New compensation disclosure rules for mutual funds have driven many advisors towards fee-based compensation. Now, a ban on embedded commissions looks like it is on its way. These changes will impact the value of a mutual fund book of business.

Moving from a client model with trailing commissions to a fee-based model could tank the sales value of a mutual funds book of business, says James McMahon, CEO of Financial Horizons Group in Quebec. He gives the example of an advisor who has a commission-based mutual fund clientele and assets under management amounting to $100 million. With the average trailing commission being one per cent, the base value of this business would be $1 million. “We cannot apply the same value to an identical client with a fee-based compensation model,” says McMahon.

New balance of power

The variation in value is due to the new balance of power that fee-based compensation entails. “Will each client still want to pay one per cent in fees to the new advisor buying their business from the seller? The client who is asked to give a $5,000 cheque to a new advisor to pay his fees for the year will question this. He will negotiate and ask perhaps to pay only $3,500,” predicts McMahon.

He adds that if it becomes a general trend in the industry, the move to fee-based compensation could lower the multiples used to calculate the value of a mutual fund book of business. “I understand that advisors are nervous, especially those who have substantial assets in mutual funds, particularly if commissions disappear, says McMahon. “The industry is going through some of its biggest changes in 40 years. We took a hit when the federal government taxed life insurance policies and annuities in 1982. But today – going after advisors’ compensation – that is a major problem.”

Michel Kirouac, vice president and general manager of managing general agency Groupe Cloutier, also believes the fee-based model will impact sales multiples. “In the embedded commissions model, manufacturers include advisor compensation in the fund’s management expense ratio (MER). For the vast majority of funds, the trailing commission is one per cent. The client doesn’t see it; it’s integrated within the three per cent MER, for example. In an exclusively fee-based formula, the client will see a two per cent MER, but the advisor will have to negotiate fees directly with the client,” explains Kirouac.

He believes this will especially impact the value of big blocks of business. The example of a single client suffices to illustrate this. An advisor is forced to transition from commissions to fees. A client has $500,000 in mutual funds assets with an embedded trailing commission at one per cent, which costs the client $5,000 annually. “If the same client has another $500,000 to invest, under a fee-based model could you sell him on the idea of paying an additional $5,000? The total fees could go down because it is not twice as much work to manage $1 million versus $500,000,” says Kirouac.

He believes the value of mutual fund blocks of business will depend on the diversification of the customer portfolio relative to its size. “A clientele spread among 200 or 300 clients, with assets that are not concentrated in the hands of few, will be less affected by the change to a fee-based model,” says Kirouac. He adds that it is in advisors’ interest to keep their small clients, so that their clientele stays well diversified.

Yan Charbonneau, CEO of AFL Group, says advisors see a big risk with the change to fee-based compensation. “This significant risk puts pressure on existing client portfolios. If revenues drop by half because of the change to fee-based compensation and you buy such a clientele, it’s like you paid twice as much as you should have. It is riskier today to acquire mutual fund business blocks,” he says.

Everything depends on negotiation

George Hartman, president of Market Logics consulting firm, wrote Exit is Not a Four Letter Word, a book dedicated to selling of business blocks. He does not share the same concerns regarding fee-based compensation.

“Trailer fees are paid by the product manufacturer to the dealer firm, which then passes a share along to the advisor. If embedded commissions are replaced by contractual fee-based compensation negotiated directly with clients, they will pay those fees to the dealer firm just as the manufacturer did. Traditionally, trailer fees average one per cent, and provided the fee-based compensation equals that amount, the value of a practice will not go down… Some clients will pay more; some will pay less,” he says.

He believes advisors can prepare for the change to avoid losses. “Many advisors will have a fee schedule adjusted for account size.For example, accounts under $100,000 may pay a fee of 1.5%,” suggests Hartman.