In the past five years, small independent firms have made heroic efforts to transform their wealth operations to meet the growing demand for holistic financial planning and broaden their corporate and institutional businesses in public and private markets.
Despite their limited size, these firms have taken advantage of technology to reach clients through digitalization and improve operating efficiencies to enhance their competitiveness. They have benefited from the extended boom in retail markets from the demographic shift to financial advisory services, and a resurgence in small-cap markets — notably the cannabis phenomenon.
However, a closer examination reveals inherent weaknesses among at least some small firms in their long-term competitiveness with challenges that threaten their viability. More seriously, the smaller dealers have not evolved a large and diversified business scale to participate in competitive and dynamic retail and institutional markets.
Scale is vital to the success of individual franchises, and can be attained through business acquisitions, amalgamations and asset purchases, among other means. Business scale is critical for retail firms to expand cost-effective client services and for institutional firms to broaden securities distribution to compete for equity offerings.
Independent small retail dealers will persevere in domestic competitive wealth markets, providing an extended shelf of financial products and services to holistically meet the life-cycle needs of their clients. But limited capacity for business scale for small firms will constrain financial product and service offerings for wealth markets and limit the scope for competitive fee cuts, while capital constraints will hinder their ability to adapt new technology to improve client interface and enhance operational efficiencies to compete for retail investors.
The ongoing competitive tempo will continue to tighten operating margins of the many small retail firms, notably the 30-50 operations of marginal retail firms. Three looming negative factors will weigh on operating decisions to seek partners and shut operations: less optimism of continued favorable investor and market conditions; a steady widespread effort among the integrated firms to aggressively strengthen efficiencies and adopt technology to capture clients; and continued competitive reductions to dealer fees, notably fee-based advisory accounts, by integrated firms.
The overall return on equity for the retail independents as a whole has averaged an uncompetitive 10%, compared to 5% for the institutional firms. The small core group of the large full-service and national firms — the integrated firms — has outperformed by a wide margin, with nearly double the return of smaller dealers, with an average return on equity of about 15%. The outlook for operating returns is not particularly positive.
However, the small dealers are not solely at fault. A major reason has been difficulty in attracting external capital, reflecting the mixed and poor financial results of these firms. Moreover, most independent firms have little capital or access to external sources to finance acquisitions, and also to onboard investment advisors from existing firms to build retail scale.
It is important to single out the extensive efforts of the Ontario government and securities regulators to reduce the regulatory burden and improve the efficiency of regulation. These efforts will lower compliance costs without jeopardizing investor protection and will strengthen financial results for the smaller dealers, enabling them to improve their access to capital to enhance their operations by investing in technology, for example.
What is striking is the resilience of the many small and mid-sized dealers competing in difficult and demanding business conditions, and the persistent tendency to retain small business operations. For the past five years, these many small and mid-sized dealers have focused efforts to improve competitive operations to meet evolving client demands, adapt technology to improve client reach and compensate with advantages of scale, improve operating efficiencies and cut ongoing costs.
The smaller retail firms will likely integrate quickly as the pace of acquisitions picks up to preserve inherent enterprise value in fast-moving dynamic markets. Moreover, acquisitions can occur quickly because the introducer firms have limited internal and legacy operating systems to complicate their integration. The reality of tougher conditions will also encourage joint ventures, even with limited capital, to integrate existing operations for small firms.
In the past two years, the resurgence in small business markets from the cannabis business and mining companies has improved the revenue and profit performance of the small institutional firms. However, the fundamental factors interfering with performance have not yet been addressed. These include limited firm scale to build out diversified investment banking infrastructure in research and coverage and broaden distribution capability, and insufficient progress to lower the regulatory costs to small business and dealers for capital-raising in public markets.
If difficult conditions in small business markets continue this year, the earnings of the 40 domestic institutional independent firms will stay at lower levels, and marginal institutional dealers may look for restructuring opportunities through amalgamations or shut operations.