Business of Fintech
Unbundled and unprofitable, equity research kicked off the brokerage waterfront
- All signs point to investment firms needing to pay for research in the future.
- This will change the structure and nature of equity analysis.
Faced with new regulations and a changing appetite for equity research, brokers are experiencing an identity crisis. Asset managers are expected to cut their budgets to the tune of $15 billion per year. The hit will be felt hardest in Europe, where new rules will restructure the way investment banks and their brokerage arms get paid. Employing an equity research team of smart, highly paid, Ivy League MBAs was considered the price of admission to the brokerage game. Brokers used their research as a point of differentiation in an industry that grew to become highly commoditized. Equity research was a freebie given to clients as a way to get a piece of their order flow. However, changing rules like Europe's MiFID II, whose implementation has been delayed until 2018, do away with those soft-dollar agreements. Additionally, there's growing evidence that organic demand for investment bank research is shrinking. The buy side has been cutting external research budgets since 2012. Nomura is completely shuttering its European equities group, laying off staff of about 1000, because it found profitability elusive. According to a survey conducted by Quinlan and Associates, a financial services consultancy, external research budgets have already been reduced by an average of 20-25 percent during this period and the firm predicts a further 25- 30 percent reduction in the global research wallet by 2020. The unbundling of investment advisory and trade execution has set off a mini-bull market, though, for experienced analysts in London. That's because, in a MiFID II world, research departments must begin to get paid for their work, and investment banks believe a good way to do that is by hiring brand-name analysts that investment firms would conceivably pay for. "Expect ER to get even more competitive in places where MiFID II is fully implemented, though there is still some question where and how much will be implemented," wrote James Valentine, founder of AnalystSolutions, an education and training company for equity research analysts. "For years, there’s been a concentration of votes for the top 3-5 sell-side analysts in each sector and I suspect this will become even more concentrated." Waterfront research providers, those investment banks with a general, inclusive coverage universe, are likely to evolve their offerings to become more specialized. "This is likely to be the case for analysts and/or teams that are ranked outside the top 5 providers in their respective country or sector," the report posited. "It is our view these teams will need to be heavily trimmed or completely cut by the time MiFID II takes effect in 2018." These market dynamics may bode well for firms that provide a performance layer on top of equity research. Since now that investors need to pay for the research, they will be more selective on what they are getting, said Uri Gruenbaum, CEO of TipRanks, which ranks the performance of equity analysts. Terminal businesses may also feel an impact. "I also see a negative impact on data aggregators such as Bloomberg and Thomson Reuters who have been distributing the research through very expensive terminals," he said. With investment banks reducing staff in their equity research departments, opportunities are opening up for new, specialized independent research firms. "Independent providers have had considerable success in the United States, with firms such as Wolfe Research (utilities, transport and energy) and Zelman & Associates (housing/ homebuilding) among a host of names who have made a notable mark in their chosen sectors," wrote Quinlan and Associates in the firm's recent research paper. Valuations in financial research seem to correlate well to specialization levels. In 2015, Verisk Analytics bought Wood Mackenzie, a metals and mining research firm, for nearly $3 billion. The same year, McGraw Hill acquired SNL Financial, a firm with deep commodities data, for $2.2 billion. Today's financial industry rewards specialization over generalization. There's a parallel to the shakeout going on in the media industry, as large, unprofitable, undifferentiated firms are struggling big time. "The battle of media relevance is only one battle: do you have the chops to cover a sector or a subject, every which way, with impact & value?" wrote Rafat Ali, a new media entrepreneur and investor. It looks like the highly-flavored research providers will win out over bland generalists.