New York, NY – Last week, we wrote an article addressing the issue of “valuing investment research”. This article responded to a comment by Lara Warner, head of US equity research at Credit Suisse at a recent SIFMA conference where she said; “I find it pretty ironic that its’ our job to value other industries and other companies, but we can’t even value our own industry”.
While Ms. Warner’s comment is true, it is clear that the problem doesn’t lie solely with investment banks, but instead with the bundled business model which has enabled both the buyers and sellers of sell-side research to avoid adopting the market discipline which would naturally produce a “price” for investment research.
The Research Model of the Past
In most markets, the ultimate price of a good or service is established once producers and consumers communicate their willingness to supply and demand these products / services at different price points. Unfortunately, this market mechanism has not existed in the sell-side research business.
Sell-side research has traditionally been bundled with execution, thereby obfuscating the price of it to research consumers. Consequently, research buyers have not known how much they are being charged for the research. As a result, they haven’t had to worry too much about how much they value this research. Of course, it must be noted that in most cases, most research buyers have not really cared how much they were being charged for sell-side research as they were not paying for it with their own money, instead, they were using client commissions to pay for this research.
Research producers, on the other hand, have not had to worry too much about what they should charge for the research they produce – particularly in a world where no one knew how much revenue was directly attributed to their research. In many instances, this led sell-side firms to disregard the cost structure of their research departments. In addition, the sell-side has not really understood what research clients really valued. As a result, they have historically “turned on the fire hose” hoping that each client would value some part of the research they produced.
The Evolving Marketplace
However, the research industry has undergone considerable changes in recent years. First, the sell-side (research producers) have suffered from sharply falling commission rates — dropping from 75 cents per share in 1975 to less than one cent per share on an electronic trading system in 2006. In addition, the Global Research Analyst settlement forced investment banks to decouple analyst compensations from the revenues associated with any banking mandates won by a firm. Consequently, most sell-side firms have started to pay considerable attention about how much clients pay and how much research resources they consume.
Research consumers (the buy-side), have also been faced with a rapidly changing business. Unbundling and commission transparency in the UK, and the impact of CSAs and CCAs in the US, have forced institutional investors to think about what they should pay for the sell-side research they consume. This has led many buy-side firms to implement broker voting systems to establish a repeatable process to help them decide how much to pay their research providers. Unfortunately, the way most buy-side firms use the broker vote makes one big (and flawed) assumption – and this is that the value of research should be related to the amount of commissions generated by an institutional investor.
Establishing a Research Market
In order to create a better market mechanism to establish a price for research, research consumers need to come to terms with what / how much sell-side research they are willing to purchase at various prices (a demand function). This means buyers need to first decide how much they want to spend on research, and what makes this research valuable.
Simultaneously, sell-side firms need to decide how much research they are willing to supply at various price points (a supply function). This determination will take into consideration what sell-side firms feel is a fair price to be paid for the research they produce, based on the cost of production, a desired profit margin, and the value they believe they are delivering.
It is interesting to note that a few buy-side firms and a few sell-side firms we have spoken with in recent months have started developing their own rudimentary demand and supply functions. This has enabled them to better negotiate a clearing price for the research they consume or produce. However, a majority of the sell-side and buy-side firms we have spoken with have not yet progressed this far. As a result, these firms remain unable to value the research they produce or use.