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Department of Labor “Fiduciary” Rule, Headwind or Hurricane?
“Change is the law of life. And those who look only to the past or present are certain to miss the future.” - John F. Kennedy
If there is one fact that I have come to appreciate in my 20 years in the financial services industry, it’s that our business is always changing. Flexibility, a strong desire to learn, and the ability to adapt are absolute necessities for survival in this ever changing environment. According to recent industry publications, an announcement on another proposed change for our industry is set to be released on April 4th. The Department of Labor fiduciary rule would represent the single, largest industry change during my career since the Gramm-Leach-Bliley Act of 1999.
Gramm-Leach-Bliley altered the industry landscape entirely. It allowed banks and insurance companies to provide financial services that previously had been closed to them. Like the proposed Department of Labor fiduciary rule, the atmosphere surrounding the Gramm-Leach-Bliley Act was one of substantial concern. Industry pundits and media outlets proclaimed the end of the industry as they knew it. Many predicated mass consolidation of assets under the largest banks and brokerage firms as the ultimate outcome. Fortunately, that did not occur, or at least not in the fashion that was anticipated. In contrast, the result can be seen in today’s diverse industry and subsequent expansion of the Independent Broker Dealer and Advisory channels.
CHANGE IS EVER-PRESENT
Seventeen years later, there is no shortage of opinion on the effect of the proposed Department of Labor fiduciary rule. The proposed regulations expand the class of investment professionals who qualify as fiduciaries. Under current law, advisors who provide advice to small plan and IRA investors under commission-based arrangements, are generally able to avoid fiduciary status by falling under a “five-part” test that defines “investment advice.” The proposed regulations will replace the five-part test with a much broader principles-based standard. Under the newly proposed DOL rule, advisors who receive commission-based compensation will, in the vast majority of circumstances, be considered fiduciaries.
The effect of a fiduciary rule on existing independent financial practices will depend significantly on their ability to weather change. Approximately 5% of the industry have built the enterprise capacity needed to adjust to significant industry upheaval. For these businesses, the fiduciary rule will simply represent a headwind that most will adapt to and overcome. For the rest, the impact will be a bit more severe. Due to the inherent lack of enterprise capacity needed to meet this new regulatory challenge, these practice owners are facing hurricane force winds that will significantly affect value and equity.
VALUE IMPACT
When analyzing the potential impact of this legislation on practice value, the primary considerations remain the same as they are today; cash flow quality, transition risk, and market demand. The effects of additional legal risk, additional regulation under ERISA, and business enhancements that may be needed will increase overall business expenses. While these will likely decrease the cash flow quality and increase the transition risk of the financial service practices being sold, it is only for the short term. In the long run, however, the fiduciary changes should move the industry in the direction of a more advice driven model. Such a change in how products are created, marketed, and sold will likely result in more firms moving to fee-based recurring revenue models resulting in higher cash flow quality. You might even view the adaptations as an investment in future value.
The effect of the regulation on market demand, however, should be a larger concern when considering its impact on value. At the time of publication, FP Transitions has not experienced any dramatic shifts in the market. The buyer to seller ratio has held steady at roughly 50 to 1, and the demand for valuation and appraisal services has increased in line with previous years. As a result, we foresee that the demand for financial service practices will remain high and that the aggregate effect of additional competition for acquisition opportunities will continue to keep values at these levels or higher.
HURRICANE WARNING
If you are predominantly brokerage oriented, have not built an enduring business, and have been telling yourself “I will sell in five years,” you may want to consider taking action in light of the proposed fiduciary rule. Undoubtedly, you will need to comply with either the fiduciary standard or the Best Interest Contract exemption as the Department of Labor has currently outlined. As we’ve already discussed, the proposed rule will have an effect on primary value drivers, and the effort to meet new requirements could substantially affect both cash flow quality and transition risk.
Finding yourself in the group described above doesn’t spell unavoidable disaster. While it will take some time and work it’s not too late to take steps toward strengthening your business–or the proper preparation to transition your business before the storm makes landfall. Whatever your strategy for adapting to the immenent change, now is the time to take action.
SAILING INTO THE HEADWIND
On the other hand, if you are already operating under an advice-based model, and are primarily receiving fee-based recurring revenue, it is likely that the Department of Labor rule will further enhance your value. The increase in value should result from additional recurring revenues, further industry consolidation, and increased overall demand for acquisitions. Further, businesses that have focused on value drivers and built sufficient enterprise capacity may find that the fiduciary rule represents a substantial equity building opportunity. This is a long-term view of these proposed changes, as businesses and firms will inevitably adjust to the new market scenario.
CONCLUSION
The proposed Department of Labor fiduciary rule is bound to have an effect on the value of your business. But, provided you are intent on developing an enduring business model–one that can weather this new operating environment, the future could look quite favorable. If, however, you’ve put off building your business and are less prepared to adapt to the changing industry, you are likely facing a more sizable headwind and potentially a full force hurricane.
As we saw in 1999 with the Gramm-Leach-Bliley Act, The Department of Labor fiduciary rule represents significant industry change and has resulted in much confusion and concern. This, however, is likely not the last regulatory challenge we as an industry will face. But if you are ready to adapt change should not be cause for alarm. Short term challenges will lead to long-term benefits – for both your business and your clients.
As you adapt to the ever-changing environment that is the financial services industy, keeping one eye on the equity you are building in your practice is essential to ensure you are prepared for what is our industries inevitable and ongoing change. In my 20 years in the industry there has been only that one constant.