Publications

Investor to investor: How the secondary market is serving RIAs and broker/dealers
- January 1, 2018: Vol. 5, Number 1

Investor to investor: How the secondary market is serving RIAs and broker/dealers

by Jordan Fishfeld

Liquidity, or rather the lack of it, is a challenge to a wide-range of stakeholders involved in providing services to investors. This holds especially true for alternative investments that normally are not listed on the major stock, bond and commodity exchanges. The advent of secondary-market platforms for alternative investments injected liquidity where once it was lacking, including the markets for private equity, private debt and private/unlisted REITs, among many others. These are areas where registered investment advisers and broker/dealers spend much of their time and energy.

Online secondary-market platforms provide investors and their representatives with new options for accessing these once illiquid assets.

A successful RIA, be it a large firm or an individual, looks to increase assets under management by providing, in the role of a fiduciary, valuable advice to clients. Whatever the eventual outcome of the current U.S. Department of Labor’s new fiduciary rule, RIAs have a moral and ethical obligation to act as a fiduciary, putting aside self-interest and personal opinions.

Broker/dealers initiate, underwrite and facilitate transactions, which means they create or source capital for IPOs and private security offerings. When selling securities to investors, they must be mindful of their clients’ objectives and risk profile, more now than ever as a result of the Department of Labor ruling. Whatever the eventual outcome of the current Department of Labor’s new rule, we can all agree that broker/dealers should also and must always act for the benefit of clients, even when also pursuing self-interests.

At first blush, broker/dealers might consider secondary marketplaces as problematic, specifically those that believe their role is simply to get paid on exploiting inefficiency. But secondary market platforms provide RIAs and broker/dealers alike with valuable services that help support clients in the following ways:

  1. Increase assets under management and transaction volume. The JOBS Act, through its changes to the 506(c) Rule and to Regulation A, as well as the advent of crowdfunding, opened the private security market to non-accredited investors and increased the scope of marketing to accredited ones. While the secondary market exchanges mean that clients will not be stuck with unmarketable private securities following the one-year holding period — an important consideration for fiduciaries. AUM increases by attracting new clients interested in exotic assets, and by attracting new investments in those assets by existing clients. The proceeds from the sale of non-compliant assets can be reinvested in compliant assets that pass the best-interests test instead of sending those assets to a self-directed IRA.

Under the new fiduciary rule, a certain portion of the holdings of broker/dealers and their clients might no longer be deemed appropriate. Secondary markets give broker/dealers an opportunity to dispose of these holdings, freeing up capital to purchase compliant assets. Because of the secondary markets’ transfer mechanism, the selling prices of non-compliant assets are objective and market-driven. These are transparent prices that can be shown to clients as the best available option, limiting any negative reaction from clients.

Secondary-market platforms can fee-share with broker/dealers who deliver client order flow, which is a triple-win for broker/dealer platform and its clients.

  1. Advise clients. A criticism sometimes hurled at RIAs is that they might be tempted to tie-up clients’ assets in illiquid investments in order to trap AUM. The potential conflict is that many RIAs receive compensation based on AUM, so that any strategy emphasizing illiquid assets works to the favor of these RIAs.

On the other side of the coin, a common criticism sometimes hurled at broker/dealers is that they might be tempted to avoid tying up clients’ assets in illiquid investments because it cuts turnover and the resulting commissions. The potential conflict is that broker/dealers receive commissions based on transaction volume, so that any strategy emphasizing illiquid assets works against broker/dealers.

The secondary markets moot this criticism by making illiquid assets more liquid, enabling RIAs and broker/dealers to give unconflicted advice to clients about alternative investments. The secondary markets also allows broker/dealers to give ongoing advice about alternative positions and RIAs to give ongoing advice about illiquid positions, truly earning their AUM fee.

  1. Better valuation. The best way to value an asset is to put it up for sale. Illiquid assets do not benefit from this valuation method unless they can enter the sale process via a secondary market. Valuations based on other criteria, such as historical prices, can be extremely inaccurate, which makes it impossible to determine a valid return on investment. If an asset is overvalued, ROI is too high and investors are tempted to maintain or increase holdings in this asset. Market-based ROIs are accurate and might cause investors to reallocate their holdings to higher returning assets, putting RIAs to work for their clients.

Similarly, secondary markets give broker/dealers new options regarding illiquid alternative assets, including inventory management, impartial valuation, higher order flow and unbiased advice. The JOBS Act has helped grow the audience for private securities, while secondary markets have reduced their risk profile to allow for better investing at all levels of the economic scale.

 

Jordan Fishfeld is managing partner of CFX Markets, an online platform for secondary-market alternative assets.

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