Developments in the UK Research Industry

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New York – Last week I met with many sell-side, buy-side, and alternative research providers to discuss how their businesses are doing in the current market environment.  Of course, one topic that consistently arose was how the marketplace has been impacted by the move to commission transparency, unbundling research and execution, and the proliferation of CSAs.  The following blog will try to capture some of the most relevant themes:
Buy-Side Developments
It is clear from conversations with a number of UK buy-side investors that while many things have changed in the past few years, many things have stayed the same.  Of course, the mandate to disclose to clients how commissions are being spent has prompted a variety of developments like the implementation of commission allocation systems and models to value their research purchases. However, many buy-side participants acknowledge that despite the unbundled environment, the bulk of their equity commission flow continues to go to the bulge bracket firms.  The major difference today is that these firms have to pay a good portion of these commissions away to third-party research providers. In addition, UK-based buy-side firms have acknowledged that their use of CSAs has become widespread enabling them to trade with whomever they want to trade with and pay whatever research provider they like – whether they are investment banks, brokers, or research only sources.Of course, one of the major complaints heard from the buy-side is that the sell-side continues to be unwilling to “price” their research.  Consequently, the buy-side is forced to blindly come up with their own measure of the value of proprietary sell-side research.  This has led the buy-side to use a number of models to determine the value of this research, using an hourly consulting model, determining what it would cost the firm to produce this research internally, and pricing sell-side research based on the cost of more transparent alternative research. One of the major concerns raised by some buy-side participants has been that the promotion of commission transparency has caused some pension fund clients to question if they have been overpaying for research.  Some pension fund clients have complained that in the past they were led to believe that part of the value they were getting from the money managers they hired were their unique research capabilities.  This was one reason they paid these managers the fees they required.  However, commission transparency has revealed that these firms have been spending even more of the clients’ assets in the form of commissions on external research.  This has led some to question if they have been overpaying for investment research. Sell-Side DevelopmentsAs is the case in the US, equity commission rates continue to fall in the UK putting pressure on the commission revenue of many sell-side firms.  This has particularly been the case with firms that don’t offer research, as these “execution only” vendors have been limited in the amount of volume they can execute for clients.  As a result, some of these execution only vendors have considered other services they might be able to offer which would enable them to earn more commissions.It is rather strange that despite falling equity commission rates, a number of boutique UK and European brokers have continued to invest in their execution platforms, hoping to attract more trading business from the buy-side.  And while we would not be surprised to see a number of local brokers succeed as boutique liquidity providers due to the fragmented nature of the European markets, we suspect that many firms will not be viewed as providers of “best execution” services.  Consequently, many of these boutique brokers’ greatest opportunity may be in providing high quality research. Many large UK sell-side investment banks, on the other hand, have become rather comfortable as providers of broad-based execution and research services and as CSA brokers.  In fact, some UK investors have indicated that a few large brokers have developed business models where they can profitably execute an increasing amount of business, even if they have to pay away large portions of these commissions to pay third-parties for their research.  This doesn’t mean that the large investment banks are not trying to compete on the quality of their research, but it does mean that these firms can make a profit even if they don’t collect a large amount for their research.  Unfortunately, we would not be surprised to see additional rationalization of sell-side research budgets if the buy-side continues to reduce the amount they are willing to pay for the sell-side’s research product.  Alternative Research DevelopmentsTwelve months ago many alternative research providers expressed grave concerns over how Commission Sharing Agreements might put them at a disadvantage.  And while CSAs are not a panacea, most alternative research providers explain that the various processes are being worked out in a reasonable manner.Many alternative research firms find that the playing field continues to remain as unlevel as it was before unbundling.  However, we think part of the reason for this is because the research product produced by many alternative research firms is limited when compared to what is offered by many brokers and investment banks.  Most buy-side analysts, PMs or hedge fund managers don’t just value a firm’s research reports.  They also value access to company management, timely sales coverage, generation of trading ideas, access to analysts, conferences, and custom research.In addition, many alternative research providers have not seen the expected increase in UK or European buy-side use of their services as unbundling and CSAs has become more widespread.  However, we suspect this is a result of two issues.  First, we think that many alternative research firms are continuing to expect buy-side firms will magically find them.  As a result most UK and European alternative research firms have under invested in their institutional sales efforts.  The second reason we think the buy-side is not purchasing more alternative research is because the needs of the buy-side have been changing.  As is the case in the US, most buy-side firms are most interested in primary and specialized research.  Unfortunately, the adoption of these new research models has been quite slow in the UK and Europe.  Instead, firms continue to produce fundamental company research, quantitative research, technical analysis, and other traditional research products.  However, the few UK and European firms that produce primary or specialized research have found healthy demand for their products. SummaryAs is often the case, the more things change, the more they stay the same.  That may be the experience thus far in the UK research business.  Of course, unbundling execution from research has had profound impacts on the financial services industry.  However, the largest suppliers of research and execution services in the old regime (the sell-side) remain the largest suppliers of these services today.  Innovative research firms (alternative research firms) continue to struggle to get noticed by the client base.  Finally, clients (the buy-side) continue to try to make sense of it all. 

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