New York – Yesterday we discussed the extraordinary changes in the hedge fund industry and the implications for alternative research. Today we tackle another big issue: research pricing. The credit crash and the resultant bear market have already affected research pricing and transparency, and we can expect further changes.
There are two main influences on research pricing: regulation and market forces. So far, the latter has had the most immediate impact. The relevant market forces are changes in the supply of research, shrinking investor assets, declining commissions, and the growth (heretofore) of commission sharing agreements (CSAs) also known as client commission arrangements (CCAs).
We have been expecting for some time that the number of equity research providers would decline. By any measure, there is a glut of equity research (at least for large cap stocks). There has been some consolidation at the top end (Bear Stearns and JP Morgan, Merrill and Bank of America, Lehman and Barclays Capital). We expect that there will be further reductions in supply at all levels: the largest bulge research departments, the 2nd and 3rd tier broker dealers, and independents. Could we see consolidation of 20-30%? Quite likely.
Research supply will have to decline because demand will shrink. Or more precisely, the ability of investors to pay for research will be less. As we mentioned yesterday, hedge fund assets were down 10%, over $200 billion, in the 3rd quarter and hedge asset outflows are projected at $150 billion over the coming year. Mutual fund assets are declining even more precipitously. Equity assets in US mutual funds were down nearly $1 trillion as of August, declining 14% from $6.5 trillion as of the end of 2007 to $5.6 trillion in August, according to the Investment Company Institute. Equities markets are down more than 30% year to date, and there is no assurance we have seen a bottom. Mutual funds are subject to further declines from the market and investor redemptions.
Fewer assets translate into lower commissions. This is exacerbated by the tendency of bear markets to depress trading volumes. One of the largest investors told us a month ago that they were in the unprecedented position of not having enough commissions to cover their research commitments. And that was before the most recent market carnage. Sell side sources tell us that they expect commission budgets to be down 40%. This will put extraordinary pressures on the broker vote process. All research providers participating in broker votes can expect a significant decline. This is the flip side to getting commission windfalls during rising markets and rising assets. It was very nice during the ride up, but it will be ugly now.
The price of research paid through commissions is being reduced, possibly by as much as 40%. If that is the case, will this set a ceiling on future pricing? In other words, as markets and commissions start to recover, will research payments also increase or will there be pressures to keep research budgets low? We suspect that mutual funds in particular will use the low water mark of the reduced commissions pool as the benchmark for research fees going forward. Increased research fees will be paid mainly for new services, aside from increases to reflect inflation. In other words, research payments will become more subscription-like, whether research providers like it or not.
Which brings us to regulation. Up until now, the SEC has been made desultory efforts to promote greater commission transparency. The current guidance for fund directors, the SEC’s tepid response to the issue of commission disclosure, comes at an interesting juncture. The comment period is closed, and in normal circumstances the SEC would be preparing its final guidance. However, it remains to be seen what happens to the SEC between now and when it would normally have produced its final regulation. Will there even be an SEC in its current form? It is highly likely that the new US regime, even if Republican but especially if Democratic, will be inclined toward more vigorous regulation of securities markets. This increases the odds of more regulatory pressure on commission disclosure. It won’t the highest priority, but sooner or later, very likely.
The future for CCAs/CSAs is more difficult to predict. CCAs took a significant hit with the Lehman bankruptcy, which along with many other assets has tied up CCA balances. There are various proposals to try to reduce the counterparty risk of CCAs through a consortium or through third parties. It is not yet clear how this will play out, but at a minimum we can expect a hiatus in the growth of CCAs/CSAs until this gets sorted.
In the short term, research pricing will be an extremely difficult environment. From these pressures will come more explicit pricing regimes and greater disclosure over the medium to long term. At the same time, however, consolidation in research providers will improve the economics–for those that survive.