The Shifting Economics of Small Cap Research

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New York, NY – Sweeping regulatory changes like Regulation FD, Sarbanes Oxley, and the Global Research Analyst Settlement; uncertainty around the future of soft dollars, and the global move to unbundling have created a sea change in the financial services industry, and more specifically in the economics of producing small cap research. However, one of the biggest problems that investment banks and broker-dealers have had to face in trying to fund equity research departments has been falling equity commissions.  Equity commissions have plunged more than 98% from $.75 per share in 1975 to $.01 today due to deregulation and the growing use of electronic trading systems. 

And despite the fact that rising equity trading volumes have partially offset this drop, total equity commission revenue generated from U.S. institutional investors has declined sharply in recent years.  According to Greenwich Associates, total institutional commissions paid for trading U.S. stocks dropped 18.3% from $12.6 billion in 2002 to $10.3 billion in 2007.   Of course, the lower volumes normally traded in small cap stocks means that the amount available to pay for small cap execution and research are a mere fraction of this total.  We estimate that approximately $1.2 bln in commissions were used to pay for small cap research last year. However, falling equity commissions are not the only revenue problem facing investment bank research departments.  The dearth of IPOs in recent year, particularly among small cap companies, has eliminated the second major revenue stream enabling many investment banks to be able to fund their equity research efforts.   For example, data provided by CMA Partners reveals that total number of IPOs fell from 429 in 2000 to 73 deals in 2003.  And even though IPO business picked up in the past few years, the number of IPOs only reached 190 in 2006 – less than half the level seen in 2000.  During this same time period, the number of IPOs for companies with less than $25 mln in revenue has actually disappeared, while the number of small cap deals (less than $2.0 bln) has fallen 54%.   As a result, the decline in the number of public offerings, on top of the reduction in equity commission revenue, has meant that many investment banks and broker-dealers who focus on small cap research are having a difficult time generating enough income to support their research operations. Consequently, many investment banks and brokerage firms have had to tighten their belts when it comes to funding their research departments.  Well-known Sanford C. Bernstein & Co. financial services analyst, Brad Hintz, estimates that Wall-Street investment banks slashed the budgets of their research departments by 35% between 2001 and 2005.   In an effort to lower their research costs, Wall Street firms have trimmed their domestic research staffs.  According to data from Thomson Financial, the number of investment analysts working for the 10 largest investment banks declined 21% to 2,641 as of November, 2006 from 3,364 analysts in 2001, according to data from Thomson Financial.  This trend is consistent with estimates provided by consultancy, The Tabb Group, which estimates that the total number of sell-side analysts will fall from 16,200 analysts in 2000 to 9,300 in 2006 and 6,000 in 2008. As you might imagine, a reduction in research budgets and a decline in the number of research analysts also has a number of consequences.  One result has been a steep reduction in the level of investment bank analyst experience as firms replace more seasoned (and more expensive) analysts with cheaper talent.  In addition, fewer analysts also means reduced research coverage – a trend that has impacted small cap companies much more significantly than mid and large cap stocks in recent years.
In recent weeks we have interviewed a number of small cap buy-side analysts and they have indicated that the general quality of small cap research has suffered dramatically in recent years as coverage has fallen and as the experience level of sell-side analysts has dropped.  Consequently, many buy-side analysts look to their brokers primarily for sales coverage or management access – not for unique analytical insight.

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