The Competitive Disadvantage for Alternative Research

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New York, NY – In recent weeks, we have written about various surveys where a significant percentage of buy-side analysts and PMs have indicated that they plan to increase their use of alternative (independent) research in the next year.  And while we agree that many trends are constructive for the alternative research industry over the next few years, it would be misleading if we didn’t point out that many alternative research providers face significant competitive disadvantages when compared to their investment banking counterparts.  The following article discusses a number of these challenges.
Product
Many indies crow about the quality of their research, particularly when compared with the research produced by the sell-side.  However, most independent research providers do not pay much attention to the fact that their firms cannot compete with the breadth of research services offered by their brethren at most investment banks.  Some of these services include;·        Global research infrastructures·        Extensive research offerings (fundamental, quantitative, economic, technical, etc.)·        Broad sectoral coverage·        Management Access·        Conferences·        Institutional Sales Support·        Custom Research Consequently, most alternative research firms provide a limited solution to the research needs of the buy-side, forcing clients to obtain research from numerous boutique providers.  In fact, the benefit of “one stop shopping” is one reason that many buy-side firms continue to rely on larger investment banks for the bulk of their research needs.
People
Countless surveys have clearly shown that one of the most important components of the investment research product is access to experienced and insightful analysts.  In fact, the importance of access to expertise is one reason for the rapid buy-side take up of “expert networks” in recent years.  Unfortunately, most alternative research firms find it extremely difficult in competing with either sell-side or buy-side firms for the most experienced analytical talent.  Independent research firms typically cannot afford to offer competitive compensation packages, nor can they provide the level of support services that many sell-side and buy-side firms can offer.  However, some analysts willingly eschew these benefits for the analytical freedom, lifestyle and entrepreneurial opportunities afforded by working for independent research providers.
Placement

Another competitive disadvantage faced by most alternative research providers is their difficulty in “placing” or “distributing” their research products.  Most investment banks have a number of touch points with buy-side clients to market their proprietary research capabilities, including trading, research sales, commission management, prime brokerage, etc.  Most alternative research firms, however, do not have as well established a network to market and support their research.  This is one very important reason why many sell-side firms, even with “lower quality” research have both a larger number of clients and generate greater fees from these clients.

Processes

A large number of alternative research providers are neither Registered Investment Advisors nor Registered Broker-Dealers.  As a result, many firms do not have the same processes and policies in place to address conflicts of interest that investment banks or broker-dealers are forced to have.  In our view, this creates a potential risk for clients and could be one reason why some buy-side firms prefer to “play it safe” with research from broker-dealers or investment banks.  Of course, we must admit that the lack of “best practices” in research could also be considered an advantage (at least in the short run) where some clients can benefit from accessing asymmetrical information.
Payment
Any advantage that broker-dealers had over independent research firms in getting paid supposedly disappeared with the advent of CSAs and CCAs.  And while this is theoretically accurate – a non broker-dealer can get paid just as easily in today’s world as a broker-dealer can – it is often true that a non broker-dealer is not paid as much.  Of course, this makes intuitive sense as a research provider who is also an executing broker-dealer should be paid more because they are providing two services versus a research provider who does not provide execution services.  However, it is clear that a boutique firm that provides great research is often paid considerably less than a firm that provides mediocre research and mediocre execution services.  Clients have an excuse to pay these firms more because they provide them with a broader range of valuable services.
Summary
As you can see, the alternative research industry faces a number of competitive challenges that will tend to limit their success when compared to sell-side research providers.  This does not mean we expect that alternative research firms will not be successful, but it does mean that many of these firms will need to work harder than their large sell-side brethren to overcome their shortcomings.   Fortunately, we also believe that the sheer number of alternative research firms, and the innovation and entrepreneurial spirit of many of these firms, will find a willing market among the thousands of institutional investors searching for new sources of alpha.

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