New York, NY – As we head into a new year, it makes sense to evaluate the major developments that took place last year, and what issues are likely to have a significant impact on the research business in the coming year. Of course, the research industry has undergone a sea change in recent years with the passage of Reg FD, the Global Research Analyst Settlement, falling equity commissions, soft dollar uncertainty in the US, and de facto unbundling in the UK.
However, we expect that a wide range of factors will continue to transform the research industry in 2007 from a sedate and conservative business into a vibrant and innovative one. The following article will introduce some of the more prominent issues that will impact the research industry.
I. CSAs and Unbundling
Of course, one of the most obvious trends that will transform the research industry in 2007 is the continued implementation of Commission Sharing Agreements and the move to unbundling the traditional brokerage relationship into two independent decisions about who to execute with and who to purchase research from.
As we have mentioned numerous times in the past, we expect that many winners and losers will result from this process. For example, many large bulge bracket firms should gain market share of the buy-side’s execution expenditures. Boutique research providers could benefit by being able to compete with larger providers purely on the quality and innovative approach of their research. Middle tier brokers, however, could suffer as the loss of execution revenue greatly outweighs the pure research business they garner.
We also expect that some of the unintended consequences of CSAs and unbundling will start to become evident in the coming year, including the policy implications of reduced research coverage, the decline in competition among execution providers, and the increased control that a limited number of sell-side firms could have over the research decisions of their buy-side clients.
II. Commission Disclosure
Another development that is likely to have a significant impact on the research industry in 2007 is “commission disclosure”. In 2006, the FSA and IMA implemented their plans to provide transparency about how money managers spend their client’s commissions. This UK mandate has enhanced pension funds’ understanding of how their commission dollars have been spent and has increased money managers’ responsibility to justify their third-party research expenditures (for sell-side and independent research) on their clients’ behalf.
Unfortunately, regulators at the Securities and Exchange Commission has sorely lagged their UK counterparts in providing investors with the information necessary to ensure that their money managers are spending their commission assets wisely. This is interesting given that in the past year, most SEC commissioners have expressed their support for increased transparency about how “soft dollars” are spent. In addition, earlier this year, SEC staffers commented that they expected to release the SEC’s proposal on commission disclosure by year end.
Of course, it is not surprising that the SEC missed its self imposed deadline for a proposed approach to commission transparency. However, it is surprising that in the wake of the general acceptance of the FSA’s rules in this regard, that the SEC would be so reticent to promote an equal level of disclosure and transparency. Despite this, we do expect that the SEC will unveil some form of commission disclosure in 2007.
III. Continued Buy-Side Staffing
One trend that started a few years ago that is likely to continue in 2007 is the continued expansion of internal research departments by the world’s largest asset managers. Of course, mid-sized and smaller money managers will not follow suit, as the cost of such a strategy is prohibitive for all but the largest fund managers.
It is interesting to note that this trend started as a way to decrease money manager’s reliance on sell-side research – particularly as research coverage plunged in the wake of the Global Research Settlement. However, the increased numbers of buy-side analysts have become obvious consumers of all types of external research, including traditional fundamental company research, primary research, and more innovative independent research services.
IV. Growth of Independent Research Distribution Platforms
In the past, the team at Integrity Research has been quite vocal about the fact that research (particularly independent research) is sold, it is not bought. This truth, combined with the more recent move towards unbundling, has encouraged a growing number of bulge bracket firms and some agency brokers to conclude that one way for them to increase their equity commission business would be to actively market and supply their buy-side clients with high quality independent research in addition to any proprietary research they might have traditionally bundled into the relationship.
Of course, this is not a new concept as firms such a BNY JayWalk, Instinet, Soleil Securities, and Capis have done this for years, with varying degrees of success. However, some of the new entrants into this market have come to realize the shortcomings of previous players and have either created new business models, more innovative offerings, or they have chosen to focus on implementing their strategy more effectively than prior platforms.
We expect that the recent confluence of events, the likelihood that agency execution providers will try to find some way to survive in a world where CSAs become more popular, and the increased difficulty in deciding what research matters most, will lead to a growing number of firms that proactively offer third-party research to their buy-side clients.
V. Consolidation of Research Providers
As we discussed above, the move to CSAs will probably lead to a consolidation of execution providers as money managers reduce the number of trading partners they work with. However, we also think that the move to unbundling will also prompt some mid-tier sell-side
firms to exit the research business altogether as they find it difficult to make their operations economically viable in a world where they are primarily a research provider.
We also suspect that some independent research firms will find a world dominated by CSAs and unbundling to be an extremely difficult one to survive in. In our estimation, the firms that will find it most difficult are the indies that currently bundle traditional fundamental company research with execution. These firms may find it extremely difficult to compete as either a “best in class” research firm or a “best execution” provider.
Of course, this consolidation should not be surprising as there are currently over 600 sell-side and independent firms that produce investment research in North America.
VI. Differentiating Sell-Side Research
One trend that has been evident over the past few years, and is likely to continue in 2007, is the search by many sell-side firms to enhance and differentiate their research offering. Whether this means lowering their cost base for maintenance research, focusing on generating trade ideas, developing new products like expert networks (Bear Stearns), moving analysts out to the trade desk (Lehman Brothers), or leveraging technology to build value-added services (CSFB and Relegance), most investment banks have been successfully reinventing their research products.
However, we expect that sell-side firms will continue these efforts in the coming years as unbundling forces investment banks to maintain their pace of innovation in an effort to compete with boutique research firms for a money manager’s research commissions.
It must be noted that sell-side research firms do have a few distinct competitive advantages over all but the largest independent research firms. The first advantage is the fact that most bulge bracket firms currently maintain extensive global research operations that are extremely costly to develop. And while this infrastructure is not important for all investors, it is obviously valuable to many of the largest international money managers in the world.
In addition, sell-side firms also provide a wide range of non-research services that buy-side investors value, including management access, capital commitment, institutional sales coverage, access to the IPO calendar, etc. Ultimately, if buy-side investors value these services, they will find ways to compensate their brokers for providing them – whether it is through “paying up” for execution services or overpaying for sell-side research. For these reasons, independent research providers will find it very difficult in competing with investment banks.
VII. Regaining Control of Research Distribution
Another development that is likely to impact the research industry in 2007 is the desire of many research providers (both sell-side and independent firms) to regain control over the distribution of their research.
As we have noted in the past, one of the factors that has dampened the perceived value of third-party research has been its unrestricted supply. This had been caused by a number of
factors, including research providers’ belief in the marketing value of distributing its research widely. In addition, many market data vendors have not been terribly concerned about implementing rigorous permissioning systems in the past, either because of the frustration this creates for their buy-side clients, or because of the complexity this creates for some of their information products, including consensus earnings estimates, etc. However, many research providers have changed their views in recent years, forcing market data vendors to implement more granular restrictions and reporting.
Of course, limiting the distribution of research providers’ research could create a real conflict in the marketplace with the market data vendors sitting squarely in the middle of this conflict. This is based on the reliance that many investors have developed in recent years on the ready availability of free research, or low cost derivative data including consensus earnings estimates, upgrades / downgrades, etc. On the other hand, research providers will want to reduce this slippage either by encouraging “free riders” to pay them directly for the value of their research content, or by increasing the scarcity value of their research.
VIII. Developing a Proactive Research Procurement Process
In the past, we have discussed how most money managers purchase third-party (sell-side and independent) research in a “reactive” manner, relying on requests of portfolio managers and analysts to pay for a specific providers’ content. To a large extent, this model has been predicated on the fact that most sell-side and many independent research providers give their research to the buy-side for “free” relying on asset managers’ willingness to pay them after the fact based on the value contributed to that manager or analyst.
However, unbundling and commission transparency will change this model as mutual fund boards of trustees, pension fund managers, and plan sponsors will finally have the information required to ask money managers to justify their use of client commission dollars to pay for external research. This move will force buy-side investors to adopt a more “proactive” procurement process for the research they purchase, similar to the process that most investors use to purchase all of the other goods or services they buy.
This trend is also likely to be encouraged as research providers, faced with the possibility that their commission revenue will plunge in a world dominated by CSAs, will start moving to a more discreet pricing model for the products / services they provide clients. This will force research directors to pay closer attention to specifically what research they are committing to, and it will also create an incentive on the part of investors to make sure they are getting the “best research” they can at the most appropriate price.