New York, NY – According to a study published by financial services consulting firm, Greenwich Associates, almost 20% of the buy-side analysts recently interviewed say they expect their firms will either “reduce” or “significantly reduce” their use of sell-side research in the coming year. Almost 30% of the analysts employed by hedge funds expect their firms will reduce the amount of sell-side research over the next 12 months. In contrast, only 9% of buy-side analysts expect their firms will increase their use of sell-side research during the coming year. The Greenwich Associates survey, completed in the spring of 2007, included the input of close to 1,100 buy-side analysts. Integrity’s Sell-Side Forecast The expected drop in buy-side use of sell-side research is consistent with Integrity’s forecast for the coming few years, as we project sell-side research revenues will fall close to 18% from $4.9 billion in 2006 to $4.0 billion in 2011. Other industry experts project an even sharper decline in total revenues received for sell-side research over the coming few years. However, these bearish expectations for sell-side research are a little misleading as some sell-side research franchises will fare better than others in this challenging market environment. In fact, we suspect that some sell-side firms will actually pick up share of clients’ research spend, while others will lose share. CSAs and Sell-Side Research The most obvious reason for this shift is the growing use of CSAs and CCAs – a trend that will enable mutual funds and hedge funds to separate their decision of who provides “best execution” versus who should be paid for their research capabilities. Various surveys have suggested that between 30% to 40% of all money managers in the US are currently using CSAs, while over 70% are using CSAs in the UK and Europe. Using a CSA (or CCA) enables a money manager to trade with a limited number of “CSA brokers” who will then use a portion of these commissions to pay for the research provided by other brokers or alternative research providers. Many expect that buy-side firms will use the transparency provided by CSAs and CCAs to negotiate the amount they spend on sell-side research lower over time – particularly if they find that they are currently “overpaying” for the sell-side research they use and value. Bundled Pricing and Overpayment Unfortunately for many sell-side firms, the bundled pricing model that most firms have used for decades has promoted clients “overpaying” for research by actually obfuscated the amount of valuable research produced and delivered to clients with the sheer volume of research created. As a result, moving away from a bundled pricing model for research will often lead firms to receive less revenue for their research than expected as clients pick out and value the research they truly require. If experience in the alternative research industry is any guide, most buy-side clients actually use (and therefore value) less than 5% of the content produced by various research providers. The big question for most research providers is that they are never really sure what 5% their clients value – or worse yet, each client values a different 5%! Of course, many buy-side firms will choose to pay less and less for maintenance research or research that adds little new insight and value to a manager’s investment process, whereas custom studies or research that is limited in distribution is most highly valued. Some Firms Won’t Fare So Well However, we believe that unbundling research and execution will have a pronounced impact on second and third-tier brokerage firms as buy-side firms try to manage their commission budgets more proactively. This will be due, in part, to the fact that large bulge bracket firms have a greater range of research services and capabilities to offer clients, while second and third-tier brokers have more limited research resources. As a result, we expect that bulge bracket firms will continue to limit their most valuable research services (access to analysts, sales coverage, company management, and conferences) to those clients who are willing to pay the most in commissions. This will force some clients to have to “ration” their commissions to pay for these value-added services. Consequently, many buy-side firms will decide, not only to scale back the number of firms they execute with, but they will also start to scale back the number of research providers they pay – concentrating their research commissions with those firms that provide the greatest value-added. We expect that this trend will hurt many second and third-tier brokers who not only lose the execution business, but who also receive less and less for their research as buy-side firms have fewer excess commission dollars to spend on “non-essential” undifferentiated research. Others Will Do Just Fine Of course, this does not mean that all boutique research providers will suffer this fate. In fact, we suspect that many regional and boutique brokers and investment banks – firms with deep industry expertise, unique company knowledge, or specific relationships with company managements – will be able to continue to earn hefty research commissions from clients. Another group of firms that should benefit from these trends are alternative research providers as buy-side clients look for cost effective and innovative ways to fill in the research gaps they have. We believe this is one explanation why 39% of all buy-side analysts surveyed by Greenwich Associates said they plan to increase their use of independent research over the coming 12 months. On average, most alternative research products are much less expensive than the research produced by sell-side investment banks due to lower production costs. However, lower prices are not the only reason buy-side firms are looking to alternative research. Most of the most unique and innovative types of new research approaches and business models have been developed by small and nimble alternative research firms. In fact, these are some of the reasons why numerous sell-side firms, including Goldman Sachs (Hudson Street Services), Merrill Lynch, Credit Suisse, and Citigroup have developed, or are developing, separate businesses to partner with and market these unique services to their clients.
