A Bullish Outlook for Alternative Research?

The Current Size of Alternative Research

Over the past four years, the team at Integrity Research Associates has developed an extensive database of close to 1,500 investment research providers, of which over 650 firms are what we would term alternative or independent research providers.

It is important to note that the number of alternative research firms has grown in recent years, for a couple of reasons. First, new research firms are springing up on a regular basis as former sell-side and buy-side analysts choose to set up shop for themselves. However, another reason the industry has grown is because the types of firms that are producing valuable content and insight are changing. For example, search based primary research firms and industry consultants are two new types of firms that we have recently added to our database due to demand from institutional investors.

Based on extensive interviews with alternative research firms and an analysis of this data, Integrity Research Associates estimates that alternative research totaled $1.81 billion in 2006 (though only $1.38 bln was generated from institutional investors). This includes all third-party soft dollars used to pay for third-party research providers, the research portion of the bundled commission received by non-investment bank broker dealers, and all hard dollar payments received from institutional, retail, and corporate clients.

Of this total, approximately $1.2 billion was spent in traditional third-party soft dollars. However, not this entire total was for research services as buy-side investors paid for market data services and analytic tools with client commissions. As a result, we estimate that investors spent $450 million of this soft dollar total on investment research.
In addition, we estimate that institutional investors paid approximately $680 million in research commissions to various alternative, regional, and boutique research providers that also have sales and trading desks (but who don’t conduct investment banking). This was out of a total of $1.2 billion in overall bundled commissions directed to these firms.
Based on our surveys, we estimate that alternative research providers received $650 million in hard dollar payments from the buy-side, retail investors, and corporations seeking research coverage. Of this total, approximately $310 million was generated from retail investors (including the Global Research Analyst Settlement) and $130 million directly from corporations.
Dispute on the Industry Size
Some analysts, however, argue that the size of the independent research industry is significantly smaller than the totals we have presented. In a recent report, Greenwich Associates noted that buy-side institutions spent roughly $750 million in commission dollars on independent research.

However, it is clear to us that this number is merely Greenwich Associates’ estimate for “third-party soft dollars” and is therefore but one part of the entire revenue picture for alternative research firms. Greenwich is clearly missing the amount of hard dollars that buy-side investors use to pay for alternative research (a total that has been increasing in recent years).
In addition, Greenwich argues that approximately $5.0 billion is being spent by institutions on broker research. We suspect that a small but significant portion of this total is being spent with brokers that produce research, have trading desks, but who do not conduct investment banking (like Sanford Bernstein, Buckingham Research, American Technology Research, and Sidoti).

Of course, the Greenwich numbers do not include the revenues generated by alternative research firms that come from other sources, including retail investors or corporate customers.

Current Demand Trends

Despite these disagreements, there can be no disagreement that various alternative research firms have met with different levels of financial success in the marketplace. In fact, our data suggests that the top 10% of alternative research providers actually generate over 90% of the revenue.

In addition, an even smaller number of firms have generated the bulk of the growth seen in the business over the past five years, reflecting the changing tastes of buy-side research purchasers. Some of the more successful research and related firms in recent years include firms that provide the following types of products and/or services:

• Expert Network Providers
• Data Mining
• Channel Checks and Targeted Market Research
• Short Ideas
• Web Robots and Software Filters
• Intelligence Gathering Techniques
• KPO (Research Outsourcing)
• Emerging Markets Research
• ESG / Governance Research
• Investment Strategy and Policy Research

This is a significant change from the past where research firms that produced fundamental company and/or specialized industry research were in the greatest demand. And even though fundamental research providers make up the largest single group of alternative research firms, they have not experienced the type of growth that Primary, Specialized, and Economic Research providers have seen.

The Integrity Forecast

Based on various surveys and our internal analysis, Integrity expects that alternative research providers will continue to gain at the expense of the sell-side, growing from a 14.5% market share to 19.8%. However, these gains are less likely to come at the expense of bulge bracket firms, but rather from second and third-tier investment banks and broker-dealers.

On an aggregate basis, we forecast that over the next five years, total alternative research revenue will grow by 37% from $1.81 billion in 2006 to $2.47 billion by 2011. The alternative research industry is expected to post this type of healthy growth for a number of reasons, including:

• The continued search on the part of institutional investors for innovative investment ideas.
• Many institutional investors will be looking for ways to pay for their most critical research providers in an environment where bulge bracket firms force them to meet minimum commission thresholds to maintain premium levels of service. This will lead many buy-side firms to switch to alternative research from more expensive services provided by second and third-tier brokers.
• Mid and smaller buy-side investors will be looking for cost-effective sources of research coverage as they will lose the research services they previously received from bulge bracket firms.
• Some sell-side firms will choose to outsource portions of their research coverage to less expensive independent firms.
• An increased demand by corporations to obtain research coverage as investment banks and brokerage firms decrease their willingness to cover all but the largest most liquid firms.

However, we do not believe that all boats will rise on this tide. In fact, we suspect some types of research will find increasing demand, while other types of research will suffer falling interest. Some of the alternative research segments that we expect won’t do so well include traditional fundamental company research, quantitative research and technical analysis as many buy-side firms have chosen to bring those capabilities in-house.
The segments of the market that we expect will post the strongest gains over the coming years include primary research (expert networks, channel checks, market research, data mining, and search based research). In addition, we expect that specialized research will also post significant gains as buy-side investors flock to the multitude of unique and innovative research sources that currently exist and that we expect will spring up in the future. Surprisingly, we also expect that Economic Research (macro, policy, political and country risk, and investment strategy) will thrive in the coming years as hedge funds look outside the US for outsized returns.

Compelling Evidence for this Outlook

It is interesting to note that Greenwich Associates recently published a report showing that 39% of all buy-side analysts expect to increase their use of independent research in the coming 12 months, whereas only 4% of these analysts expect to decrease their use of independent research during this time frame. Of all buy-side analysts, mutual fund analysts were the most bullish on indie research, with 56% saying they plan to use more independent research in 12 months than they do today.

These buy-side analysts were not quite so encouraging regarding their future plans to use sell-side research. Approximately 18% of all analysts surveyed said they expect to use less sell-side research in 12 months than they do today. This compares to the 9% of all buy-side analysts who expect to use more sell-side research in 12 months. It was somewhat alarming that close to 30% of all hedge fund analysts polled said they plan to reduce the amount of full-service broker research in the next 12 months.

The Upshot

This evidence, combined with the increased use of CSAs and CCAs, initial signs of the “barbelling” of the research industry, the move on the part of numerous bulge bracket firms to market alternative research to their institutional clients, and the likelihood that the SEC will eventually move on commission transparency, all suggest to us that the independent or alternative research industry could actually undergo even stronger growth over the coming five years.