Also available as podcast (Episode #85)
What Could Prevent An Advisor From Starting An RIA?
The Registered Investment Advisor (“RIA”) model is not for everyone. While there are significant economic benefits, and flexibility, it also comes with additional responsibilities. If upon completing an analysis on how the model works, what it would look like for your practice, what the pathways into the model are, the solution providers available, if it’s a fit for you, is there something that could prevent you from moving forward? Yes, depending on your circumstances there are hurdles you might not be able to overcome. Of note is the ability to get the RIA registered, and also procuring a custodian to use.
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What could prevent an advisor from starting an RIA? That is today’s question on the Transition To RIA question and answer series. It is episode #85.
Hi, I’m Brad Wales with Transition To RIA where I help you understand everything there is to know about why and how to transition to the RIA model.
If you’re not already there, head to TransitionToRIA.com, you can find all the resources I make available from this entire series in video format, podcast format. I have articles, I have whitepapers. All kinds of resources to help you better understand the RIA model.
On today’s episode we’re going to discuss what could prevent an advisor from being able to start an RIA?
Now, generally, I don’t get asked that question verbatim because it doesn’t necessarily occur to some folks to say, “Why might I not be able to do this?” But unfortunately, for some folks, I end up answering the question for them because of their circumstances.
Many, if not all these items, hopefully don’t apply to you. But if they do, it could be a potential challenge for you to start your own RIA. I come across these issues from time to time, and it does create challenges. So, I wanted to make an episode to talk about what some of those are.
Those of you that have listened to a lot of these episodes know, I am a big believer the RIA model is not for everyone. I am obviously a big proponent of the model – I help advisors understand the model, understand how to transition into the model – it’s not for everyone.
So, just as a precursor to rest of the content on this episode, know that the first thing you must do if you’re considering the RIA model is understand how the model works. How the economics work. How the flexibility works. What the responsibilities are.
You must factor all these pieces in and decide how it would look for your particular practice to then decide, “Would it make sense for me to transition my existing practice into the RIA model?”
There are different pathways into the model. I talk a lot about that on these episodes.
On today’s episode, we’re going to assume we’ve got past that first layer. For those still contemplating it though, that’s a big part of my value proposition, helping you understand it, how it works, and what it would look like for your practice.
If you’re determined the RIA model is a good possible fit, that’s where some of the hurdles we’re going to talk about today could then come into play. Again, for most of you, these won’t be applicable, but it is worth pointing out because for those of you that it is relevant, these could present challenges.
In no particular order, first is getting the RIA registered.
Your RIA must be approved by either the SEC or state, depending on your circumstances. I’ve done an episode on that as well.
Let’s say you’re large enough of a practice to be SEC. Your RIA registration must be – they don’t technically use the word “approved,” basically, accepted, if you will, by the SEC.
They’re going to review your ADV. They’re going to look at the background of the main principles, the main owners, to see if there’s any concerns. There is no guarantee they will approve it, and then you can go live. So, what might prevent you from being approved?
An example, if you have significant CRD items or there is a U5 reason you’re now seeking out the RIA model – perhaps you have been terminated by a broker-dealer – that could be an issue.
Not too long ago, a rather large advisor at one of the traditional wirehouse firms came to me and said, “I’m ready to move my practice into the RIA model.” Upon digging deeper it turns out he had just been terminated by his broker-dealer.
Now maybe he had been thinking about the RIA model for a long time, but it was the termination that caused him to take this more concrete step.
Without going into all the details, he had been terminated under pretty harsh circumstances and the language on the U5 was going to be pretty harsh.
He came to me with the impression that he could essentially just pivot, start his own firm, and never have to worry about someone terminating him ever again.
I had to point out to him, as he didn’t realize, that there was no guarantee he would be able to get approved (by the SEC), particularly with the circumstances now on his record. That was tough to communicate to him, as I could see him (on the Zoom) feel deflated upon learning that. He didn’t realize that could even be an issue.
The regulators will look at that sort of thing, in part, because of criticism over the years where regulators were not talking to each other. Maybe a broker gets kicked out of the brokerage industry and then goes and sets up shop as an insurance salesperson and the insurance regulators aren’t talking to the securities regulators.
The states and the federal level are trying to tighten that up and say, “If you’ve been banned in one of these channels, it’s going to be a very big hurdle to get approved in a different channel.”
But even if short of being banned, it depends on what the circumstances are, what the CRD items are, it could be an issue. There could be reasons your state or the SEC will not approve you.
Next, even if you don’t have that issue, you have a clean record, you don’t have any skeletons in the closet, you can get approved by the state or SEC….well, if you want to manage assets, whether on a discretionary, non-discretionary basis, you are going to need a custodian.
I’ve done a lot of episodes talking about custodians. I did one on how to choose a custodian. You can check that out if you want. But you’ll likely need a custodian to work with.
There are different reasons some custodians might be available to you, and some not. They typically have minimums, so some might have a higher minimum asset level that your individual practice is not at yet, so they’re just not available to you for that reason.
But of the ones that you’ve reached the minimums, there’s still circumstances where a custodian might not be willing to enter into what’s often referred to as a clearing agreement with your RIA. Your RIA needs a clearing agreement with at least one custodian. One day you might have more than one custodian, but you need that clearing agreement.
Regarding the advisor I mentioned earlier, I had to communicate this custodian challenge to him as well.
One of the things custodians will look at is who are the main owners, the main principals of the RIA. They will look at their background, and they could potentially say, “Under these circumstances, we’re not comfortable working with this individual, or this team.”
That is a typical part of the due diligence a custodian plays on you as the advisor, or the team that would like to use them. Just as you do due diligence on the custodian, they need to be comfortable with who they will, in turn, be doing business with as well.
If you have meaningful CRD issues, that could be a challenge, a hurdle in the custodian’s eyes to approve you. So, just know, this is relevant, not only at the registration level, also the custodian level.
Another reason a custodian might choose not to do business with you is due to your client type.
An easy example of this is if you have almost exclusively foreign clients. That’s a higher risk for any custodian or broker-dealer. There’s more logistical hurdles with the AML and know-your-client responsibilities. There’s more risk because the regulators are assessing fines on firms because they don’t feel their AML policies are tight enough.
If you have a lot of foreign clients, or all foreign clients, the custodian might simply take a pass.
An advisor reached out to me recently, and he unfortunately had two things going against him. First, he had almost all foreign clients, And two, he was a modest-size practice.
I’m not judging this advisor or their clients, but it is what it is. There’s a heightened risk associated with having foreign clients.
And in this case, he has to attempt to find a custodian and effectively say, “I’m not that big to begin with to generate you meaningful revenue. And on top of that, the profile of my clients is not necessarily ideal either.”
So, it depends on your client type, and then probably the main example of that is foreign clients, whether they’re in another country or they’re Americans that are living abroad, there’s all kinds of different scenarios. That could be an issue for a custodian to be able to accommodate your business.
Another example where a custodian might take a pass, and I dealt with this recently, is if your practice has a lot of very small accounts. Maybe you have some big accounts mixed in there too, but if you have a lot of small accounts, that math doesn’t work for a custodian.
It’s an extreme example, but I had a team come to me recently and they had thousands of accounts under about $10,000 each, thousands of them. It is a lot of work and responsibility for a custodian to maintain an account. They must send out tax forms, statements, all those sorts of things. Not to mention, the initial process of opening the accounts.
So, to reach out to a custodian and say, “I have thousands of accounts that have $3,000, $4,000, $5,000 in them,” they will likely take a pass. The math doesn’t work for them. The economics doesn’t work for them. So, that’s an example of what could be another hurdle.
The final related hurdle I want to mention on what might cause a custodian to take a pass is will an RIA be a reasonable revenue generator for them.
I’ve done an episode on how custodians generate revenue. They are a for-profit business. For them to do business with you, it has to make economic sense for them. They will make sure to understand what the revenue drivers would be for them.
I’ll give you an extreme example. Even if you have a couple hundred million dollars, but you show up and you say, “We basically hold no cash in client accounts,” which, by the way, that’s a meaningful revenue driver for custodians. “We don’t use any mutual funds,” that’s another potential revenue driver. “We only own/trade individual equities,” which typically don’t have a transaction charge. “We buy blue chip stocks and hold them for decades. We might do three trades total in an account per year. It’s all equities, and that’s all we do.”
There’s no meat on the bone for the custodian at that point. There are a few potential other revenue drivers that could come in, but in this extreme example, there’s practically no revenue for the custodian. They in turn have costs though associated with being able to service your relationship. They might respectfully say, “We’re not going to be a good partner for you.”
Those are two of the main hurdles of what could prevent you from starting an RIA. Can you get registered, and can you get a custodial relationship.
The final thing I want to mention is even if you get past both of those hurdles, can you successfully navigate away from wherever you are now to transition your practice into the RIA model?
I’ve talked about this in a couple of different episodes. I’m not going to go too deep on it here, but I’ll give some examples of where it might not work.
The first example, I won’t name names, but there are, among others, custodial firms out there that also have their own branded retail storefronts. It might be in a strip mall for example. Clients can walk in and open an account, there’s someone there to help them.
The advisors in those locations typically are hired to essentially service those relationships. The advisor is typically not tasked with going out and finding new business. The arrangement with the firm is, “We’ll bring all the clients to you.” Or, “We already have this huge amount of clients. We just need you to service those relationships.”
That can be a wonderful career for folks that want to play that role. It can pay good compensation as well. But make no mistake, if you are in one of those roles and you want to leave and maybe start your own RIA, the firm that you’re leaving is not going to take that lightly. They are not going to let you just walk out the door and try to solicit and woo clients away from them.
That’s a very specific circumstance where, for the most part, the advisor has not gone out and got those clients themselves. They’ve essentially been given to the advisor to service, to be that relationship person.
That’s an example where if you try to leave, they’re not going to let you go (with their clients) easily.
The point of that is even if you can get your own RIA registered, even if you get a custodian, depending on where you leave, you might not realistically be able to take your clients with you.
Now, I don’t want to scare anyone off because there are very few instances or scenarios where that’s a hard stop. In most instances, even if you have a non-solicit or some sort of contract language, there’s usually still a way to navigate through it successfully. But there are some scenarios which are, unfortunately, pretty much a hard stop. That’s one of them.
Another example that’s a hard stop, I have come across this, is if you have a practice, you’ve grown it over the years, and at some point, you sell the practice. Perhaps to an RIA or whatever the entity type is, you’ve sold it and they’ve maybe kept you on for a period of time. And now, whatever your motivations, maybe you’re not happy there anymore, and you say to yourself, “I’m going to leave. I’m going to go start my own RIA and take my clients with me.”
The firm you sold to will have an issue with that. If you have sold your practice and received compensation for it, it is not reasonable to think you can then go and essentially double-dip and take those clients away from them. They will have an issue with it.
You’d leave it up to the attorneys to sort through whatever agreement you signed, but more than likely, that’s most likely going to be a dead end. And that’s fair, because if you’ve sold a practice, the buyer has paid compensation for that asset, it would not be fair for you to then try essentially to pull that away.
This is not an exhaustive list, but a final example, and this one is not as black and white, is if you’re a junior member on a team. Maybe you’ve come in towards the latter part of the tenure of the team, and the bulk of their assets were in place prior to you arriving.
If you want to leave and go in a different direction, maybe some sort of independent model, but the rest of the team doesn’t want to leave, well, if you leave and start trying to take clients from them, particularly clients that you didn’t bring to the table, they are going to have an issue with that.
It’s likely going to cause you legal challenges. Maybe you can navigate through some of it, but that would be another example where it’s not going to be an easy path to simply start your own RIA and move your clients to it.
This has not been an exhaustive list, but I wanted to give examples of some of the hurdles that could prevent you from registering an RIA, prevent you from being able to get a custodial relationship, and even if you get past those, what might prevent you from realistically being able to transition your clients into the new practice.
For most of you, none of these scenarios will apply. But for those where it is applicable, these are meaningful things that you’ll need to think through. There’s no reason to try to take a path that you’re essentially destined for failure with. So, just be aware of these items.
As I said back at the beginning, the first step is making sure the RIA model is a good fit for you to begin with. That’s what I help advisors with. And then if we get past that, is to look through some of these individual variables that might come up. That’s a big part of what I do, understand your practice and point out what issues might be on the roadmap that you want to be aware of.
Like I said at the top, my name is Brad Wales with Transition To RIA. Again, this is what I help advisors with. Having the conversation, providing the education of what the RIA model looks like. Understanding your practice, helping you understand what it would look like in the RIA model, helping you sort through the available pathways, determining the solutions needed, going over the transition process, etc.
That’s what I do. I’m happy to have that conversation with you as well.
At the top of every page is a contact link. Click on that and you can instantly and easily schedule time to have a one-on-one conversation with me, whether you want to talk about today’s topic, or anything else RIA-related, I’m happy to have that conversation with you.
With that, I hope you found value in today’s episode, and I’ll see you on the next one.
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