The CFA Society of the UK has published a position paper which outlines approaches to valuing investment research. The paper, which expands upon valuation techniques outlined UK regulators, seeks to help asset managers implement new regulatory guidelines. Nevertheless, it is unclear how much asset managers will invest in procurement processes when the future of research procurement is in doubt.
The CFA Institute and the CFA Society of the UK co-sponsored a position paper authored by Frost Consulting entitled “Investment Research Valuation Approaches: A Framework and Guide for Investment Managers and Asset Owners.” The paper, released last week, can be obtained by request via http://www.frostconsulting.co.uk/research-valuation/.
The report was commissioned in response to new UK regulation which went into effect in July requiring asset managers in the UK to perform “fact-based analysis” to price research services. The regulators proposed comparing unpriced bundled services to priced services such as independent research and/or estimating the cost to internally perform the service.
The primary challenge facing asset managers is valuing unpriced investment bank research which has historically been bundled with execution payments. In the past, payments to investment banks would increase as commission volumes increased, irrespective of whether the research was providing more value. The UK Financial Conduct Authority is insisting that asset managers more proactively budget their research spending, as if the expense were coming out their own pockets rather than paid through client commissions. [The FCA has also recently proposed eliminating altogether the ability to pay for research with client commissions.]
The CFA position paper offers a number of frameworks to help asset managers more intelligently ration their research usage. Part of the analysis needs to be top-down considerations of how much research is truly needed. One approach is to budget research consumption by sector and/or region. If the asset manager or fund is most active in a defined set of sectors or regions, is waterfront coverage really essential? The paper predicts that the purchase of waterfront coverage will be increasingly limited to fewer banks, a view we share.
Another important top-down consideration is which component products are important. Investment bank research bundles a variety of services, including sales support, financial models, conferences and analyst access. Are all products necessary from all providers used, or can the asset manager focus on those products of most value? For example, the paper makes the point for analysts who use externally provided financial models the value of incremental models declines after the second or third model. And for analysts who don’t use models why pay for them?
The paper highlights the limitations of the current broker vote process, which allocates commissions but doesn’t address the budgeting of research products. Historically, a bank might reduce the services it provides the asset manager as a result of the commission levels allocated by a broker vote, but rarely have asset managers proactively reduced payments by limiting the services purchased. Broker votes provide information about which services are used and/or valued internally, but they typically don’t provide budget discipline.
The CFA paper offers a few bottom-up valuation approaches, notably price benchmarking and cost analysis. While the FCA encouraged comparisons to priced services such as independent research in its new guidelines, Frost Consulting has thoughtfully expanded the analysis to include other benchmarks such as outsourcing firms and management consultants. Further, the analysis seeks to develop price benchmarks at the product level, including models, analyst access, etc.
Price benchmarks could also be developed at a sector or regional level primarily through comparisons with priced independent providers. The purpose of developing price benchmarks is to use them in negotiating with investment banks to ensure that managers are not overpaying for bank research.
In its guidelines, the FCA suggested that managers seek to estimate what it would cost them internally to perform the research service. In the CFA paper, Frost Consulting seeks to develop a cost model for investment bank research.
The model seeks to develop a cost for sector-level research by starting with the cost of the analyst and adding to it the cost of the analytic support team, IT, overhead and a profit margin. The cost is then tiered based on the service levels. The largest portion of cost is allocated to service levels involving full analytical support, with lesser amounts allocated to tiers offering partial or no analyst contact. Finally the costs are allocated over an assumed number of clients for each tier. Full regional coverage of a sector would imply multiples of the single-sector cost.
In its guidelines, the FCA envisioned asset managers competing on the effectiveness of their commission management process, even though asset owners have evidenced little interest in monitoring commission spending. (This may help to explain the FCA’s recent move to the more radical stance of banning research commissions.)
Nevertheless, the position paper has an extensive appendix designed to help asset owners understand the issues around research valuation. The paper posits that discipline around research procurement may ultimately develop the research equivalent to Trade Cost Analysis (TCA).
The CFA paper is a thoughtful amplification of the FCA guidelines for research budgeting. By offering a variety of approaches, the report seeks to help asset managers cope with the complexity of valuing and budgeting unpriced investment banking research.
Unfortunately, asset managers are so confused about the regulatory environment it is unclear how carefully they will heed the advice provided by the paper. Six weeks after implementing its new guidelines requiring more rigorous budgeting for research, the FCA announced it was supporting a total ban on research commissions.
A ban is by no means certain since it depends on the interpretation of MiFID II language, which is still in progress. Even if MiFID II leads to a ban, the implementation would not be until 2017, and in the meantime UK asset managers would have to abide by current FCA rules.
Nevertheless, we have heard from numerous sources that many UK managers are so uncertain about the regulatory environment they are reluctant to take on new services including priced independent research. Hopefully the CFA position paper will help managers to develop FCA-compliant procurement processes and procurement will resume. In the meantime, it seems that priced independent research is the victim of the new FCA guidelines, not unpriced bank research.