New York, NY – In recent years, a growing number of commentators have expressed grave concerns about the outlook for the investment research industry as buy-side investors demand new and innovative types of research, Commission Sharing Agreements and Client Commission Arrangements become more widespread, and various other technology changes transform the financial services market.
Changing Client Demand
A decade ago, buy-side investors relied on detailed fundamental company analysis produced by sell-side investment banks and brokerage firms. However, in the past few years, Regulation Fair Disclosure and Sarbanes Oxley have effectively reduced the value of investment bank research as sell-side analysts have less and less access to company management. The reduction of this confidential information in sell-side research has prompted many buy-side investors to bring a great deal of their analytical needs in-house. In turn, this has changed the type of research that buy-side investors have found most valuable.
Today, most institutional investors value access to experts, company management, various sources of proprietary data including channel checks and custom market research, profitable trading ideas, and new and innovative analytical techniques. In addition, many buy-side investors (particularly hedge funds) value information that is not widely distributed to other investors.
This change in buy-side research tastes has had a negative impact on traditional fundamental company research – including that of most sell-side firms and many alternative (independent) research providers. At the same time, it has stimulated the growth of new types of research providers, including expert networks such as Gerson Lehrman, channel checking firms such as Off the Record Research and web-oriented research providers such as Connotate, Kapow and First Rain. It is the new, innovative types of research which are growing the fastest, increasing the demand for alternative research overall.
Regulatory Shifts and CCAs
In July 2006, the Securities and Exchange Commission issued its long awaited interpretive guidance on the Section 28(e) safe harbor providing clarity into the use of “soft dollars” to pay for investment research. While much of this guidance was generally expected, one aspect of the SEC’s missive – the formal introduction of Client Commission Arrangements – has had a huge impact on the research business.
A Client Commission Arrangement (CCA) is an arrangement whereby a money manager may agree with one of its executing brokers to set aside a portion of the commissions generated from trading for its accounts into a “pool of funds”. This money manager may later request that the broker-dealer make payments out of this pool to providers of certain research products or services on its behalf.
The introduction of CCAs has allowed many buy-side firms to quickly reduce their number of trading counterparties under the belief that they would be focusing their business with a smaller number of “best execution” providers. This trend has had a negative impact on second and third tier investment banks, leading to a deterioration in the quality of research from some previously high quality research providers. Some smaller investment banks have lost a significant amount of their execution revenue. It is easy to say that these firms should just “close down” their trading desks. Such a move, however, could have devastating consequences for their overall business, as most investment banks compete on their ability to make markets in the stocks they finance or bring public. In other words, the squeeze on the trading business has a knock-on effect for the whole company.Why should this have an impact on the research they produce? The revenues and profits lost from trading (and other related businesses) actually supported the salaries, bonuses, infrastructure, and other related costs of running a high quality research business. The loss of these profits are being felt by the analysts – an impact that could prompt many of the best analysts to leave for greener pastures.
Technology Developments and Research Productivity
As mentioned earlier, a number of the larger buy-side firms have “internalized” their research capabilities in the past few years. And while some firms have chosen to invest more in their own analytical capabilities, most firms have increased the research burden on existing analysts — a development that has forced buy-side analysts to cover more and more companies.
This trend has prompted many buy-side research directors to look for tools to increase the productivity of their analysts. One development which has been in the offing for a few years could be a real boon to buy-side (and sell-side) analyst productivity is the widespread adoption of the Extensible Business Reporting Language or XBRL.
XBRL is an electronic tagging system developed by a consortium called XBRL International that users of financial statements (analysts and investors) can use to select and pull both financial and non-financial information from the text and financial statements of public disclosures such as press releases, 10-Qs, and 10-Ks.
Despite vocal support from SEC Chairman Christopher Cox, XBRL has not been widely adopted in the US; only 54 of more than 10,000 publicly traded US companies are voluntarily filing in this format. However, the global use of XBRL is gaining considerable momentum. In fact, as of September 2005, more than 800 Chinese companies filed their half year reports using the XBRL standard.
The major issue in the US is that the XBRL format has not been mandated by either the SEC or by the individual stock exchanges as it has in many overseas countries. However, a number of extremely influential members of the SEC have publicly commented that at some point in the future, they would support mandating that public companies file their SEC documents using XBRL.
Once XBRL becomes the standard for financial reporting, the buy side will disintermediate much of the financial analysis currently performed by the sell side. Buy side analysts will find it faster and easier to populate their own models directly rather than waiting for the sell side to do it for them. Hedge funds will seek low latency access to the XBRL feeds to maximize their trading advantage on market moving XBRL figures. We are already seeing innovative new companies developing turnkey models for the buy side to facilitate this process.
The Integrity Forecast
These developments lead us to conclude that the research industry will experience a significant amount of “barbelling” in the coming years as bulge bracket investment banks lose some share of the research market, second and third tier sell-side firms suffer deep losses of research revenue, and a number of alternative research providers experience increased demand for their services.
Our forecast indicates that sell-side research revenues will fall close to 18% from $4.9 billion in 2006 to $4.0 billion in 2011. This decline is consistent with a survey done this past summer by financial services consulting firm Greenwich Associates, which revealed that almost 20% of the buy-side analysts expect their firms to either “reduce” or “significantly reduce” their use of sell-side research in the coming year.
Integrity expects that alternative research providers will gain at the expense of the sell-side, growing from $1.81 billion in 2006 to $2.47 billion by 2011, thereby increasing their share of the market from a 14.5% in 2006 to 19.8% in 2011. However, we do not expect all boats to rise with this tide. The most innovative research providers should experience the best growth, while traditional fundamental research providers could actually decline over this period. This forecast is consistent with the recent Greenwich Associates survey which showed that 39% of buy-side analysts expect their firms to increase their use of independent or alternative research in the next 12 months.
Finally, the team at Integrity Research anticipates that buy-side institutions will increase their spending on their internal research capabilities by 28.8% over the next few years from $5.8 billion in 2006 to $7.4 billion in 2011 as they continue to rely less and less on sell-side research and they rely more on their own research capabilities.