New York, NY – Last weekend we wrote a piece on the Integrity outlook for equity research produced by U.S. sell-side or investment banks over the next few years. And while our view was mildly pessimistic, we have a somewhat more upbeat (albeit mixed) outlook for the independent or alternative research industry. This week we will provide a detailed discussion of Integrity’s outlook for the U.S. alternative research industry.
Definitions
A lot has been made of the term “independent research” in the past few years – particularly in the wake of accusations of biased investment bank research and the resulting Global Research Analyst Settlement. As a result of this baggage, and for some of the reasons we will discuss below, the team at Integrity Research Associates has chosen a new term for this type of analysis and insight – Alternative Research. As we start discussing our outlook for this industry, it makes sense for us to clearly define what we mean by the term “alternative research”.
While there are many ways to define alternative research, Integrity Research Associates has decided to take a rather inclusive view of this type of research. Our definition, rightly or wrongly, defines alternative research as all investment research produced by firms that DO NOT CONDUCT INVESTMENT BANKING. Thus, alternative research excludes research produced by any firm that helps public or private companies in raising funds in the capital markets (either in the form of debt or equity), as well as in providing strategic advisory services for mergers, acquisitions, and other types of financial transactions.
This, however, should not be construed to mean that all “alternative research” firms do not face their own conflicts of interest. In fact, almost all research firms have to deal with their own conflicts of interest. The real issue is how well they address these issues. A few of the most common conflicts that some “alternative research” firms face include:
- Proprietary Trading
- Money Management
- Issuer Sponsored Research
- Analyst Ownership of Stocks Under Coverage
- Maintaining Favor of Company Management
Thus, Integrity’s definition merely eliminates one large source of conflict – that of investment banking. Consequently, we see three primary groups that produce equity research, Sell-Side firms (also known as Investment Banks), Buy-Side firms (typically for internal use), and Alternative Research firms. As defined, alternative research firms produce and sell their investment research to retail investors, institutional investors, and corporations.
The Current Picture
Based on our extensive research and analysis of the industry, and interviews with close to a hundred research firms, we estimate that the U.S. alternative research industry generated approximately $1.8 billion in revenue in 2006.
However, one should not jump to the conclusion that this means that buy-side investors are spending that much to purchase alternative research. In fact, our estimates reveal that only $1.4 bln was generated from buy-side clients (the remaining came from retail and corporate customers). Of this revenue, we estimated that approximately 67% came either in the form of third party “soft dollars” or in bundled commissions generated by clients trading through the firm’s trading desk. The remaining revenues were in the form of “hard dollars” or checks from buy-side investors.
Of course, some alternative research firms also generate a significant amount of revenue from either retail investors or corporations looking for research coverage. Based on our analysis, alternative research firms received approximately $400 million from these sources. In fact, between 60 and 70 independent research firms are currently receiving between $80 million to $90 million in annual revenues from the Global Research Settlement alone.
It must also be noted that the alternative research industry is quite different from the sell-side based on the sheer number of firms in the business, and the great diversity in the type of research produced. Based on our surveys, we have identified between 500 to 550 alternative research firms in North America (including small one and two man research shops) producing various forms of investment research.
In addition, we have identified a wide range of primary research methodologies used by these firms that could help a client identify or differentiate these firms. And while we have identified a large number of extremely granular methodologies to categorize these firms, we typically break the industry down into six (6) primary research styles or methodologies, including:
- Fundamental
- Quantitative
- Economic
- Technical
- Primary
- Specialized
Of course, the largest category, both in the number of research firms and by revenue generated, is the fundamental research group, with economic research being the second largest category. However, traditional fundamental research has not been the fastest growing group in recent years as buy-side investors have been most interested in research produced by firms in the primary and specialized research categories.
A few of the types of firms in the Primary Research category include Expert Networks (Gerson Lehrman, Vista Research, Coleman Research), and Channel Checkers (Off-The-Record Research, Farmhouse Equity Research, Detwiler, Mitchell & Co.). Specialist research firms include Forensic Accounting and Quality of Earnings Research (CFRA, Behind The Numbers, Audit Integrity) and SRI Research (Innovest, KLD, and Asset4).
In addition, many of the most innovative new research providers that are springing up on a regular basis are firms that defy traditional models. As a result, we categorize many of these unique research firms as “Specialized” research providers.
Challenges for Alternative Research
Despite Integrity’s historic focus on alternative research, we clearly see that the industry faces numerous challenges that threaten the viability of the business. A few of the more formidable threats include:
Inability to attract top analytical talent – One of the greatest difficulties facing alternative research providers is the difficulty these firms have in attracting the best analysts due to the financial limitations most alternative research providers face. With over 80% of all alternative research firms generating less than $5.0 million in annual revenue, it is quite difficult to hire top analysts who could be worth well in excess of $500,000 per year to a sell-side or buy-side firm.
Continued soft dollar chill – While many hoped that the SEC’s interpretive guidance on Section 28(e) of the Securities Exchange Act of 1934 that was issued last summer would resolve market concerns, the truth is that many asset managers have remained skittish about using traditional third-party “soft-dollars” to pay for alternative research. As a result, many alternative research firms have continued to suffer from the chill around using soft dollars to pay for their products and services. Fortunately, the growing popularity of CSAs and CCAs could address these concerns.
Lack of standards to mitigate conflicts – Traditionally, most alternative or independent research firms have not been required to be regulated as a Registered Investment Advisor as they have been deemed to be “publishers”. As a result, many alternative research firms have not worried too much (nor have their clients) about establishing rigorous policies and procedures to mitigate the impact that conflicts of interest could have on their research. However, events like the Gradient / Overstock or Biovale lawsuits have started to raise industry concerns that additional scandals could actually call into question the credibility of alternative research, much as the Global Research Settlement cast sell-side research in an unfavorable light.
Competition from sell-side – Reg FD and the Global Research Settlement started to level the playing field between sell-side research and alternative research. This trend was continued as the UK’s FSA mandated commission transparency through a more regular and rigorous disclosure regime. Unfortunately, this also means that alternative research providers will be forced to compete with sell-side research on a more equal footing – a difficult prospect given the more extensive resources that investment banks have to dedicate to the issue. This is particularly tricky given the fact that most alternative research firms have under invested in the sales and marketing of their research products. Also, sell-side firms offer a broader suite of services not typically offered by alternative research firms, including research breadth, management access, access to an IPO calendar, etc.
Increased internalization by buy-side – In the past few years, as sell-side firms have reduced their coverage of domestic stocks, large buy-side firms have increased their investment in their internal research capabilities. And while this trend helps certain types of research providers (expert networks and channel checkers), it also hurts other research firms, particularly those providing fundamental company research, as buy-side analysts don’t need this type of research if they can produce it themselves.
Unbundling and commission transparency – On the one hand, increased unbundling and commission transparency has leveled the playing field between sell-side and alternative research firms. However, on the other hand, commission transparency and unbundling has increased the need on the part of buy-side firms to develop and implement a more proactive and rigorous selection, evaluation, and due diligence process to justify their research spend to clients. This will mean that any weaknesses in their people, process, performance, or policies will become more evident to potential customers.
Use of CSAs and CCAs hurt alternative research B/Ds – As mentioned previously, the proliferation of CSAs and CCAs could help overcome the unwillingness of some buy-side firms to use third-party soft dollars. However, one group of firms that will suffer as CSAs and CCAs become more popular are alternative research firms that also operate sales and trading desks. These firms could see a significant reduction in their overall commission revenue as buy-side firms choose not to execute trades through them, but rather they might pay for their research through a select group of CSA brokers.
Comment by David Miller:
I think there is considerable value in the term “Independent Research”. Your ‘new’ term “alternative Research is not objectionable, however, and may even be helpful to firms like ours who eschew the big conflict of interest of gaining revenue from brokerage/trading fees.
The argument can be made there is no such thing as totally objective research, and that may well be true. We’re human, after all, and objectivity is a togh thing to cultivate. But that doesn’t mean we shouldn’t try.
Spitzer latched on to the easiest conflict, between analysts and investment banking. He latched on to it precisely because it was the most obvious, not because it was the most damaging to investors. That award goes to conflicts with the trading desk and proprietary trading desks.
As such, I see Independent Research as a subset of a broader Alternative Research label. As long as nobody tries to claim the two are equivalent, I see no problem with another label for our industry.