Vertical integration – beauty or beast?

Vertical integration is a simple idea. An adviser firm which provides an integrated set of services from investment management to platform to financial advice, can both simplify and streamline processes, and use the consequent economies of scale for greater profit for the business and lower prices for customers.

There is little evidence that costs paid by customers have reduced, though the customer service ratings remain high. The new FCA "Value for Money" requirement may well tease out greater visibility of any efficiency issues.

But can this really be true? Does it work in practice? Can it only work for restricted advisers? Are there wider opportunities for smaller adviser firms? Is vertical integration a get rich quick scheme for the founders or can it offer great value for money?

The idea

There are relatively few ways in which product providers sell in the UK:

  • Direct to customers
  • Via financial advisers
  • Advisers with in-house manufacturing (investment, product, platform).

The latter integrated model should allow better alignment of interest and economies of scale to be delivered to customers.

The evidence

In theory, the ability for adviser firms to grow assets and use their simplified and streamlined processes to reduce costs is compelling. But this theory may well be tested as part of the FCA's Platforms Market Study – surely with platform assets approaching £600bn there should already be some customer benefit from reduced fund costs? Though adviser-facing platforms will argue that they don't control which funds are bought and sold, so cannot have any influence of the price that asset managers sell their funds for. Vertically integrated firms may face tougher questions.

Does it work?

There is little doubt that St. James's Place Wealth Management (SJP) has been successful for the business owners, it has grown assets rapidly and has a fast-growing adviser network – but has it worked for customers? There is little evidence that costs paid by customers have reduced, though the customer service ratings remain high. The new FCA "Value for Money" requirement may well tease out greater visibility of any efficiency issues.

Other networks/consolidators are still in the early growth stage. They have growing scale but little evidence of costs falling yet. And while they have many of the elements in place to drive integration (DFM, platform permissions, adviser scale), it is too early to identify the outcomes for shareholders. Cynics will take the view that these "aggregators" are just in it for what they can get out of it – grow scale, create internal synergies and quick exit – with little customer benefit.

Issues

The FCA will shortly require Authorised Fund Managers (AFMs) to disclose their Value for Money. This assessment will revolve around some key metrics:

  • Quality of service
  • Performance
  • Costs
  • Economies of scale
  • How the funds compare to others in the market.

These would seem good metrics to be able to assess whether Vertical Integrators (who are themselves AFMs) are delivering good outcomes – current evidence of the cost and economies of scale metrics would seem to suggest they are yet to add value.

What is a fair price?

Based on the most recent Barclays Equity Gilt study (2018) the long run annual return (over 50 years) for UK Equities was 5.6% and for Gilts 3.1% (after inflation).

For simple balanced fund of 60% Equity and 40% Gilts this would lead to a return of (before costs) of 4.6%pa.

Real investment returns by asset class (UK)(%pa).

2017 10 years 20 years 50 years
Equity 8.4 3.2 3.2 5.1
Long dated gilts -1.9 4.0 3.6 3.1
Corporate bonds 0.7 3.6
Long dated Index-linked -1.7 4.0 3.9
Cash -3.9 -1.9 0.3 1.2

Source: Barclays Equity Gilt Study 2018

Cynics will take the view that these "aggregators" are just in it for what they can get out of it – grow scale, create internal synergies and quick exit – with little customer benefit.

It would not seem unreasonable therefore, that the total costs (advice, platform, fund management etc.) "spent" in the pursuit of this return should be less than 1.84%pa. Otherwise the customer (who ultimately supplies the investment capital) is rewarded with less than 60% of the total market return. That would surely be a poor outcome?

I will leave readers to judge whether the costs incurred by customers of the Vertically Integrated firms represent good outcomes.

The value chain

The elements available to be integrtaated would typically include:

  1. Advice and tax planning
  2. Portfolio construction – asset allocation/risk profilin
  3. Platform/ACD management – tax wrapper, custody and dealing
  4. Asset management – the management of funds/securities
 The value chain

The value available (and possible issues) for each are as follows:

  1. Streaming the advice process across many advisers should allow reduced compliance cost and better value to customers – but the immediate issue is the "shoe-horning" of customers into in-house products.
  2. Building an in-house DFM and/or ACD would allow the award of segregated mandates to asset managers. But there is little evidence so far that this has reduced consumer cost (even though some mandates are well over £1bn).
  3. White label platforms are available – usually with the Integrator gaining platform permissions – but the evidence so far is that there is little, if any, cost saving to end customers under these arrangements.
  4. The governance and oversight of mandates should deliver good outcomes – but the addition of DFM costs and charges/the speed with which mandates can be changed could be argued to be less beneficial – and the use of internal funds seen as a conflict.

Conflicts and management stretch

The existence of very low-cost passive funds, new platform entrants (that will white label for adviser firms) and lower cost DFMs that offer truly bespoke and "whole of market" models for adviser firms, with discounts for scale, may see the emergence of many smaller vertically integrated adviser businesses.

Perhaps the biggest issue facing firms looking to operate a Vertically Integrated business are managing the whole supply chain and the associated conflicts of interest.

Recent events suggest that just managing platform suppliers/change programmes is challenging enough. Add to this the fund management outsourcing (including an ACD/AFM) and possible discretionary permissions. Plus, the CRM and wider IT complications. And the compliance/oversight/integration and management of a possibly broad-based adviser team, and the management scope becomes substantial.

Managing this diverse operation, the potential conflicts of interest, cross-subsidy issues while growing profit, and delivering economies of scale leave many commentators extremely sceptical (polite version) of this business model.

Smaller firms

Is the opportunity for vertical integration only available for larger firms, or can smaller firms and their customer benefit? My firm has seen growing interest in bespoke adviser model portfolios. By offering a whole of market approach aligned to the adviser risk tool output we can meet the needs of the bulk, but not all, of the advisers' customers. The adviser can secure platform discounts that are passed directly to the customer. We have agreed an upfront discount to investment fees (underwritten by the adviser), again passed directly to the customer. All-in fees (advice, platform, tax wrapper, DFM, VAT and underlying funds) of 1.4%pa are achievable.

There clearly needs to be robust governance and oversight but this model works for all parties.

Future

The ability of banks to use their customer data integrated with other information (under the new Payment Services Directive (PSD2) rules to suggest better products and services may see the gentle rebirth of bancassurance. No reason why advisers should not take advantage of these too!

The FCA is clearly pursuing a wider "Value for Money" agenda – and this spans advice, asset management and platforms – any new Vertical Integrator should face some serious scrutiny to make sure good outcomes are at the heart of the business.

The more onerous MiFIDII cost disclosures and the requirement to have an independent director on all AFM boards may also make any future business case harder.

But the existence of very low-cost passive funds, new platform entrants (that will white label for adviser firms) and lower cost DFMs that offer truly bespoke and "whole of market" models for adviser firms, with discounts for scale, may see the emergence of many smaller vertically integrated adviser businesses. And they will be both more profitable and offer better value for money than the first generation.

For more information about model portfolios designed for adviser firms please drop me a line. David A Norman aka DAN david.norman@tcfinvestment.com