Research Tectonics


New York – The research topography has shifted dramatically over the last two weeks, creating lasting impact on the investment research industry.  Not all of the implications are yet clear.  Consolidation is a major theme, but there are others:  the migration of talent to boutiques and the buy side, the standing of US financial institutions relative to European and Asian institutions, the rise of the larger hedge funds and private equity firms accompanied by decline in the number of smaller hedge funds.  All will have a big impact on the way research is conducted, disseminated and paid for.

You would think that consolidation would be cathartic for investment research-reducing capacity and improving the health of the survivors.  However, as we have discussed earlier  the case for catharsis is not clear.  The rescuing firms understandably don’t have research as their top-of-mind priority.  Barclays is selling off Lehman Europe and Lehman Asia, which presumably includes a major component of Lehman’s top ranked research team.  JP Morgan’s retention strategies with Bear analysts suggest that preservation of Bear’s high ranking in equity research was not top of mind. The commitment to research on the part of the consolidators doesn’t appear strong.

As a consequence, analysts are moving to the buy side and alternative research.  This is not a new trend but the current turmoil is increasing the exodus.  Does this exodus strengthen or weaken the full service research model which has been the norm among the investment banks?  Having fewer full service providers increases the leverage and pricing power of the survivors, but the talent drain undercuts the overall value proposition.  We think it is positive for the remaining ‘bulge’ research players but, in the short term, the benefit is undercut by shrinking commissions during the current market turmoil.  There are fewer bulge firms competing for the commissions, but the pie is also shrinking.

Consolidation doesn’t cure the underlying cause of the current glut in fundamental research, which is a dysfunctional market for research.  Bundled commissions are over-subsidizing fundamental large cap research.  The lack of pricing mechanisms makes it difficult for buyers to signal what is truly valuable, and hard for the sellers to optimize their resources around what the buyers really want.  The longer the bulge research market retains this structural flaw, the greater the growth in alternative research, which is more subject to market forces.

But consolidation is not the only change we are seeing.  The relative decline of U.S. based financial institutions has implications for research also.   More research will be conducted outside the US,  wherever it is ultimately consumed.  The US has historically been a net exporter of research, and this balance will shift.

Perhaps the most important shift, however, is the rise of the larger hedge funds and private equity funds.  The rise of hedge funds and private equity funds implies continued emphasis on primary and specialized research, which is positive for those alternative research firms which provide those services, but negative for traditional fundamental research, including bulge research.   Consolidation in the hedge funds has mixed implications for research, however.  Consolidation in hedge fund assets is not a new phenomenon.   As hedge funds have increasingly attracted pension investment, the trend has been for the big hedge funds to get bigger.   In the current environment, this will accelerate and be accompanied by a reduction in the number of smaller hedge funds.

The negative for research is fewer research clients and a consolidation in the purchasing power of those that remain.  Even more importantly, the larger hedge funds are bringing research in-house.  This ultimately includes primary research, as the largest hedge funds create their own private expert networks, channel checking, survey teams, etc.  Current primary research firms can ‘white label’ their capabilities and provide infrastructure support, but this is not as high margin as their regular services.

The shifting tectonics of the financial markets is transforming research, and while some of the trends are clear, there will doubtless be more changes to come.


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