In recent weeks we have written a few articles about the improving outlook for cash equities and the equity research business. And while the research business has clearly been on the mend in the past few quarters, some trends – like a growing void in small cap research coverage – suggest that the underlying health of the research industry may not be so robust.
Weak Market Conditions & Regulatory Changes
The five years between 2007 and 20012 were not been banner years for the cash equities and the equity research businesses. Most financial market participants agree that the equity commission pie shrunk 30% to 50% over this period. While Integrity’s estimate for the drop in global equity commissions over this time frame is not quite so sharp, we estimate that buy-side spending on global equity research dipped 20% during the same period.
As we have mentioned in recent articles, equity commissions have rebounded higher over the past 6 months. Despite this improvement, there are some storm clouds on the horizon which don’t bode well for the business – at least in the UK and Europe.
The FCA’s announcement earlier this month that “investment managers should use client dealing commission only to pay for substantive research or costs related to executing trades” will prohibit UK asset managers from using client commissions to pay for management access. Some believe that a similar regulation may also be adopted in Europe.
One consultant, Richard Phillipson of Investit, suggests that this could reduce the amount that UK asset managers pay for investment bank research by 50%, as a considerable amount of the commission pie is currently spent to pay banks for corporate access.
Impact on Capital Markets
The negative impact of these developments has been significant over the past few years, and could continue to hamper the capital markets in the future. One obvious effect of the weakness in the equity commissions from 2007 to 2012 has been a deep cut in the number of equity analysts employed by sell-side firms. Some suggest that the number of equity analysts actually fell by 50% during this period.
The consequence of these layoffs has been a drop in the number of companies that receive research coverage. As of December 31, 2012, Keating Investments published a white paper revealing that nearly 29% of all exchange listed companies had zero or no meaningful analyst coverage of their stocks. This, however, understates the impact on small or micro-cap stocks as 55% of companies with market caps of less than $250 million have little or no analyst coverage.
Unfortunately, the lack of research coverage has a proven negative impact on the cost of equity capital, meaning the equity prices for stocks with no coverage are generally lower than the price of similar sized companies in comparable industries. Ultimately this could hinder the growth prospects of these uncovered or under covered companies and negatively impact their willingness to invest and hire.
This issue has not gone unnoticed by regulators and lawmakers. The European Commission is considering what to do to encourage research coverage for small and mid-sized companies. This concern also prompted the JOBS (Jumpstart Our Business Startups) Act, signed into law on April 5th 2012.
The JOBS Act specifically allows investment bankers and research analysts to formally collaborate on an IPO for a smaller “emerging growth company” (although appropriately retaining the independence safeguards designed to protect investors), and it allows equity research to be published immediately after the IPO, instead of waiting 40 days.
Possible Solutions
Although the public sector is rightfully concerned about the negative economic impact of declining research coverage and is considering possible options, a number of market-based solutions are available. For example:
- Issuer sponsored research: Some uncovered or under covered public companies choose to directly pay research firms to cover their companies. These issuers have made the commercial decision that the benefit of research coverage greatly outweighs the cost of that coverage and the market perception that this type of research is biased. However, a limited number of high quality issuer sponsored research firms, and the credibility concerns some investors have with this type of research, has kept it from gaining considerable traction in the marketplace.
- Exchange “fee based” research: Over the past decade, a few third-party initiatives have sprung up to try and address the credibility issue associated with issuer sponsored research. Most of the programs that have gained the most traction have been run by stock exchanges which directly hire research providers to write the research on behalf of uncovered listed companies thereby removing the economic incentive on the part of the research firm to write overly optimistic research because they are being paid directly by the corporate issuer. The London Stock Exchange, as well as exchanges in Australia, New Zealand, Singapore, Malaysia, and India have all developed similar “fee based” research programs.
- Increased buy-side coverage: Some market participants suggest that the real answer to the problem of declining sell-side research coverage is to have asset managers increase their own internal research efforts to cover more public companies. And while some buy-side firms have expanded their research departments to address this issue, the cost to do so is normally quite high prompting these firms to pass on these costs in the form of higher fees to their clients. Also, this approach is inefficient as it would require buy-side firms to duplicate their efforts as they would cover many of the same companies.
- Alternative research: A more economically rationale approach to addressing declining sell-side research coverage is for buy-side firms to pay alternative research providers to undertake this research. Not only can most alternative research firms produce this research at a lower cost than buy-side or sell-side coverage, but an alternative research firm can spread the cost of this coverage across a number of buy-side clients. Unfortunately, most alternative research firms find it hard to justify covering small cap companies as investors are interested in a wide range of different stocks, thereby making the demand for research coverage on any single company limited.
Summary
We clearly see evidence of a rebound in the cash equities and equity research business over the past few quarters. However, this doesn’t mean that the research industry is healthy and robust. You certainly would not believe this if you were the CFO or CEO of a small or mico-cap company that did not have research coverage, or a small-cap money manager looking for research on the hundreds of names in your interest list.
Unfortunately, recent regulatory developments, like the FCA’s announcement that UK asset managers cannot use client commissions to pay for corporate access is likely to make it even more difficult for small-cap UK (and potentially European) companies to get sell-side research coverage. Many UK investment banks will probably experience a significant drop in equity commission income, prompting fewer analysts on staff and less research coverage.
In our assessment, small cap public companies will probably have to look for research coverage in less traditional ways, like from issuer sponsored research firms or from exchanges with “fee based” research programs. Buy-side firms, on the other hand, will either need to increase their internal research departments or they will need to procure more alternative research to fill the growing research void.