maybe should — have sorted out in 2012, says M&A consultant DeVoe, who was not involved in the deal. That is, he adds, if both sides had been serious about making a lasting commitment.

Successful M&A matchmaking "is a chess game and you need to think not two or three, but 10 or 20 chess moves down the road," DeVoe says. "Not taking into account how principals could be compensated could be a potential risk." By sorting out those details in advance, he says, "ideally you are not paying for assets on one day with the idea that those assets will walk out the door seven or eight years later."

One potentially serious threat to both IEQ and Evoke will be whether First Republic turns adversarial.

"When you have very large teams, of course it makes a dispute more likely because firms by their very nature, like to make examples of them," says lawyer Brian Hamburger, who helped the Luminous founders plot their successful separation from Merrill in 2008. Hamburger is CEO of MarketCounsel, which works with wirehouse breakaway brokers.

"If I'm First Republic," says another source familiar with both the bank and Luminous, "I'm thinking, 'Does this constitute tortious interference?' That is the single greatest threat to the early success of these new platforms."

However, knowing Hou and Sear from their last high-stakes breakaway, Hamburger, who is not working with them today, says he's not worried. "I know how careful these guys are with ensuring that they have a good understanding of their risk," he says.

With so many top advisors gone, can First Republic maintain growth in its wealth management division?

If the first three months of this year are any indication, it would seem so: In that time, it has added $14 billion in AUM.

Recent acquisitions include its purchase of $6 billion AUM Constellation Advisors in 2015 for $115 million, in a deal Nesvold handled, representing the RIA. In April of last year, the bank brought over advisor James Atwood with nearly $5 billion in client assets from Merrill, Diamond says. And just last month, he adds, the bank announced that it landed Arif Ahmed, a Silicon Valley advisor who managed $4 billion for Merrill.

"Over time, they can replace the $17 billion hole," Diamond says.

As for the Luminous team — who, no matter how they brand themselves going forward, will forevermore be associated with the Luminous name — what may the future hold? "They have the opportunity to break back into being business owners and benefit from the economics there," Diamond says, "and sell again in the future."

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