New York, NY – Yesterday we started a piece on our outlook for equity research produced by alternative research firms (non-investment banks) in the U.S. over the next few years. Below we have included the remainder of our analysis of the U.S. alternative research industry.
Regulatory and Market Drivers
Despite the significant business challenges discussed in Part 1 of our analysis, we do expect that the regulatory and industry climate will continue to favor the alternative research industry. Certainly, in 2000, the SEC started the ball rolling with Regulation FD which effectively eliminated the greatest competitive advantage held by sell-side research – unequal access to company management insights.
In 2003, Eliot Spitzer, the SEC, the NASD and others reached the Global Research Analyst Settlement with ten of the world’s largest investment banks, severely questioning the credibility of sell-side research, and creating a number of new regulations and procedures which made sell-side research even more costly. This settlement helped boost demand for research that was purportedly less conflicted that was produced by independent or alternative research providers.
More recently, the FSA mandated that UK asset managers provide transparency to their pension clients how much of their equity commissions were being spent on execution and research. Consequently, as their research / execution decision has effectively been unbundled, some UK fund managers have felt more willingness to pay for alternative research with their commissions.
Last July, the SEC released its interpretive guidance on the use of client commissions to pay for brokerage and research services (formerly called soft dollars). This release was important in that it reiterated its definition of soft dollars as all commissions in excess of the cost of execution. As a result, it became clear that money manager’s use of bundled commissions to purchase proprietary sell-side research was also a use of “soft dollars”. In addition, the SEC’s most recent guidance helped legitimize the use of Commission Sharing Arrangements (CSAs) and Client Commission Arrangements (CCAs) to pay for broker and non-broker research.
In the past nine months, two additional regulatory initiatives have developed. The Canadian Securities Administrators has proposed new rules dealing with acceptable soft dollar practices that would require increased disclosure of equity commission use. Most recently, the Department of Labor Employee Benefits Security Administration (EBSA), the regulator of ERISA plans, recently approved regulation which, when and if implemented in 2008, would require the unbundling and separate valuation of brokerage and research services provided to pension funds.
Along side these regulatory developments, buy-side firms have continued to struggle to generate excess investment returns. As has traditionally been the case, a very small percentage of mutual funds consistently outperform their comparable market indices. And while the growth in the actual number of hedge funds has not abated, the performance of these investment pools has slipped, making their higher fee structures more difficult to justify.
Consequently, institutional investors will continue to hunt for sources of profitable investment ideas, unique industry and company insight, and proprietary data to give them an edge in terms of their investment performance. Simultaneously, the regulatory developments discussed above have made it clear that buy-side firms are going to have to be much more discerning about how they spend their clients’ commissions, and why they select their execution and research partners.
As a result, we suspect that the market environment will insure that the buy-side will continue to demand value-added providers of unique research, insight, and proprietary data. The regulatory environment, on the other hand, will require more rigorous justification for their research spend. Both of these trends are likely to make the more innovative and cost efficient research produced by alternative firms extremely attractive.
The Outlook
We expect that the culmination of these various trends will enable the alternative research industry to flourish over the coming years due to continued hedge fund demand for primary, specialized, and economic research.
However, this overall expansion does not mean that all alternative research firms are expected to fare equally well. In fact, our analysis suggests that many segments of the alternative research industry are likely to struggle in the coming years, with a significant number of firms consolidating through mergers or outright exiting the business.
The firms we expect will be the biggest winners in the coming years will those firms that can benefit most from the various trends discussed above. Based on our own analysis, we project that the biggest winners from the internalization of buy-side research will be firms collecting and providing primary information like expert networks, channel checkers, and custom market research providers.
In addition, firms providing global economic research and investment strategy are also likely to succeed as hedge funds continue to search for alpha in emerging markets. We also project that new innovative types of research providers will find favor with buy-side investors, including forensic and quality of earnings research, SRI research, patent analysis, management access, and tools that aggregate and analyze disparate sources of relevant market information.
Some firms, however, will not perform quite as well in the coming years. Despite the fact that an overwhelming majority of buy-side firms employ quantitative filters as part of their investment process, stand alone quantitative research will continue to be a difficult sell to institutional investors as many choose to build their own proprietary solutions rather than relying on “off the shelf” systems.
Although technical analysis has made considerable headway in many markets, the equity research industry remains extremely biased towards fundamental forms of analysis. As a result, technical analysis will post modest growth over the coming years.
However, the one research segment that is likely to see actual deterioration over the next five years is fundamental company research. This is due, in part, to the fact that this research will face the most direct competition with sell-side research and with research produced internally by buy-side analysts. In addition, a number of these fundamental research providers will also be hurt by the move from paying for third-party research using bundled commissions to the utilization of CSAs and CCAs.
In fact, we suspect that these developments will lead the number of alternative research providers in North America to actually shrink over the next five years. We must note that this decline could be even more severe except for the fact that the economics of the business will enable small boutique research providers to survive, and in many cases even thrive. As a result, new innovative entrants are likely to replace some of the research firms that choose to exit the business.
The Skinny
As a result of numerous regulatory developments and market trends, the team at Integrity Research Associates expects that the demand for various forms of alternative research will continue to be strong over the coming years. Demand for primary research, economic analysis and investment strategy, and specialized research should grow at double digit rates.
However, these developments will not benefit all alternative research boutiques equally, with some firms actually suffering lost business and extreme competitive pressure. Ultimately, buy-side investors will continue to reward the most innovative sources of unique insight, profitable trading ideas, and proprietary data.