March 27, 2006

Back to the Drawing Board


When Wall Street's top investment banks formalized their $1.4 billion global research settlement with the SEC in April 2003, in addition to making numerous reforms, they agreed to pay $450 million over five years to provide clients with independent equity research alongside their own. The idea was to create a new model for the industry that would avoid the conflicts of the old investment banking-driven one, while still producing a high-quality product. But in practice, it doesn't seem to be working for much of anyone.

That includes the hundreds of boutiques that opened in the hope of making a mint selling independent research "untainted" by the conflicts of interest that plagued analysts at traditional broker-dealers. By some estimates, there are 300-400 independent research firms, many of which are struggling. In fact, the only ones that really seem to be benefiting in terms of settlement-driven business are a handful of large players, such as Morningstar, S&P and Bank of New York's Jaywalk.

Meanwhile, many big Wall Street firms are themselves rethinking their commitment to research now that investment-banking revenues can't be used to subsidize it. Scrutiny of their money-losing research efforts will only grow more intense when the cycle turns and they stop reporting record-breaking profits.

The real problem is that-with the apparent exception of Fidelity Investments-large buyside institutions and hedge funds simply don't want to pay hard cash for research, in some cases choosing instead to ramp up their own analytical capabilities. Moreover, portfolio managers have traditionally paid for research with soft dollars-directing a portion of their trading commissions to firms whose research they use. But in recent years, there has been a steady downward pressure on commissions with the rise of more efficient computerized trading systems, which cuts into the amount of money available to pay for research. Regulators have also been pressuring the industry to cut down on the use of soft dollars.

Integrity Research Associates, a consulting firm focused on equity research, issued a report last month saying investors were likely to reduce their spending for sellside research by 28% to $3.9 billion annually over the next five years.

Meanwhile, 85% of the asset managers surveyed said they plan to be spending either no more or only slightly more on independent research in 24 months than they do today. That type of spending is not going to support the droves of independent research shops out there, especially once the settlement cash flow dries up in 2009.

As a result, most observers expect a shakeout in the independent research arena, more than halving the number of players to about 150 by the time the settlement period ends. Consolidation and closures have already begun.

Late last month, Criterion, an independent stock and bond research outfit set up in 2002 by former Fitch Vice Chairman Neil Baron, sold out to the Center for Financial Research and Analysis. Last year, Fulcrum Global Advisors sold most of its assets to Soleil Securities Group. Precursor Group, which had been in the independent research game for five years, left the business in January to focus on consulting. Second Opinion Research, launched three years ago, shut its doors last month.

"It's a really hard time for the independents right now. You have to have the ability to create the research, to distribute it, to follow all the regulations, and to have a mechanism to collect payment, whether it's through hard dollars or trading commissions," says Paul Spillane, CEO of Soleil, a New York-based broker-dealer and aggregator of independent research. "It's a very complicated equation at this time."

Thomas Clarke, CEO of, says his firm folded its independent research and broker-dealer unit, Independent Research Group, because its model was no longer viable. His clients were largely hedge funds, and when they're not doing well, they don't want to pay for research. "By hiring analysts, a research firm has a fixed cost. You hope your hedge fund clients are going to pay you through soft dollar commissions, but they have no fiduciary responsibility to do that," he says. "What other business is there where you create a product or service, but you don't dictate how much people have to pay?"

Window of opportunity

While the audition period is quickly running out for many of the upstart shops, the larger independents have another few years before the funds flowing from the research settlement are shut off. In the interim, they are going great guns to win the allegiance of clients they hope will continue to pay for their products post-2009.

Both S&P and Morningstar, for instance, have dramatically expanded their staffs and product offerings. The number of stock analysts at Morningstar has nearly tripled to 87 since 2003, while the number of stocks the firm covers has swelled to more than 1,700 from 500 over the same period. S&P, meanwhile, now has 65 equity analysts covering 1,560 stocks, up from 50 analysts covering 1,300 before the settlement.

However, "the future after 2009, when the settlement expires, is unclear," says an S&P spokesman, who nonetheless maintains that the firm is committed to providing research.

Still, the door is seemingly open to independent shops able to provide value-added products, especially since access to traditional sellside analysts has been considerably less valuable to the buyside since 2000, when the SEC adopted Regulation FD. Reg FD requires listed companies to make any potentially market-moving information available to all investors at the same time, rather than the old model of giving it first to their favorite analysts, who in turn passed it along to their best clients.

One obvious way for the independents to differentiate themselves is to offer superior stockpicking. Timothy Alward, president and CEO of Ford Equity Research, says his revenues were up 35% in 2005, not because of the settlement but because sellside firms either left the research business or allowed the quality of their research to deteriorate to the point that investors sought alternatives.

"Mutual funds have a set pool of money they can use, and they have to dole out those dollars very carefully. They're sensitive to who they pay for research, so you have to be able to prove you add value," he says.

And the record of some independents speaks for itself. A recent survey by, which monitors analysts, shows that independent firms such as Ford and Argus Research more accurately predicted which stocks in the Russell 2000 would rise and which would fall over the past two years than their sellside rivals. Investors who listened to Argus, for instance, would have generated annual returns of about 37.7%, while those that used, say, Merrill Lynch's analysis would have earned only 6.9%, found.

Wall Street rethinking

Smaller independent firms aren't the only ones still figuring out how to respond to the research scandal and subsequent settlement. Many of the large Wall Street firms are starting to wonder whether they should continue to offer traditional published research in exchange for a cut of trading commissions.

"You've got the settlement, you've got the buyside saying they're going to build their own. Why would investment banks with large proprietary trading operations continue with it when their return on equity for having equity research is zero, possibly negative?" asks Soleil's Spillane.

It's no secret that providing research on its own is a money-losing proposition for the big banks. An Integrity Research study released in 2004 showed that Wall Street firms received $5.91 billion from money managers for research in 2003 but spent an estimated $9.1 billion producing it. Some of the large Wall Street firms were spending as much as $600 million annually to run their research departments.

"The business is often not profitable on a stand-alone basis for the large investment banks," says David J. Blumberg, a managing partner at Blumberg Capital, a San Francisco-based venture capital firm that recently cashed out of an investment in independent research. "It doesn't seem to carry its own weight unless it's tied to corporate finance, which has conflicts, or proprietary trading, which also has conflicts. In order for it to make sense at an investment bank, it seems to need a cross-subsidy."

Dengler of Soleil says the big Wall Street firms haven't exited the research business yet because other parts of their businesses are doing so well right now, enabling them easily to cover the cost of producing reports. He also says no firm wants to be the first to abandon traditional research altogether.

Many observers argue that firms such as Goldman Sachs and Lehman Brothers would get a bigger bang for their buck by using their analysts to come up with trading strategies for their proprietary traders rather than writing research reports for buyside clients. "It wouldn't surprise me if five years from now, Goldman got out of the research business," says Clarke of Both Goldman and Lehman declined to comment.

A number of the largest brokers already have cut back on the amount of research they publish, instead providing their buyside clients who trade most actively with real-time advice either electronically or over the phone.

Others are refocusing their efforts to concentrate on areas where they feel they can better differentiate themselves. Just last week, Morgan Stanley cut 60 equity research positions in the US and Europe in favor of beefing up its efforts in Asia and emerging markets, where the firm feels it can add more value.

Some Wall Street firms with big retail brokerage operations, such as Merrill Lynch, may be more willing to hold onto their existing research operations, though they may change the way they distribute it. Instead of just giving research away to institutional clients, they may also begin providing it to retail clients as part of the service covered under an annual management fee, suggests TheStreet's Clarke.

He adds that Merrill, like some of its competitors, is already moving toward a management fee structure, under which retail investors would pay an annual fee based on a percentage of assets rather than for each trade. Throwing research into the pot might be another way of enticing investors to agree to the concept of management fees. "The institutional model of today will be the retail model of tomorrow," Clarke says.

For the big investment banks, the equation only becomes more complicated-and potentially less profitable-if more investors decide to pay for research with hard dollars rather than soft dollars. Right now, Fidelity is the only firm unbundling its research payments from trading commissions. In October, it struck a deal with Lehman in which it would pay 2.0-2.5 cents per share for trade execution and $7 million a year for equity research. The money manager hammered out a similar deal with Deutsche Bank in December. So far, few seem eager to follow Fidelity down this path-some 85% of asset managers surveyed in January say they still pay for research with soft dollars, according to Integrity.

Nonetheless, John Webster, a consultant with Greenwich Associates, says some investors are prepared to pay hard dollars for research, though he's not sure a "fixed-payment" model is ideal for the sellers. When a sector is hot, he explains, everyone wants to talk to the analyst covering it, and the firms that pay the most ostensibly receive more of the analyst's time. But Fidelity has effectively bought a slice of that time for what some view as a fairly low price.

"So if the hedge funds come along, Lehman won't be able to service them because that scarce resource will be taken up by Fidelity," Webster says. "It's a good reason to have this as a floating charge rather than a fixed charge."

Proprietary models

Some independents think they have the answer to providing investors-legally-with timely, tradable information that the market doesn't have. Vista Research and Gerson Lehrman, for instance, connect their institutional investor clients with a giant database of about 100,000 hard-to-find contacts in academia, consulting, management-even retired executives. They are contacts the research firms have ferreted out, vetted, and placed on retainers of some $500 per hour.

These contacts-which essentially help buysiders do their own research-are particularly helpful to hedge funds that want specific information across a variety of sectors before others in the market have it. And they've been willing to pay as much as $500,000 a year for it.

"For portfolio managers, knowledge is power," says Blumberg, whose firm sold off its profitable investment in Vista Research to S&P. "Being able to go direct and unfiltered to the industry source gives the investor a proprietary edge because they're the only one hearing this information. When a Wall Street analyst writes a report, it goes out to hundreds of customers simultaneously."

It was Criterion's proprietary accrual model that attracted the attention of its eventual buyer, the Center for Financial Research and Analysis (see related news story). "Unless you have something unique to offer, I think your traditional fundamental research is gong to be obliterated by Wall Street research," said Criterion's Baron. "I don't think the [research] settlement is going to, nor has it, nor will it, create more demand for independent fundamental research."

Kenneth Dengler, COO at Soleil, says one value-added service his firm provides is arranging meetings between company managers and buyside clients. "Portfolio managers are very, very busy. They want to see the management, but they will not take a full day to go out and visit a company. If we can deliver that management to their doorstep, they'll pay for it," Dengler says.

Indeed, combined annual revenues for the top half-dozen firms using proprietary independent research models was $200-250 million, according to Integrity. Gerson's revenues alone last year were rumored to be about $80 million, Blumberg says. Vista has been growing rapidly as well, though he declines to provide figures.

Vista's president, Stanton Green, agrees that proprietary is the operative phrase. And with 8,000-9,000 hedge funds looking for an edge, he sees a lot of growth potential in research models like his. "Traditional written research-it doesn't work for hedge funds," Green says. "Once 30 people have read the information, too many people have it, and the hedge fund no longer has an advantage over its peer group."

However, even if this new model catches on, it's unlikely to be a panacea for the research industry.

And it certainly won't help one group most likely to be hurt by the decline in sellside research-smaller public companies.

A growing number of these have found their sellside coverage entirely dropped, leaving their stocks to languish. Some have even turned to paying for research coverage themselves-a model that is, of course, rife with conflicts, even though some firms charge them upfront annual fees to ensure that their research can remain independent of corporate influence (see "Better to Shine a Light," IDD, March 28, 2005).

In any case, it seems clear that none of the current fixes for the old, broken research model are really touching all of the bases. Perhaps the right combinations of independent models will come closer.


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