In the past few weeks Integrity has written a few blogs outlining the various trends that are likely to impact the investment research industry, including hedge fund closings, industry layoffs, projected declines in institutional equity commissions, etc. This past week, we aggregated these trends to present our view of the independent research industry at Investorside’s annual Member’s Day conference. The following is a review of our outlook.
Size of the Independent Research IndustryBased on Integrity’s analysis, the U.S. independent research industry generated $1.90 billion in revenues in 2007. Buy-side institutions spent the bulk of this total, generating $1.40 billion in sales. Retail investors and corporations (in the form of issuer sponsored research) generated the remaining $500 million in sales.
Institutional investors paid for this independent research in two primary ways – either via commissions (soft dollars, bundled commissions, or Commission Sharing Agreements / Client Commission Arrangements) or via hard dollars (cash). We estimate that approximately $1.05 billion of the total of $1.4 billion was paid for in some form of commissions. Buy-side investors paid close to $350 million for independent research using hard dollars.
Composition of the Independent Research Industry
Not all independent research is made alike. The staff at Integrity Research has undertaken extensive analysis to determine what type of investment research clients use. This is done by categorizing all existing independent research firms based on their primary analytical methodology.
2007 U.S. INDEPENDENT RESEARCH INDUSTRY
Table 1 – Market Share: Percent of Revenue
Table 2 – Market Share: Percent of Firms
The primary methodolical categories we have identified include fundamental research, quantitative research, technical analysis, primary research, economic research, and specialized research (which includes a wide range of niche types of research).Table 1 above shows how the $1.90 billion in 2007 independent research sales breaks down based on Integrity’s six primary research categories. As you can see from this table, 39% of all independent research sales in 2007 came from fundamental research providers, 21% from economic research providers, 18% from primary research firms, 9% from quantitative research firms, 9% from specialized research providers, and 4% from technical analysis firms.
However, Table 2 shows how the entire universe of independent research providers breaks down based on their primary research methodology. Based on this chart 45% of all independent research firms produce fundamentally-based investment research, 23% are specialized research providers, 11% are primary research providers, 10% are economic firms, 6% are technical analysis firms, and 5% produce quantitative research.
Near-Term Projections for the Independent Research Industry
Unfortunately, the financial meltdown that we are currently experiencing across the globe is likely to have a significant impact on the financial services industry, and more specifically on the investment research business.
As we have mentioned in recent weeks, equity commissions generated from buy-side trading are expected to plunge close to 40% in 2009. Many industry analysts project that 30% to 50% of all hedge funds will close in the next 18 months due to poor investment performance and investor withdrawals. Consequently, hedge funds are expected to lay off up to 10,000 staff in the coming months.
We believe these factors will lead to reduced buy-side revenue for both sell-side and independent research. Of course, it is highly likely the firms that will suffer most directly will be those that are paid in bundled commissions or through the broker vote as the amount available to pay these firms will be directly impacted by the 40% drop in equity commissions expected next year. Consequently, sell-side investment banks and brokerage firms could see a tremendous drop in research revenue.
Firms that are paid via subscriptions (including many independent research firms) are likely to be impacted less dramatically as most buy-side firms subtract their subscription liabilities from their commission pool first, and then allocate the remaining commission dollars to pay the remaining firms based on the broker vote.
While we have not yet completed revising our research industry forecast for 2008 and beyond, the recent market developments do suggest we will see substantial revenue declines, particularly in 2009. In fact, preliminary estimates suggest that independent research sales could fall between 15% and 20% in 2009, after posting modest growth in 2008.
The bulk of these declines should come from firms producing and marketing fundamental research as many of these research providers either bundle their product with execution, or they market themselves via the broker vote. Of course, we do expect primary, economic, and specialized research will also post hefty losses as the number of clients decline due to hedge fund closings and staff reductions.
This projected drop in buy-side expenditures on investment research is likely to prompt a number of small and mid-sized investment banks, broker-dealers, and independent research providers to close their doors for good in the coming years, thereby reducing the supply of investment research going forward.
Future of the Independent Research Industry
However, once the dust settles (in late 2009 or early 2010) we anticipate that the market for investment research, and particularly non-traditional independent research, is likely to improve markedly. This view is based on a number of factors. Many of the remaining buy-side institutions will probably have fewer internal analysts on staff than they do today. For these buy-side analysts, high quality external research will be critical to be able to keep up with the number of companies they have under coverage. This, in addition to the tightened supply of research, will naturally raise the value investors will be willing to pay for good investment research.