New York—As Integrity’s internal database of research providers recently topped 1700 (1735 to be exact), where is the consolidation in research providers we keep predicting? Asked to picture the alternative research landscape, observers might call up images of teaming rabbits or, if suburbanites, deer devouring all vegetation in sight. Conventional wisdom says that Eliot Spitzer’s largesse caused the population to swell to unsustainable levels. And, like other overpopulated species, alternative research providers are due for a crash.
Growth of the Alternative Research Industry
Let’s take a look at the evidence to support this view. Integrity Research’s database of research firms offers some insight on this question. We analyzed the information Integrity collects on the start dates of research providers to get a sense of whether there was a post-Spitzer bulge in the formation of new research providers. The chart below is a histogram of the start dates of alternative research providers (ARPs) from 1910 to the present.
The chart shows that the independent equity research industry was minute until the elimination of fixed commissions in 1975, after which the number of new ARPs accelerated. Growth accelerated in each subsequent decade, with the number of research providers nearly doubling in the 1980’s and 1990’s.
Bear in mind that Integrity’s database only tracks ARPs that are currently around today, so these numbers are understated, and probably more understated the further back you go. Chances are good that there were more ARPs formed in the 1970’s than the 66 that survive today. This would tend to overstate the growth from decade to decade. Nevertheless, our analysis shows pretty clearly that there was a significant population of ARPs going into the new millennium.
The Spitzer Effect
If we look more closely at the current period, we can see the Spitzer effect. In the 1990’s around 20 new ARPs were forming each year. Toward the end of the decade, at the peak of the tech bubble, the number of new ARPs increased—35 new ARPS in 1999, 34 in 2000 and 38 in 2001. The Research Settlement was officially announced December 2002, but reports of the pending settlement were widespread in the summer and fall of that year. So it is not surprising that we see a spike in ARP formation in 2002. In 2002, 47 new ARPs were formed and 55 the following year, then dropping down to 35 in 2004, 24 in 2005, 12 in 2006 and 17 in 2007.
There is clearly a spike in ARP formation around the settlement, but it does not explain the large number of ARPs. If the typical rate of ARP formation was around 20 firms per year going into the end of the 1990’s, then ARP ‘boomers’ created during the end of the tech bubble and Spitzer settlement represent an additional 120 firms over our hypothetical typical rate. This represents a 20% increase in the population of ARPs—meaningful but not cataclysmic.
What does this say about alternative research consolidation? An increase of 20%, while significant, does not represent a major overhang of overcapacity. It can be “sweated out” over time, in part by a reduced number of new entrants, which seems to be the case the last few years.
What about exits? The economics for most IRPs are such that they don’t need a lot of clients to make a go of it. Many boutiques break even with a dozen clients. Or take Cleveland Research Company, which spun out of FTN Midwest in 2006. Their plan has been to limit clients to 125, so that clients would feel they were getting more value. With fees in the six figures, the limited client base creates a nice cash flow for the firm.
There has not been a large number of ARP’s exiting the business over the last few years. IRG, Fulcrum, Crownstone, Avalon, Precursor, Sturza’s, Provident. No rush to the exits, yet. The formation rate, even at diminished levels in recent years, seems to exceed the exit rate.
We are not seeing a dramatic crash in the population of ARPs. Looking at the formation rates, we see evidence of a vibrant and growing alternative research industry before the tech bubble and the Spitzer boomlet. The Global Research Settlement attracted new entrants, but the bigger effect was to create visibility for the larger community of existing ARPs. The economics of the industry are such that many alternative research firms are run as ‘lifestyle’ firms, generating sufficient cash flow to keep the principals doing what they enjoy doing.
Alternative research industry is like a giant ‘roach motel’, the ARPs come in and never go out. Our official prediction is still for consolidation, and surely we will see an increase as a result of the current bear market. But in the meantime, our database keeps growing…