By Jason Zweig | May 17, 2013 5:46 p.m. ET
Image Credit: Christophe Vorlet
Millions of investors already invest with financial advisers. Now some are investing in them.
With stocks and bonds near record highs, gold tumbling and cash earning zilch, a few investors have taken the bold step of either buying an ownership stake in their adviser’s firm or lending money to it.
At first blush, that sounds tempting. Most advisers not only have relatively low overhead, but they earn their annual fee—often 1% or more of their clients’ investments—regardless of whether the markets go up or down.
“We see these businesses growing in value by better than 10% per year on average,” says Todd Fulks of FP Transitions, a company in Portland, Ore., that provides valuations of financial-advisory firms.
None of that means investing in your financial adviser is a good idea for most people. Such transactions are risky and fraught with the potential for conflict of interest and even fraud. Still, while these deals are rare, they appear to be on the rise.
“There’s no doubt that it’s been coming up more and more frequently,” says Brian Hamburger, managing director of MarketCounsel, a firm based in Englewood, N.J., that helps advisers comply with financial regulations.
So far this year, he says, a half-dozen advisers have asked for advice on structuring an investment by clients in their firm. He estimates that several hundred out of the nearly 11,000 federally registered financial-advisory firms have gotten funding from clients, mostly in the past few years.
Peter Cooper, a securities lawyer at Lawrence, Kamin, Saunders & Uhlenhop in Chicago, says he also is fielding more inquiries from advisers about borrowing money from clients. “With yields on fixed income so low, clients appear to be looking for an opportunity to make a better return,” says Mr. Cooper. “And some advisers and clients together think they can structure something that can provide that.”
As growing numbers of stockbrokers leave big firms to hang out their own shingle as independent financial advisers, they need funding to get started. Loyal clients often want to help kick-start their adviser’s new venture by providing a loan or an equity investment, says Mr. Hamburger.
What do clients get in return? Bragging rights on the golf course, perhaps a fee discount (if it is disclosed to all clients) and the chance to help the firm (and thus the clients’ own stake) grow through referrals.
But anyone considering such a move must thread the eye of a fine needle. These transactions must be carefully structured, caution Messrs. Cooper and Hamburger.
In at least 37 states, state-registered advisers—generally managing up to $100 million—are prohibited from borrowing money from a client, according to Andrea Seidt, securities commissioner for the state of Ohio. Valerie Mirko, associate general counsel at the North American Securities Administrators Association, says “the majority of states” would likely regard an equity investment by a client in a state-regulated advisory firm as a “prohibited transaction.”
The potential for conflict of interest is most troubling of all, says Mark Tibergien, chief executive of Pershing Advisor Solutions, a firm that provides safekeeping of assets and other services to financial advisers. “If your adviser is asking you to participate in something where he has a vested interest,” he says, “then who will advise you on what is in your best interest?”
Two recent cases show what can go wrong. In February, the Securities and Exchange Commission found that a Phoenix-based adviser, Walter Clarke of Oxford Investment Partners, had sold a minority stake in his firm to a client for $750,000 without an independent valuation. The SEC found that he had “deliberately inflated” the firm’s value. Without admitting or denying the SEC’s findings, Mr. Clarke agreed to $274,000 in penalties and other sanctions. He didn’t respond to requests for comment.
Jonathan Brooks, a financial adviser in Aiken, S.C., offered some clients an 8% return for lending money to companies he controlled, according to a lawsuit filed in state court last month by the South Carolina Securities Commission. The state claims that Mr. Brooks spent much of the proceeds “for personal use” instead of investing in his businesses.
Robert Rikard, a lawyer at Rikard & Protopapas in Columbia, S.C., says he has five clients who lent a total of roughly $1.5 million to Mr. Brooks’s firms. “The money they worked a lifetime for is gone,” he says. “These are not sophisticated investors who can shrug off losses. [They] now have to worry about finding money to pay the mortgage.”
Mr. Brooks declined to comment.
For most people, investing with a financial adviser might be a good idea. Investing in a financial adviser is probably a bad one.
Source: The Wall Street Journal