Peter Hargreaves made himself a billionaire by selling mutual funds through his discount broker, Hargreaves Lansdown Plc (HL/). Now, as planned rules threaten his business model, he intends to raid fund managers’ profits.
Hargreaves built the firm into the U.K.’s biggest retail broker, the country’s equivalent of Charles Schwab Corp (SCHW) (SCHW)., by selling funds and charging money managers rather than clients. Starting in 2014, U.K. brokers will have to charge clients directly, a move analysts say jeopardizes the firm’s 64 percent profit margin. Hargreaves says funds must eat the cost.
“All the groups are sitting there, smug, thinking we’re getting 0.75 percent and we’re not going to give Hargreaves anything anymore,” Hargreaves, 66, said in an interview at his office in Bristol, western England, where he started the firm in his spare bedroom 30 years ago. “That’s not going to happen. They need to bear some of it.”
The Financial Services Authority, the U.K. regulator, plans to ban brokers from receiving cash from money managers and require investors to pay brokerage fees directly to bolster transparency in an industry where costs are more than double those in the U.S. Hargreaves Landsown has increased earnings sixfold since 2007, and the stock has climbed 65 percent this year in London trading, making it the second-best performer in the FTSE 100 Index. (UKX) Still, the shares have slipped 7 percent this month on concern the rule change will crimp earnings.
“In the past many providers could remain high cost without it being visible because it was through rebates rather than through an explicit fee,” said Adam Seale, acting chief executive officer of London-based Interactive Investor Plc, a Hargreaves Lansdown competitor. “Once fees become explicit, low cost becomes a greater source of competitive advantage.”
Hargreaves Lansdown’s net income was 113 million pounds ($182 million) in the year to June 30, compared with 17 million pounds in 2007. About 42 percent of the company’s 239 million pounds of annual revenue comes from payments from fund managers, including Fidelity Worldwide Investments, Invesco Perpetual and Schroders Plc (SDR). The rest comes from commissions for trading shares, interest on cash balances and fees for advice.
The FSA will ban payments from fund companies as part of its so-called Retail Distribution Review. The rules, which will be completed in the first quarter of next year and implemented in 2014, are designed to make fund fees more transparent and eliminate conflict of interest between investors and advisers.
“Is it all at risk?” Hargreaves said, referring to revenue from rebates. “Yes. Will we lose it all? Definitely not.”
Hargreaves plans to introduce charges to replace the payments, called trail commission in the U.K., which would either be an annual fee based on the value of clients’ assets, a charge for each trade or a combination of the two. He declined to give more details on his pricing plans before the FSA approves the rules. The fees, which he called “competitive,” will probably apply to existing clients’ funds, he said.
“Operating margins of 60 percent plus are just not sustainable in the new environment,” said Jeremy Grime, a London-based analyst at Panmure Gordon & Co. “Customers will be able to see charges for the first time, and this will put pressure on intermediaries.”
Hargreaves, an accountant by training, started his business with co-founder Stephen Lansdown from his home in 1981. The pair needed to make a profit in six months, otherwise their savings would have run out, Hargreaves said. It took them three days.
The company pioneered selling mutual funds by mail, telephone and over the internet in the U.K. and took advantage of a wave of do-it-yourself investing as employers closed define-benefit pensions and state retirement plans were reduced, putting the onus on individuals to invest.
Hargreaves calls his firm a “mini Schwab,” referring to the biggest independent U.S. brokerage by client assets. Hargreaves Lansdown, founded 10 years after Chuck Schwab started the company that bears his name, has about 28.5 billion pounds of assets under administration, compared with San Francisco- based Schwab’s $1.3 trillion.
Hargreaves reaps about 40 million pounds a year in dividends on his 32 percent stake in the business, which puts his net worth at about $1.9 billion, according to data compiled by Bloomberg. Lansdown owns 20 percent of the firm after selling 10 percent to buy Bristol City Football Club, a soccer team.
While Lansdown, 60, lives in Guernsey, a tax haven in the Channel Islands, Hargreaves said he has no plans to leave the U.K. even though he pays 12 million pounds a year in taxes.
“I hate false avoidance schemes, and I don’t think I’d want to live in exile,” he said.
In any case, Hargreaves Lansdown, which employs 650 people, is his main hobby, he said. He owns one house, where he has lived for 17 years, and one car -- a Range Rover -- and now works at the firm four days a week as executive director, after stepping down as CEO in 2010.
Hargreaves has gained market share by offering customers discounted fund management fees in a country where the average charge is about 2.21 percent a year, compared with 1.04 percent in the U.S., according to research published in the Review of Financial Studies.
A client who puts money in Fidelity Worldwide Investment’s U.K. Special Situations Fund through Hargreaves Lansdown pays an annual fee of 1.3 percent of assets, compared with 1.5 percent if they went directly to Fidelity, the broker’s website shows. The broker also waives Fidelity’s 3.5 percent initial charge for entering the fund and pays customers a loyalty bonus for keeping the assets with Hargreaves Lansdown.
Typically, fund managers pay Hargreaves about half of the 1.3 percent annual fee in return for selling the fund, providing administration services and dealing with clients’ enquiries, Hargreaves said. On some funds, such has Henderson Group Plc (HGG)’s Special Situations Fund, Hargreaves receives rebates of as much as 1 percent, according to Nitin Arora, a London-based analyst at HSBC Holdings Plc with a sell rating on the stock.
Such payments will end in 2014 if the FSA sticks to the proposals outlined in Retail Distribution Review. Clients will pay brokers directly and compensate fund manager separately.
The change “is likely to move bargaining power out of the hands of Hargreaves and into the hands of consumer,” Arora wrote in a note in October. “Hargreaves will no longer be able to squeeze revenues because of its scale, which is likely to put downward pressure on revenue margins.”
Seale, of Interactive Investor, the U.K.’s fifth-biggest execution-only broker, agrees. His firm stopped taking payments from fund managers in July, passing on the savings to clients.
“We believe we will grow market share because people will realize the true cost of investing and they will come to people like us who make sure that the cost of investing is as low as it can be,” he said.
Although the basic fee is typically 1.3 percent of assets, the power of compound interest means that charges have a huge impact on fund performance over time, according to the Royal Society of Arts, a London-based social policy research group. An investor paying a 0.5 percent fee a year will end up with 33 percent more in their fund after 25 years than someone paying 1.5 percent a year assuming equal performance, RSA said.
The regulatory changes, greater focus on costs and the possibility of clients leaving for cheaper brokers mean Hargreaves Lansdown’s stock is overvalued, according to Gurjit Kambo, a London-based analyst at Credit Suisse Group AG who has a sell rating on the firm. It is “priced for perfection,” he said in a note published in October.
The company is valued at 24 times next year’s estimated earnings, compared with the FTSE 100 Index (UKX)’s average of 15 times, according to data compiled by Bloomberg. The firm has two buy ratings, four holds and three sells, the data show. The stock has more than quadrupled since 2009.
“It’s clearly a reasonably highly rated stock,” said Harry Nimmo, an Edinburgh-based fund manager at Standard Life Plc (SL/), who manages 1.2 billion pounds and has been a top 15 investor in Hargreaves Lansdown shares since 2009. “Hargreaves has tended to come out ahead of the pack in being more flexible and adaptive to regulatory change. I’m quite sure they have a strategy in place for dealing with that.”
Hargreaves agrees that the FSA’s new rules to separate brokers and fund managers’ fees will encourage clients to shop around for the best price, which will probably reduce margins in the industry. When that happens, it will be fund managers rather than his brokerage that will have to cut costs, he said.
“Because I offer more shelf space, I ought to be able to get a better deal for my clients, just as Tesco does,” he said, referring to Tesco Plc (TSCO), the U.K.’s largest retailer. “One thing’s for sure: the fund managers aren’t going to charge 0.75 percent for the funds and me get less than that. That is absolutely certain.”
Fidelity, the fifth-biggest fund manager in the U.K. by assets, will create a range of new share classes for brokers and financial advisers once the RDR is introduced. The firm will charge a 0.75 percent fee for most actively managed funds, with the customer paying the broker or financial adviser separately, it said in a statement.
Keren Holland, a Fidelity spokeswoman, declined to comment on Hargreaves’s remarks. Officials at M&G Securities Ltd. and Invesco Perpetual, the two biggest U.K. retail fund managers, also declined to comment as did Mona Patel, a spokeswoman for the Investment Management Association, a lobby group.
Hargreaves says he is confident he can lower customers’ costs while maintaining his profit margin even as the regulator’s changes force him to rewrite his business model.
“I haven’t sold any shares,” he said.
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