New York, NY – In the past few months, a number of institutional investors in the UK and the US have asked the team at Integrity Research Associates if we can help them solve the research pricing problem – in other words, they want help in figuring out if they are paying too much for their research. And while this problem not much of an issue when dealing with alternative research providers (most of them have specific prices for their services), the issue is quite pronounced when addressing the kind of bundled research offered by most investment banks and broker-dealers as many of these firms have been unwilling to put a price on the research they produce. In addition, many money managers have ignored this topic, assuming that the issue that matters most is how much they value the research (hence the proliferation of commission management systems). However, a number of changes are taking place in the industry which suggests that determining the value of research without paying attention to price might not be acceptable – either to clients or regulators.
Is Value Enough?As we have argued numerous times in the past, using the “value” of research as the sole determinant of how much to pay for it – while understandable from the perspective of the money manager – could be completely inappropriate for the client whose commissions are being used to pay for this research.The first reason is that using value without price could lead to a gross overpayment (or underpayment) of client commissions. An analogy might be appropriate. Let’s say someone who returns from being lost in the desert for a week might be willing to pay an exorbitant sum for a bottle of water (they value water highly). However, a bottle of water might normally cost very little (the price of water is low). The big question is, “Did the person who paid a lot for that water use their money wisely?” Of course, this is an even bigger issue if the person used someone else’s money to purchase the water. Will that client think this was a wise and prudent purchase? This is exactly the problem that exists when asset managers use “value” as the sole determinant of how much of their clients’ commissions should be spent on specific research providers.Another problem with this approach is that it assumes that, at any moment in time, an asset manager has the best research providers for their situation in the pool to begin with. However, we have discovered that many money managers have research providers who, while they may have been great at one point in time, are not necessarily the best for a managers needs at present. This is due to changes in market conditions, changes in the research providers themselves, AND new innovative entrants into the research marketplace. Consequently, these managers may be overpaying research providers who are no longer “best of breed” and they are underpaying undiscovered research providers who can add value to the asset manager’s investment process.And while many money managers conduct regular “research votes”, they often do not review and manage their entire research portfolios to determine which firms should be removed from the pool. As a result, many asset managers are dividing the commission pie among too many research providers, resulting in smaller average payments for all research providers.
The impact of the SEC’s Interpretive GuidanceHowever, in last July’s interpretive guidance, the SEC indicated that the price charged by a broker dealer for its research could, in fact, be considered an important reference point when an asset manager makes his/her “good faith determination” that they are paying an appropriate amount for this research. Earlier this week, Larry E. Bergmann, former Senior Associate Director in the Securities and Exchange Commission’s Division of Market Regulation and special counsel in the Corporate and Financial Services Department of Willkie Farr & Gallagher LLP in Washington, posted a blog on this topic. In his post, Mr. Bergmann explained: “One of the thornier aspects of this thicket of issues is how to value the eligible research component of “bundled” products and services offered by so-called full service broker-dealers in return for the commissions paid by the manager. Where the research is produced by the broker-dealer, i.e., proprietary research, it may be unable or unwilling to put a separate price tag on it. As a result, the manager has fewer reference points for the valuation of such research. Recently, however, some broker-dealers have been accepting separate payments for their proprietary research, often in connection with the new client commission arrangements facilitated by the SEC’s July 2006 interpretive guidance on Section 28(e). In this context, the SEC has said that price can be relevant: “[W]here a broker-dealer also offers its research for an unbundled price, that price should inform the money manager as to its market value and help the manager make its good faith determination.” Accordingly, the price charged by a broker-dealer for its research can be useful to a money manager in making its value determinations of bundled products, although, as discussed above, price is not determinative of value. What is less clear is whether this suggestion by the SEC will become an expectation in reviewing a manager’s satisfaction of the requirements of Section 28(e). Put differently, will the SEC staff (or the manager’s clients) expect that the manager will ascertain whether a broker-dealer sells its research for an unbundled price and, if it does, has the manager taken that fact into consideration in making its good faith determination?”
The Current State of Pricing ResearchOf course, most Wall Street firms have publically tried to duck this issue, asserting when asked that they cannot (or will not) put a price on their research. However, in private an increasing number of investment banks and broker-dealers have been willing to price their research in response to client demands. As a result, these banks have “negotiated deals” with clients reflecting an individual client’s utilization of the bank’s research resources.Unfortunately, these “negotiated deals” have made it very difficult for asset managers to integrate these “reference points” as a part of their research valuation process. It is for this very reason that Integrity Research Associates has started working with a limited number of mutual fund and hedge fund clients to help them discover these “research pricing” reference points to enable them to more systematically make their good faith determination if the amount they are paying for their research is reasonable and appropriate.
