Rising Interest Rates’ Boost to Cash Sweep Revenues Will Create Selective Opportunities for IBDs and RIAs to Enhance Recruiting Deals
The success of any broker-dealer or RIA firm correlates heavily with their ability to grow, which is accomplished in three ways: organically, through acquisition or via new advisor recruiting. Most broker-dealers can’t influence organic growth, which is measured by their advisors’ growth and strongly influenced by the stock market.
This leaves acquisitions and recruiting as the two largest growth drivers within the control of a broker-dealer or RIA. For many firms – especially broker-dealers – only a few acquisition opportunities present themselves each year, leaving recruiting as the only significant controllable factor in the firm’s success.
Recruiting Before and After COVID
You often hear that “recruiting is the lifeblood of a broker-dealer.” Prior to COVID-19, we experienced increasing interest rates, a roaring stock market and a V-8 economy firing on all cylinders. Competition increased with the common goal of winning a particular recruit and recruiting deals soared to record levels at various broker-dealers including independent and employee firms.
Then COVID-19 struck, crushing interest rates to zero, which eliminated profits generated from cash balances. However, recruiting competition remained high and aggressive transition deals continued, especially for advisors leaning towards fee-based business models.
And that brings us to today’s question: With interest rates increasing again, will we just see firms become more profitable on the same deals they made available last year, or will we see firms use that new profit to enhance deals again?
Interest Rate Increases Raise a Firm’s Profitability
Let’s review how cash affects a firm’s profitability with the following hypothetical example of a reasonably large and successful independent broker-dealer / corporate RIA firm:
- Let’s start with some background. A broker-dealer works on a 10% EBITDA margin, meaning EBITDA is 10% of revenues, and maintains a ratio of 0.8% return on assets (ROA), which means that the firm generates revenues amounting to 0.8% of its total assets. Finally, the firm carries a total cash position of 5% of their clients’ accounts.
- If this hypothetical firm held $10 billion in total bank sweep balances at the close of 2020 and generated income following the ratios above, the firm would have:
- $200 billion in total assets
- $1.6 billion in total revenue
- $160 million in EBITDA
- If interest rates increase to the point where the broker-dealer can generate 1% on cash balances, that translates to an additional $100 million in new revenue.
- While it’s impossible to determine the expenses for cash balance revenue, it’s clear that expenses are very low, so we can safely presume to add the full $100 million to the $160 million in prior year EBITDA which would result in more than a 60% increase in EBITDA.
- Increased EBITDA of over 60% provides significant additional spending capital available for redeployment to other uses.
Raised Profits Will Increase Recruiting Packages for Select Advisors
What will broker-dealers do with the extra profit? It’s safe to say that firms will retain some profit to improve year end results, but most firms will use a portion of increased revenues to invest in the future, meaning projects that have a favorable return on investment (ROI).
Delayed or slowed initiatives and projects could find new funding. Look for new developments in technology spending due to its favorable ROI. However, based purely on ROI, recruiting tops the list in spending priorities. Don’t expect firms to spend extravagant money on any single recruit, which could cause the ROI on that recruiting opportunity to go negative, but do look for firms to spend on increased recruiting packages for selective advisors.
How High Will Deals Go?
How much higher will the deal numbers rise? Although no one can predict with specificity, it’s safe to assume firms are already pushing the limits on their ROI analyses, but with higher interest rates, advisors are instantly more profitable to the firms due to their clients’ cash balances.
This increased profitability will create more opportunity for larger deals, though firms will certainly spend carefully because the absolute numbers have risen so high. Broker-dealers want to ensure they don’t get burned in the long term.
Jeff Nash, CEO of BridgeMark Strategies, is Chair of WSR’s Recruiting Roundtable.
BridgeMark Strategies is a nationally recognized advisor recruiting, consulting and M&A firm. He can be reached via email@example.com