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Check for This Red Flag Before Hiring a Financial Advisor

A red flag blows in the wind on a beach. Research from the University of Oregon indicates that financial advisor firms acquired by private equity companies are far more likely to engage in misconduct following their acquisition.

When selecting a financial advisor, there are a number of things you should consider, including an advisor’s professional credentials,  fee structure and investing philosophy, not to mention your personal rapport with this expert. A new study, though, highlights the importance of researching the ownership of a financial advisory firm.

Research from the University of Oregon indicates that financial advisor firms acquired by private equity companies are far more likely to engage in misconduct following their acquisition. Doing your homework on the ownership structure of an advisor’s firm can help give you more peace of mind when making this important decision to hire an advisor.

Whether you’re looking for help with financial planning, asset management or both, a financial advisor can be a valuable partner. Find a trusted advisor today.

Private Equity’s Impact on the Advisory Industry

A financial advisor presents his client's portfolio to him. Research from the University of Oregon indicates that financial advisor firms acquired by private equity companies are far more likely to engage in misconduct following their acquisition.

Researchers at the University of Oregon set out to determine whether ownership by private equity firms encourages or deters financial misconduct. Finance professors Albert Sheen and Youchang Wu, and Ph.D. candidate Yuwen Yuan examined data from 2000 to 2020 and found “a sharp increase in adviser misconduct measured both at the adviser and the firm levels” following a private equity takeover.

To gauge the impact that private equity firms have on the advisory businesses they acquire, the trio of researchers identified 275 private equity acquisitions completed between 2000 and 2020. Of those advisory firms that were bought out, 57 had Securities and Exchange Commission (SEC) filings available before and after they were acquired. Using those filings, the researchers were able to track an uptick in alleged misconduct.

“Our estimates suggest that private equity ownership leads to an increase of 147% in the percentage of the acquired firm’s financial advisers committing misconduct,” Sheen, Wu and Yuan wrote in their study, “Private Equity and Financial Adviser Misconduct.”

What constitutes misconduct? A variety of behaviors, from recommending certain investment products when cheaper alternatives are available to committing criminal offenses like fraud or theft. While financial advisors who are registered with the SEC are legally bound by fiduciary duty, some may run afoul of legal or regulatory restrictions. When that happens, they ‘re required to report these disciplinary actions on their Form ADV, the public paperwork they must file with the SEC each year.

There are generally five different types of disclosures related to financial advisor misconduct:

  • Criminal: A criminal disclosure is the result of a formal felony charge or certain misdemeanor offenses, including bribery, perjury, forgery, counterfeiting, extortion, fraud, and wrongful taking of property.
  • Civil: A civil disclosure may involve a court-issued injunction related to investment activities; a court finding that investment-related activities violated certain statutes or regulations; or a settlement agreement that results in the dismissal of a regulatory complaint.
  • Regulatory: A regulatory disclosure is the result of disciplinary action taken by a regulatory authority when investment-related rules or regulations are allegedly violated.
  • Customer: A customer disclosure is the result of an arbitration award or civil judgment for a customer following allegations that an advisor violated sales practices.
  • Termination: This is the record of an advisor’s discharge or voluntary resignation after being accused of violating “investment-related statutes, regulations, rules, or industry standards of conduct.”

Prior to being acquired by private equity firms, the financial advisory businesses the University of Oregon researchers studied had a significantly lower misconduct rate compared to industry averages. However, the number of misconduct incidents spiked after buyouts to reach industry averages.

“Overall, our findings indicate that PE chooses cleaner firms in terms of misconduct as buyout targets. After PE takeover, however, firms commit more misconduct,” Sheen, Wu and Yuan wrote. “These results suggest implications about the value of misconduct. If we assume PE maximizes firm value, the increased level of misconduct implies that higher misconduct is related to higher profit. PE firms choose targets with untapped ‘misconduct slack’ and exploit this opportunity to make profit, perhaps at the expense of customers.”

However, it’s important to note that only a small percentage of financial advisory firms are backed by private equity. Pointing to previous research on the topic, the University of Oregon researchers noted that private equity companies participated in 5% of all registered investment advisory firm merger transactions between 2013 and 2019. However, those deals comprised 26% of the deals by AUM.

How to Check for Red Flags

A financial advisor overs over her clients' financial plan with them. Research from the University of Oregon indicates that financial advisor firms acquired by private equity companies are far more likely to engage in misconduct following their acquisition.

When looking to hire a financial advisor, examining the advisor’s Form ADV can provide valuable insight into their business and any disciplinary disclosures on their record.

Form ADV is accessible through the SEC’s Investment Adviser Public Disclosure website. The document, which must be updated each year, consists of two sections: Part I and Part II. The first part is a fill-in-the-blank form that provides a firm’s location, number of employees, number of clients, amount of assets under management (AUM) and other boilerplate information about the business. To examine the disclosure record of an individual advisor and/or a firm, click on the “DRPs” tab that’s listed under the various sections of Form ADV Part I. If an advisor or firm has been cited for a legal, regulatory or criminal violation, you’ll be able to read about the allegations and potential resolution there.

The second part of Form ADV is a brochure written in prose describing the firm’s services, investing approach and any conflicts of interest that may exist. Part II will provide some background on the ownership of the firm, and perhaps, recent ownership changes.

Additionally, financial advisors who sell securities must be licensed with the Financial Industry Regulatory Authority (FINRA). As a result, information about their business and any disclosures are available on FINRA’s BrokerCheck tool online. Similar to the SEC’s IAPD website, BrokerCheck instantly tells you whether a broker or firm is registered to sell securities, offer investment advice or do both.

Remember, all financial advisors who are registered with the SEC are fiduciaries, meaning they are legally obligated to act in your best financial interests. However, those who are solely registered as brokers with FINRA don’t abide by this higher ethical standard. They instead must follow what’s known as the suitability standard. What’s more, some professionals are registered as both investment advisors and brokers. The line between the dual roles can sometimes be blurred so it’s best to be clear which role your advisor is acting in when they provide specific advice: your financial advisor or stockbroker.

Bottom Line

Researchers from the University of Oregon recently found that financial advisory firms and their advisors are more likely to engage in misconduct after being acquired by private equity companies. Their study identified a 147% uptick in misconduct among firms that were bought out by private equity between 2000 and 2020. Keeping this trend in mind can help in your search for a financial advisor that’s right for you. You can research a firm’s disciplinary record, ownership and business by accessing their Form ADV online.

Tips for Finding a Financial Advisor

  • A financial advisor can add a lot of value to your financial life, from helping you manage your portfolio to planning for retirement. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Having an idea of what you hope to accomplish is a vital first step to take before hiring an advisor. Whether you hope to retire by a certain age, buy a home or pay for your children’s education, identifying your goals beforehand can help you choose an advisor that best aligns with your personal situation.

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