New York – 2011 is shaping up to be a challenging year for independent, third party research. The insider trading investigations are creating uncertainty which is expanding beyond expert networks. Meanwhile, the Department of Labor’s new commission disclosure guidelines will go into full effect this summer, and we think the guidelines will have the perverse effect of focusing pension scrutiny on independent research rather than on the proprietary research offered by investment banks. Finally, the likely resurgence of the IPO market will tilt commission payments further toward investment banks at the expense of independent providers. Not a pretty picture for independents.
Insider Trading Investigations
The investigations have reduced usage of expert networks as investors pull back to review compliance practices, and in some cases suspend use of expert networks altogether. Scrutiny is not limited to expert networks, however. Channel check firms, survey firms and other primary research firms are impacted. We are even hearing from boutique fundamental firms that are losing clients over compliance concerns. Increasingly, asset managers are requiring independent research firms to either be broker dealers or registered investment advisors.
The longer the investigations drag on, the more widespread the concern from asset manager clients. There is already confusion over what constitutes an expert network (for example, the Wall Street Journal labels John Kinnucan’s channel check firm Broadband Research as an expert network) and this shows no sign of abating. Take Karl Motey, for example. Motey, who emerged as a cooperating witness in indictments released before the holidays, is an ex-sell side analyst who set up his own research boutique, further complicating the picture for independent firms.
We have no idea how long the investigations will go on, but it is likely they will continue at least into the second quarter. The reportedly high volume of subpoenas suggests that there is much more to come. Since it appears that investigators are trying to gather evidence against targeted hedge funds and as yet no hedge funds have yet been charged, we are still in the early stages of this investigation, which can easily go on into the second or third quarter.
DOL Form 5500
The Department of Labor implemented new disclosure requirements for pension funds, which include information about soft dollar payments. Technically, these reforms were supposed to be implemented this year, but they were effectively postponed until July 31, 2011 because pension funds had difficulty obtaining the necessary information. The new form requires the listing of indirect soft dollar payments, for both proprietary investment banking research and independent research. However, because independent research tends to be unbundled (and specific amounts listed in the form) and proprietary research is bundled (with no specific amounts listed in the form), the reporting will most likely focus pension fund attention on the cost of independent research.
Some independent research providers see a silver lining in the fact that proprietary research will emphatically be labeled as soft dollars. We suspect this will have little impact since the amounts will not be disclosed. The impact will be just the opposite. We have been commenting on a trend for independent research to move away from unbundled pricing toward bundled pricing. The revised Form 5500 will likely increase this trend.
According to PricewaterhouseCoopers LLP, IPO volumes in 2010 doubled from the previous year. With 154 IPOs totalling $37.5 billion, 2010 activity represents a 123 percent increase in volume and 49 percent increase in value, compared with the $25.2 billion raised from 69 IPOs in 2009. PWC believes that the surge of activity in the fourth quarter of 2010 confirms the IPO market has recovered from the doldrums of 2008 and 2009. Growth was driven by a continued wave of financial-sponsor support for IPOs, a surge of foreign–particularly Chinese–companies going public here and the massive single offering by General Motors Co. (GM), which was the second largest in U.S. history, accounting for more than two-thirds of total IPO proceeds in the fourth quarter.
Continued strength in IPO volume will put pressure on institutional investors to allocate higher portions of their commission volumes to investment banks for deal flow. Although this is represents a grey area for soft dollar payments (it is not clear that IPO allocations meet the definition of research), the reality is that in the world of bundled commissions, deal flow is an important factor in commission allocation. All things being equal, higher allocations to investment banks will translate into lower allocations to independent research providers.
What do the insider trading scandal, DOL reporting and IPO volumes portend for longer term trends? We think it likely that the insider trading investigation will translate into structural change for independent research, requiring more focus on compliance for all types of research firms, not simply expert networks. Asset managers are increasingly requiring that their research providers either be broker dealers or registered investment advisors, as a proxy for some level of regulation. As we have pointed out in the past (http://www.integrity-research.com/cms/2007/04/20/sleeping-dogs-part-2/ and http://www.integrity-research.com/cms/2008/09/15/to-be-or-not-to-be%E2%80%A6an-ria/), research firms that are not RIAs are taking risks, particularly if they are providing any form of customized service to clients.
In the current environment, clients are not tolerant of risky sources of research. Structurally, this is raising the bar for independent research, requiring firms to invest more heavily in compliance and regulatory matters. Barriers to entry for new research firms will increase, and the cost advantage that independents enjoy relative to broker/dealer research will decrease.
The longer term impact of the DOL guidelines is more ambiguous. The regulatory intent was to create more transparency for commissions, and although we believe that the watered down DOL guidelines will have an opposite effect in the short run, the regulatory trend is still intact. Over time, regulators will force more commission transparency. At this point, however, we are talking decades, given the lack of leadership from the SEC on this issue. Restoring enforcement prowess, in the form of insider trading litigation, is a much higher priority.
IPO volumes are cyclical, and the IPO rebound is one further sign of the investment banks recovery from the depths of the financial crisis. While it will translate into an upswing in revenues and profits for banking research, it does nothing to change the volatility of research as a product line, which is the greatest challenge for proprietary research.
So, although the outlook for 2011 is negative for independent research, the longer term prospects are more mixed. We believe that independent research will become more regulated as a result of the insider trading investigations. Regulatory support for commission transparency is likely to continue, despite any setbacks from the DOL guidelines and the IPO rebound is cyclical rather than structural. Nevertheless, for independent research firms struggling to get by, longer term prospects represent cold comfort. The challenge will be getting through the next year.