New York – Not surprisingly, we have been looking at the actual and potential trends in the research world over the past week. We have covered the dislocation that is occurring and winners and losers as the regulators hunt for a solution to the problem. But despite gloomy musings that the investment banking industry is dead, we remind readers that it is the bulge bracket that has been staggered. Running a brief scan of our database we find that there are at least 263 investment banks that offer research. Here we try to incorporate industry and regulatory trends into an assessment of the outlook for analytical talent and compensation in the future.
Because of the sheer number of IBs in operation, the eventual resolution to the problem, if there were no bailout, would be a Darwinian one. Indeed, we have already seen the cheap business lines of the bulge firms being snapped up, with JP Morgan buying Bear, Bank of America buying Merrill, Barclays and Nomura buying certain Lehman businesses and even Warren Buffett making a $5.0 billion investment in Goldman. Second tier and boutique investment banks-such as Lazard-are certainly having late night meetings to plot an opportunistic course through this crisis.
And now that ownership rules for financial services companies have been eased, the way has also been paved for private equity to descend on the investment banking assets. However it is not just the bulge bracket that is in turmoil. Though it remains below the surface, the impact of these changes on the asset management business is another serious consideration. Just like banks, asset managers can suffer from withdrawals of funds from their AUM base. With lower AUM and uncertain markets, it is certain that long-only funds will pull in their horns and reduce trade flow. While this is clearly an integral topic, we will deal here with the factors that are affecting the equity research space.
As with any market, the market for equity research is determined by the interplay of supply and demand dynamics. Additionally, we argue that the market also faces structural changes, owing to completely different economic and regulatory systems that will be operating in the market.
Research Supply Considerations
We are all well aware of the supply side of the equation. The surplus supply of fundamental analysts on the street has and will continue to grow in coming weeks. The full extent of the excess supply is not known, but if the Bear Stearns example holds up, then only about half of the current analysts will find similar jobs. And given that Bear analysts were actually the lucky ones, the ratio could be even lower. By itself, the supply glut will drive down salaries. But there’s more.
Research Demand Considerations
On the demand side of the equation are two competing elements. First, the likely reduction in AUM for money managers-at least temporarily-may lead to less trade flow and therefore less commissions available to pay for research. This is exacerbated by the fact that mutual fund crowd will be playing defense and the hedge fund crowd has been curtailed from taking on short positions for some period of time. On the positive side, there are a large number of regional and boutique investment banks that will view available analysts as an opportunity to expand their businesses.
Structural Changes in the Research Paradigm
But even if the excess supply of analysts on the street is soaked up, analyst pay packages are going to take a permanent hit. This will be a result of their bargaining power and perhaps their physical relocation to a regional center. But an even more substantial impact on analyst compensation will be the fact that the old bulge bracket firms will be more closely aligned with the rules of the commercial banking system. This is a result of either ownership changes, such as in the case of Bear and Lehman, or voluntary changes, such as in the cases of Morgan and Goldman.
Because these firms will have a requirement to meet of reserve requirements on deposit accounts, the leverage achievable by these entities will be vastly reduced. For example Goldman’s gearing was as high as 30 recently, while the gearing at BofA was a modest 11. Especially in markets where interest rates are low, one of the few successful ways to increase profit margin is to increase gearing.
The impact of commercial bank requirements for the bulge firms will be to lower overall profitability, lower volatility of earnings, and lower compensation structures for all employees in general, and analysts in particular.