We persist in the belief that ’13 will be a lucky year for the research industry. However, some hard luck will be mixed with the good.
2012 did not offer much relief to research firms already pressured by declining commissions. Greenwich Associates estimated U.S. equity commissions paid by the institutional investors it surveys declined another 6% in 2012 for a total decline of 26% since 2008. Volumes fell more precipitously, by 20%, so Greenwich’s estimates may be on the optimistic side.
Will the trend of declining commissions reverse in 2013? Surely commissions must bottom at some point. The sources we talk to expect the trend to continue to be negative. Assets continue to flow out of actively managed equities and trading costs continue to shrink. Nevertheless, the rate of decline seems to be slowing.
The overall commission trend is not the whole story, however. Commission declines have been tempered somewhat by institutional investors allocating higher portions of commissions to research (and less to execution), through the use of CSAs and other means. This has meant that the decline in research-related commissions since 2008 has been ‘only’ 18% compared to the 26% decline in overall equity commissions.
This has been cold comfort for smaller broker-dealers and independent research firms, since an increasing share of commission allocations have gone to the largest investment banks. We estimate that spending on independent research has fallen 34% since 2008.
So, equally important to the trend in overall commissions is whether research-related commissions will continue to outweigh execution, and whether large investment banks will continue to take share from smaller research providers. The outlook seems mixed. While many investors will likely continue to allocate more to research and less to execution, there are limits to how much can be shifted. Greenwich estimated that the portion of U.S. equity commissions allocated to research fell back to 57% in 2012 from nearly 59% in 2011.
The most interesting question for us is the share of commissions going to large investment banks. Analysis by Coalition, a London-based consulting firm that tracks the investment banking industry, shows how marginally profitable cash equities has become for the large banks. Coalition estimates that cash equities headcount declined 11% in 2012, yet cash equities remains the least productive of the major investment banking product lines. For the Americas, cash equities’ productivity is $600,000 per employee, which contrasts markedly with the $1.2 million per employee for prime brokerage and the $2.5 million for fixed income.
Given the commission trends, how much longer will large investment banks subsidize research? 2012 saw consolidation in smaller brokers, including ThinkEquity, Rodman & Renshaw, Kaufman Bros., Ticonderoga, Pali Capital and WJB Capital. Stifel bought KBW, B. Riley acquired Caris & Co., Evolution Securities was bought by Investec, and Collins Stewart Hawkpoint was absorbed by Canaccord. Nomura cut back its equities staff, Auriga pulled out of the U.S., and Royal Bank of Scotland shut down its equity research altogether. Credit Agricole sold Cheuvreux last month to rival firm Kepler Capital Markets. Deutsche Bank and JP Morgan were rumored to be considering significant cutbacks in their research staff in the spring of last year.
2013 will see more consolidation, and we think some majors will cut back significantly or exit altogether. The market has become less able to support nine global full-service research operations.
This year we can expect the final chapter in Preet Bharara’s Ahab-like quest for Steve Cohen’s white whale. Irrespective of whether Cohen gets harpooned, compliance concerns will remain on the front burner, particularly for unregulated research firms. We are working on some solutions to help ease the burden.
Where will the regulatory lightning will jump next? In the UK, the Financial Services Authority (FSA) has decided that management access should not be paid through commissions. At the same time, more media scrutiny is being given to inside trades by corporate management. It would not be surprising to see U.S. media and regulatory scrutiny applied to management access.
Soft dollars do not seem to be on the regulatory radar scope, but this is the big sleeping dog for the research industry. Given the increasing regulation of hedge funds, who knows what an earnest young SEC examiner might uncover?
Which types of research?
Investorside Research, the U.S. trade association for research, conducted a survey of independent research providers in November. Overall, survey respondents were expecting around 1.5% growth in 2012. Fundamental research providers were the most flush, estimating 3% growth in 2012 on average, followed by economic research providers at 1%. Primary research providers were the least sanguine, expecting declines of 2% on average. Looking toward 2013, all were more optimistic, expecting 8.5% growth on average. Fundamental research firms were most bullish, expecting growth of 9%. Economic research firms were the most conservative, at 5%.
Primary research is a key bellwether. Expert networks got hammered in late 2010 and 2011, and anecdotal evidence was that the market environment had stabilized in 2012. The Martoma case makes 2013 less certain depending on how much renewed pressure will asset owners put on asset managers to cut back on expert networks.
A sleeper segment to watch for 2013 is ESG (environmental, social, governance) research. The segment went through extensive consolidation in 2009 and 2010, and this seems to be paying off as interest in ESG continues to grow, particularly in the US.
Has it gotten so bad it’s good? We are entering the fifth consecutive year of commission declines, shrinking the overall payment pool for research. Consolidation began in earnest in 2012, and is likely to accelerate in 2013. Regulation is a wild card. Increased compliance around insider trading has been a negative for independent research in 2011 and 2012. If regulatory scrutiny shifts to management access, it will impact investment banks far more than independents.
Given the diversity of independent research, some firms and segments will fare well despite the overall environment. In the Investorside survey in November, some firms reported an 80% decline in 2012 revenues while others reported doubled revenues. Despite everything, the research market remains large, with an estimated spend of $7.5 billion in the U.S. alone. Independents are getting between 15% and 20% of that spend; we estimate $1.4 billion in 2012.