The Odd Couple: Bulge Bracket & Alternative Research Firms

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New York, NY – For many years, alternative research firms have thought of bulge bracket investment banks as their primary competitors or THE ENEMY.  As a result, alternative research firms have often compared the performance of their stock recommendations, their independence, and the innovation of their research with that of their sell-side brethren, smugly concluding that their products were better.
Unfortunately, very few alternative research firms have ever achieved significant financial success as they have lacked a few things that the bulge bracket firms have – and that is distribution and a readily accepted payment mechanism.  This fact, plus various market developments, has created a “perfect storm” where it makes considerable business sense for this “odd couple” to work together in the future.

The Likely Business Model

Numerous alternative research firms have asked us why we think firms like Goldman Sachs and others have undertaken extensive initiatives to market various investment tools and alternative research providers to their mutual fund and hedge fund clients.

We suspect that the major reasons for today’s environment is the move to unbundling in the UK, the growing acceptance of CSAs and CCAs around the world, and the requirements of new regulations like Reg NMS and MiFid that mandate “best execution”.

These developments have created a scenario where the largest investment banks and broker dealers face both a significant opportunity and a tremendous threat.  The threat is that some firms could potentially suffer a loss in “research commissions” as buy-side investors make independent decisions who they want to use as their execution providers and who they want to pay for their research.  The opportunity, however, is that the largest brokers in the world could experience a significant increase in their execution market share.
As an example, one large UK-based asset manager recently explained that prior to unbundling, that manager had spent 80% of its commissions with bulge bracket firms.  Now, that same firm was spending 55% of their commissions with bulge bracket firms for their execution, with the remaining 45% going to pay for research produced by investment banks, boutique brokers, and independent research firms.  However, that asset manager expected that the bulge bracket firms would benefit financially as the bulge bracket firms would be the CSA brokers that conducted 100% of the execution and paid for all of the external research.

Consequently, a number of bulge bracket firms have come to the conclusion that they can make up for some of the potential losses in research commissions they might suffer in an unbundled world, and they can increase their share of the equity commission pie, if they offer valuable services that their competitors don’t provide.  This is why some investment banks have decided to market innovative and unique alternative research to their clients – in order to attract the additional execution business that the buy-side will need to direct to them in order to pay for these services.

The Commercial Opportunity

Based on our estimates, the alternative research industry generated approximately $1.81 billion dollars per year in revenue in 2006, and is likely to grow by close to 37% over the next five years, to reach almost $2.5 billion by 2010. The growth in this business is based, to a large extent to the growth in hedge funds, the introduction of hedge fund like instruments at mutual funds, and the extension of unbundling in the United States.

Of the current spend, over a $1 billion of it is paid by using traditional third-party soft dollars which grossed up at tradition soft rates represents approximately $1.2 billion in execution order flow.  Going forward more third party research will be paid through the use of CCAs which will represent a higher ratio of execution than traditional soft dollars. Of the incremental $700 million in growth we project over the coming five years, at least half would be through CCAs.

In addition, of the total $10.9 billion in total institutional equity commissions generated in 2006, we estimate that second and third-tier brokerage firms collected about $2.9 billion in total commissions.  The proliferation of CSAs and CCAs suggests that the portion of this total used to pay for execution could be captured by bulge brackets firms ($1.4 billion) as the buy-side chooses to pay for this research through a limited number of CSA brokers.

As an aside, as unbundling progresses, the $1.5 billion currently paid out in research commissions to these second and third tier firms will also be vulnerable as a number of second and third tier brokerages will not be able to compete as their execution revenues disappear (e.g. Prudential Equity Group).  As a result, we estimate that between $500 million to $600 million of the research revenues currently directed to second and third tier brokerage firms could eventually be captured by alternative research providers.  However, from the perspective of CCA brokers, the $1.5 billion is still an opportunity, however it is split.

As a result of this analysis, the market opportunity for bulge bracket firms which build robust alternative distribution platforms is to grab a dominant share of the $3 billion in equity commissions used to pay for third party research.  This is comprised of $1.55 billion in commissions used to pay for alternative research ($1.2 billion in soft dollars today plus $350 million in incremental CCA commissions over the next five years) and $1.5 billion of commissions used to purchase second and third-tier brokers’ research.

Of course, it is obvious that the only way a firm can compete for this business will be if they are considered a “best execution” provider.  However, we also suspect that the investment banks that build the most compelling brand and the most robust suite of services around finding and providing unique and innovative alternative research to their clients is likely to get the lion’s share of this business.
Creating a New Bundle

Some might wonder how, in an unbundled environment where “best execution” is the driving force, they can effectively create a new bundle by convincing their clients to direct the additional execution flow to them in order to pay for these alternative research services.

It is clear that buy-side clients will have the ultimate say about how they pay for third-party research (as they do today).  In addition, various systems are being developed by numerous software vendors to help institutional investors manage how their research payments are allocated.

Despite these developments, some firms obviously believe that as long as they are deemed a “best execution” provider, that the ultimate determinant of whether they get the execution business or not in an unbundled world will be based on two factors – personal relationships and the quality of services provided by the bank.
This rationale is consistent with what many investment banks experience today with their “low touch” offerings.  If execution price and quality are the same, then the major factors that help a trader decide who to trade with are personal relationships and other services provided by the bank (access to the IPO Calendar, Prime Brokerage services, etc.).
The Example of Hudson Street

The one bulge bracket firm that has moved most aggressively in this space in the past year has been Goldman Sachs with the introduction of its Hudson Street Services alternative research platform.  In fact, Hudson Street has already announced partnerships / minority investments with 6 firms, including Wall Street on Demand, Asset4, Connotate, Investars, iSupply, and Medley Global Research.  Hudson Street has said publicly that it is planning to develop partnerships and make minority investments with numerous research firms around the world over the next few years.
We believe that Hudson Street is attempting to get paid in a number of ways.  First, Hudson Street will receive a “sales commission” from helping their partners sell their research to their clients.  In addition, Hudson Street is expecting that most of their clients will choose to pay for these third-party research services by trading with their desk.  As mentioned previously, clients will have complete latitude to pay however they want to – with cash, by executing through another broker, or by trading with their own desk.  Despite this, Hudson Street expects that a majority of clients will reward them for finding these new services, by trading with them.

In the longer term, Hudson Street plans to bolster its alternative research returns by selling the minority stakes it has in its partners.  One industry observer suggested that Goldman Sachs could easily facilitate a sale of these firm’s minority stakes by leveraging the small company private investment exchange that the firm has been working to develop in recent months.

Ultimately, we believe that one of the reasons Goldman has been so aggressive in this area, is because they believe that the firm will eventually be branded as the place clients can go to find and pay for innovative new tools, data sources, and research services.  As a result, we think that Hudson Street hopes to be able to capture a significant share of the $3 billion in execution business associated with buy-side purchases of boutique broker and alternative research.

The Rest of the Street
Numerous other investment banks have been investigating what they want to do in response to the Hudson Street move and in response to the potential business opportunity.  And while few firms have officially announced their intentions, it is clear that they are trying to decide 1) Should they play in this space at all, 2) What business model makes the most sense, and 3) Who should they partner with?
One obvious concern with the Hudson Street strategy is whether it makes sense to invest in these alternative research providers.  One question we have about this strategy is how you pick your partners.  Investment banks with established brands usually want to partner with well established, “blue chip” research firms.  However, these firms often don’t need the distribution provided by bulge firms.

Also, how do you deal with the fact that some clients (hedge funds) value research providers with little brand recognition?  Another concern we have with the “investment” issue is that the marketplace for alternative research is in a state of considerable flux.  As a result, we suspect that a “hot” research firm today might not be a great research provider in a few years time when a new innovation has impacted the client base.
Another major issue that must be addressed is how an investment bank plans to leverage its extensive distribution capability to successfully sell whatever products or services they choose to market.  As we have said countless times before, “research is sold, it is not bought”.  Consequently, the only way an investment bank is going to develop a successful alternative research strategy is if they get the “sales strategy” right by leveraging their research sales team, their prime brokerage businesses, and their global commission management operations.

Perhaps the biggest issue is how to reconcile alternative research with an investment bank’s own proprietary research.  The bulge firms are understandably reluctant to cannibalize their own research business and have concerns that distributing alternative research will ultimately dilute their distribution of proprietary research.  A related fear is that proactively selling alternative research will accelerate unbundled pricing of proprietary research, a situation most banks would like to forestall as long as possible.

Goldman’s Hudson Street platform has been careful (for the most part) to partner with alternative research firms which are highly differentiated from its proprietary research – the exception being Medley Global Advisors’ policy analysis which overlaps in part with Goldman’s economic research.  Hudson Street is also a distinct entity, although owned by Goldman Sachs.  Goldman has crossed the bridge, but others are finding it more difficult to follow.

Despite these issues, it is clear to us that the other bulge bracket investment banks face a limited window of opportunity to develop and implement an alternative research strategy given the progress that Hudson Street is currently making and the lessons they are learning.  And while we believe that a few firms (at most 3 or 4) will be able to generate a degree of success with their platforms, it is also clear that the firms that are first to market typically walk off the bulk of the market share.  The rest of the firms will probably be playing catch-up.

Comment by Bill George:
In my opinion the comment above, by David Miller, is right-on the money.

It’s sort of amazing to me that investors can’t come to the conclusion that was reached by the regulators who put together the Global Analyst Research Settlement. Under that penalty arrangement the regulators felt it necessary to mandate rigorous safeguards and strict regulatory oversight to insure that the independent research to be distributed by the firms being punished would remain independent.(1) Why doesn’t the market understand the risks of compromised independence?

Admittedly Goldman’s distribution network and marketing approach are different from most bulge bracket firms. Most of other bulge bracket firms have significant retail distribution resources which Goldman doesn’t have; but, everybody should see the problems of believing that independent research providers can maintain their independence once they have whiffed the heady vapors of fame and fortune delivered by serving the sometimes conflicted interests of investment banking brokers with powerful distribution networks.

It’s very odd to see the market’s reaction to emerging paradox of “captive independent” investment research. Perhaps what seems to be wide acceptance, by professional investment advisors, of this “captive independent research” concept is caused by the more or less natural interdependence of institutional advisors and broker dealers (an interdependence which is described, in part, by David Miller’s post above). For years, after 1932, the interdependence and collusion between advisors and broker dealers was made difficult by The Glass-Steagall Act. However, the Glass-Steagall Act was emasculated during the late stages of the 1990’s Tech Bubble; so now it seems professional investment advisors and brokerage firms are eager to marginalize, (or compromise) independent research and get back to the business of trading favors for their mutual benefit to the detriment of the investing public. (2)

Footnotes:
(1) See Wikipedia entry Global Settlement >

(2) See Glass-Steagall Act >

Comment by David Miller:
When we’re talking about the value of research to Wall Street firms, I wish we’d quit prancing around the elephant in the room.

Any firm that depends on hedge fund trading revenue (excepting those that compete solely on price) will not last long as a business without a research arm. The more dependent the firm is on trading revenue, the more necessary a trading arm is.

Research arms of these firms are now expected to assist their clients’ positions. Have a major client buried in a long position? Research sends out an aggressive buy recommendation. Have a major client buried in a short position? Research sends out an aggressive sell recommendation. Since financial media outlets are conditioned to report such things, especially the more outrageous they are, these conflicted research notes will have the desired effect in the market, partcularly in the small cap stocks where these Wall Street firms make their living.

NASDAQTrader.com used to have an application where you could watch the trading volume for different market participants over time for a particular stock. When it was updated monthly, it was a great dentiment indicator for how hedge funds thought about a company. If you saw an unusual research opinion, watch the volume to that firm. If it jumped, then that’s the way the hedgies were leaning.

I’ve had people argue that this is the way the sell side is supposed to work. People are just “voting” with commission dollars for the research. I give that the same weight I give to people who tell me the earth is flat. Write the research your clients need to make their positions more profitable and you’ll be rewarded.

If any of us “independent” research firms *choose* to play this game, we can be equally successful as sell side research.

Pick any moderately successful independent firm and you’ll discover all their top people could be making much more money at a sell-side firm. Some of us, however, put more weight on being able to look at ourselves in the mirror each day. We want to write what we actually believe about a company instead of worrying about whether the head of trading will have us on the carpet for writing something counter to a major client’s book.

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