Ring In 2009 — Wring Out the Settlement

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New York – As we enter into 2009, many of the affected alternative research providers are looking to aggressively address (or redress) their research models. The problem for those affected is, of course, how to replace the revenue that will be lost to the settlement.  For those firms not involved in the settlement, there is still a serious concern about the usage of alternative research once the settlement runs out.  In a letter to the Financial Times of London, Shane Smith, Chairman and CEO of Independent International Investment Research (appended below) address the concerns of ARPs in general and those that are involved in the settlement in particular.

Mr. Smith’s main point is that the settlement has worked and that it should not be discarded out of hand. He predicts that cash starved corporations will be looking to raise cash to outlast the recession at the same time as the investment banks are aggressively looking for underwriting business. Mr. Smith indicates that this is a recipe for the reincarnation of biased research, as proprietary research shops feel pressure to be supportive of underwritings for firms that have weak fundamentals.  The answer to this problem, according to Mr. Smith, is for regulators to support the re-establishment of the settlement, in order to keep the sell-side shops honest.

Judging from all our conversations with research providers, though, the probability that the settlement will be re-upped is about zero.

Further, our forecast is for overall institutional commissions to fall by about 32% in 2009, which is forecast to lead to a near 20% decline in alternative research spend.  The combination of the ending of the settlement and the expected drop in institutional commission flow seems to present a bleak picture for the ARPs in 2009.

However, there are some positive signs emerging which point to ARPs taking a more prominent role in the overall research industry. Investment bank analyst staffs are being cut in most shops. This is a result of redundancies at firms such as BofA (who purchased Merrill), Barclays (who purchased Lehman) and JP Morgan (who purchased Bear), as well as the result of sharply diminished sell-side financial health.  While we do not have an accurate count, our experience as we have been updating analyst rosters over the past month is that bulge and regional IBs have cut senior analyst counts by 40% to 50%.

Given these massive declines in analytical talent, the research vacuum must be filled somehow. Additionally, many buy-side shops value alternative research and have already begun to pull together research providers for the use by accounts as well as to supply information to portfolio managers.

What ARPs need to look at is what direction research will take if it is not produced by the sell-side.  One thing that the sell-side model provides is a consistent view of a large number of stocks.  A consistent and complete investment perspective might include a top down economic outlook which would lead to country and asset class allocations; sector forecasts; stock analysis, such as valuations, competitive analysis, channel checks and EPS forecasts; and then some form of risk assessment perhaps through governance analytics, forensics, earnings quality metrics and credit risk assessments.

From a structural perspective then, the ARP industry could be set to begin an extensive vertical integration in coming months. This is not an easy task, as evidenced by the aggressive accumulation of RPs followed by their sale at Xinhua. Any integrated approach will necessitate a good deal of capital and commitment. As a result, the sell-side may be the most likely to ramp up their minority stakes in alternative research providers, to craft research products that more closely match the requirements of the buy-side. Firms that have already demonstrated leadership in this area are Goldman, Merrill, Morgan and UBS.

Letter to the Financial Times of London by Shane Smith, Chairman and CEO of Independent International Investment Research.

Sir,

President-elect Obama’s appointment of Mary Schapiro to head the SEC is a timely new broom.

Amidst  recent turmoil, a milestone date has dropped out of sight.  The U.S. Global Research Analyst Settlement implemented in 2004 expires in July 2009.

The Settlement was the outcome of greed during boom times.   Now, investment banks are in desperate straits and will become hungry for business; with liquidity at a premium issuers will be desperate for cash.  Different but perfect conditions to sow the seeds for a new round of research abuses particularly as regulatory attention is diverted by other matters.

Detractors of the Global Settlement , in articles on these pages and others, largely miss the point.  The provision of independent research alongside sell-side research has kept the sell-side honest: in the past four and a half years, no research abuses have emerged.   This is not the time to retire the policeman.

Two eventual outcomes are sensible.  The provision of independent research must continue, so that the sell-side doesn’t relinquish the progress that has been made in credibility and quality of its offering to clients.  Or more sensibly still, given the massive gulf between the costs of traditional research production on Wall Street vs. Independent research, in the interests of shareholders Wall Street should make a dignified exit from this activity in which it has enjoyed oligopoly despite no comparative cost advantage.

Firms such as mine have diversified to minimise the impact of the end of the Global Settlement.  But across the industry, it is clear that without decisive action now, the end of the Settlement will severely reduce the supply of high-quality independent research to investors.  The timing could not be worse for investors, who will also see a decline in the availability of sell side research as banks and brokers struggle with costs just when such information is most needed.

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