The True Cost of Building and Operating Your Own Exempt Market Dealer

This article is current as of the time of publication, is for informational purposes and does not constitute professional advice. Independent legal advice should be sought prior to relying on any information herein.

As investment funds grow, the fees paid to an external exempt market dealer can become increasingly visible. At some point, management may ask whether it would be more economical to establish an affiliated exempt market dealer and bring distribution in-house.

The comparison can appear straightforward. If the fees paid to an external dealer exceed the cost of registering a dealer and hiring compliance personnel, an internal EMD may seem less expensive. But that calculation is incomplete.

The cost of an internal EMD is the cost of operating a regulated securities dealer year after year. It includes registration and establishment costs, recurring compliance infrastructure, supervision, technology, professional services, management time and the cost of dealing with regulatory and personnel issues as they arise.

For investment fund managers considering whether to establish their own dealer, the relevant question is therefore broader: What is the full cost of owning and operating the dealer infrastructure required to support the firm’s distribution activities?

Registration Is a Small Part of the Cost

An exempt market dealer is a registered securities dealer subject to ongoing obligations under applicable securities laws, including National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations.

Obtaining registration is therefore only the beginning. An affiliated dealer must maintain appropriate registered personnel, compliance systems, policies and procedures, financial controls, insurance, books and records, supervisory processes and regulatory reporting infrastructure on an ongoing basis. These obligations exist independently from the investment funds distributed by the dealer. This distinction matters when evaluating cost.

A fund manager may already have sophisticated operations, accounting, legal and investor relations functions. Some of those resources may support an affiliated dealer. However, the existence of those functions does not eliminate the dealer-specific work required to operate a registered firm. The more useful analysis is to divide the economics into four categories: establishment costs, recurring fixed costs, variable costs and episodic costs.

1. Establishment Costs

Before an internal EMD begins distributing securities, the firm must build the infrastructure necessary to operate as a dealer. Depending on the proposed business model, establishment costs may include:

• legal and regulatory structuring;
• registration applications and related filings;
• development of policies and procedures;
• establishment of the compliance and supervisory framework;
• recruitment or designation of appropriate registered personnel;
• insurance arrangements;
• financial reporting systems;
• investor onboarding and identity verification technology;
• KYC and suitability systems;
• books and records infrastructure;
• minimum capital requirements; and
• systems for transaction processing and regulatory reporting.

These costs are front-loaded. The dealer may incur substantial professional, technology and personnel expenses before it generates any distribution revenue or processes its first subscription. For managers comparing an external dealer arrangement against an internal model, these initial costs should be amortized over the expected life of the dealer rather than ignored because they are non-recurring.

2. Recurring Fixed Costs

Once the dealer is registered, it develops a recurring cost base. Some of these costs do not vary materially with annual fundraising volume. The dealer requires a chief compliance officer and ultimate designated person. Compliance systems must be maintained. Policies and procedures must be kept current. Insurance must remain in force. The dealer must maintain required regulatory capital, monitor its excess working capital and satisfy applicable financial reporting requirements. Technology systems must remain operational. Registered individuals require training and supervision.

The dealer may also continue to rely on securities counsel, compliance consultants, accountants, auditors and other advisers. This creates an important economic characteristic. A manager may raise considerably more capital in one year than another, but much of the dealer’s infrastructure remains in place throughout both periods.

That means an internal EMD generally carries a meaningful fixed-cost component. The economics can improve as the manager spreads those fixed costs across greater fundraising volume. However, that should not be confused with the idea that dealer costs stop increasing as the business grows. Some costs are fixed. Others scale with activity.

3. Variable Costs as Distribution Scales

More fundraising generally means more dealer activity. Each additional investor can increase the work associated with identity verification, KYC, suitability, prospectus exemption compliance, subscription processing, recordkeeping and follow-up. Each additional product can increase the dealer’s know-your-product work and the complexity of suitability assessments. Each additional jurisdiction may introduce registration, filing and supervisory considerations. Each additional dealing representative creates further training, registration, supervision and monitoring requirements.

As a result, the economics of an internal EMD do not depend solely on the amount of capital raised. For example, two managers may each raise $50 million annually and operate very different dealer businesses. One may raise that capital through a small number of institutional investors, a limited product shelf and a concentrated distribution team. Another may raise the same amount through hundreds of individual investors, multiple products and a geographically dispersed network of dealing representatives. The compliance workload, and therefore the cost of operating the dealer, can be materially different.

Each Dealing Representative Adds More Than Compensation

The cost of a distribution team also extends beyond salaries and commissions. A dealing representative must satisfy applicable registration and proficiency requirements and operate within the dealer’s compliance framework. The firm must provide appropriate training, monitor the individual’s activities, supervise dealing conduct, review client documentation, address conflicts and outside activities where applicable, and maintain appropriate records.

The dealer must also be capable of identifying and addressing deficiencies in a representative’s conduct. As the number of dealing representatives grows, the supervisory function generally becomes more demanding. This is particularly important for fund managers considering whether to move an existing investor relations or sales team into an affiliated dealer. The relevant cost is not simply the compensation already being paid to those employees. It is the incremental regulatory infrastructure required to support them as registered individuals.

Management Time and Opportunity Cost

Some of the most significant costs of an internal EMD may never appear as a separate line item. A CCO’s compensation is visible. Senior management time often is not. The CEO, CFO, general counsel, operations personnel and other executives may become involved in dealer matters involving registration, financial reporting, compliance reviews, personnel issues, systems, client complaints or regulatory inquiries.

The ultimate designated person also has specific responsibilities within the dealer’s compliance framework. For a fund manager, this creates an opportunity cost. Time spent operating a registered dealer is time that cannot be spent on acquisitions, asset management, portfolio oversight, investor relations, product development or other elements of the manager’s core business.

That cost can be difficult to quantify, but it should not be treated as zero. A manager evaluating an internal EMD should therefore distinguish between accounting cost and economic cost. The accounting cost is what appears on the dealer’s financial statements. The economic cost includes the value of management and organizational resources consumed by the dealer function.

4. Episodic Costs

The fourth category is less predictable. Registered firms are subject to regulatory oversight and may be selected for compliance reviews. Regulatory inquiries may require the dealer to assemble records, respond to questions and explain its policies and practices. Where deficiencies are identified, remediation may require changes to policies, client documentation, supervision, training, technology or operational processes. External legal or compliance advisers may become involved. Personnel changes can create similar costs.

The departure of a CCO, senior dealing representative or other key registrant may require recruitment, reassignment of responsibilities, registration applications and additional supervisory work. These costs may not occur every year, but they form part of the long-term economics of maintaining a registered dealer. A cost model that assumes uninterrupted personnel continuity and no material regulatory remediation will therefore tend to understate the actual cost of dealer ownership.

Key-Person Risk Has a Cost

Smaller internal dealers may be particularly dependent on a limited number of registered individuals. If significant compliance knowledge is concentrated in one CCO or one senior employee, the departure of that individual can have consequences beyond recruitment expense.

Management may need to reallocate responsibilities, retain external support, modify supervision or delay certain activities while replacement personnel are identified and registered. The same issue can arise where a small group of dealing representatives accounts for a substantial portion of the dealer’s distribution activity.

Succession planning and operational continuity therefore form part of the cost structure of an internal EMD.

The Break-Even Question

The central economic question is usually: At what level of sustained fundraising does an internal EMD become more economical than using an external dealer? There is no universal break-even point. The answer depends on several variables, including:

• annual fundraising volume;
• external dealer fees;
• number of dealing representatives;
• number of investors;
• number and complexity of investment products;
• jurisdictions in which securities are distributed;
• existing internal legal, compliance and finance resources;
• technology requirements;
• management time devoted to dealer operations; and
• the level of regulatory and supervisory complexity.

The internal model can be viewed conceptually as:

Fixed dealer infrastructure + variable compliance costs + management allocation + episodic regulatory and personnel costs

The external model can be viewed as:

External dealer fees + internal resources required to manage the dealer relationship

This is a more useful comparison than asking whether an external dealer’s annual fees exceed the salary of an internal compliance professional. The economics of an internal EMD may improve considerably at scale because fixed costs can be spread across a larger amount of fundraising activity.

At the same time, growth can increase investor volume, transaction volume, product complexity and supervisory demands. The point at which internalization becomes economical therefore depends on the characteristics of the distribution platform, not simply the gross amount of capital raised.

When an Internal EMD Can Make Sense

An affiliated EMD can be an appropriate model for some investment managers. A manager raising substantial amounts of capital on a continuing basis may be able to spread the dealer’s fixed costs across sufficient transaction volume.

An internal dealer may also provide greater direct control over distribution personnel, supervision, systems, client relationships and operating processes. The model may be particularly practical where the broader organization already maintains substantial legal, compliance, finance and technology infrastructure and is prepared to operate a securities dealer as a permanent business function.

A manager with a large, stable distribution team and a long-term commitment to continuous fundraising may therefore conclude that owning its dealer infrastructure is economically justified. The important point is that the decision should be made using the full cost of the dealer, rather than a narrow comparison of external dealer fees against one or two internal positions.

Internal Dealer vs. Outsourced Dealer Economics

An external EMD produces a different cost structure. Rather than building and maintaining the entire dealer platform internally, the investment manager relies on an existing registered dealer’s compliance, supervision and operational infrastructure. The external dealer will charge for those services under the applicable commercial arrangement.

The manager will still incur internal costs. Personnel will need to coordinate with the dealer, provide product information, respond to diligence requests and support investor onboarding and transaction processing. However, the manager does not have to own the full dealer infrastructure itself. This effectively changes the allocation of cost.

An internal EMD generally involves higher fixed infrastructure costs and greater direct control. An outsourced model generally involves lower internal fixed dealer infrastructure and a greater external service cost. Neither structure is inherently preferable in every case. The appropriate model depends on scale, organizational capacity, distribution strategy and the manager’s willingness to operate a regulated dealer over the long term.

Conclusion

The economic question is not simply whether an investment fund manager can obtain exempt market dealer registration. It is whether the manager wants to own and operate the personnel, systems, supervisory framework and regulatory infrastructure of a securities dealer on an ongoing basis.

For some managers, fundraising scale, existing infrastructure and a permanent internal distribution team may justify that investment. For others, using an external EMD may provide access to established dealer infrastructure without assuming the full fixed cost and operational responsibility associated with dealer ownership.

The appropriate comparison is therefore the full cost of operating an internal dealer against the full cost of outsourced distribution.

Contact Us

Startly Inc. provides outsourced exempt market dealer services to investment funds and other issuers raising capital under prospectus exemptions. If you are launching a new fund, expanding an existing exempt offering, or evaluating your distribution model under National Instrument 31-103, contact us to discuss how our EMD platform can support your capital raising activities.