High costs, regulatory challenges, and lack of differentiation in a competitive marketplace, are raising serious questions on the long-term commercial viability of sell-side research.
The sell-side investment research industry has been structurally challenged for the best part of the last decade. Yet, little has come about in the industry in terms of innovation or step-change in business process, to address these structural challenges.
The structural challenges within the sell-side industry can be summarized as a combination of high costs, lack of significant productivity initiatives, and declining value-add to the consumer (in this case the institutional investor). Additionally, the external customer environment of a declining commission pool, shrinking broker panels in most buy-side organizations, and the rise of commission sharing arrangements (CSAs), bring into sharp focus the cost structure of the full service sell-side research industry.
Given the structural decline of the investment research service proposition, market participants find themselves struggling to make their cost paradigm sustainable in the long-run.
In our estimates, an analyst at a median broker-dealer cannot cover more than 8-10 companies effectively. We estimate the direct cost of (research) coverage of one company on a per annum basis works out around US$55,000. We believe the long-run cost of coverage per company needs to decline to around US$30,000 per annum, in order to build a sustainable business case for sell side research. Given the cost challenge, analysts will have to start effectively covering 15-20 companies each, in order to meet the strategic cost reduction targets.
Such a massive strategic cost reduction target is unlikely to be realized in the absence of process innovation and adopting appropriate technology innovations already available to sell side research organizations that seek longer term viability – if not outright movement from a loss to a performance/profit center.
In short, the widening gap between the cost of research (from the sell-side) and the value attached to the research service (at the buy-side) is raising serious sustainability questions within the sell-side research universe. Additionally, the institutional brokerage business is perhaps one of the most peculiar industries where the consumer (i.e., the institutional investor client) puts a price on the services consumed, after it has consumed the service. In other words, the sell-side is always at a strategic disadvantage to its client(s) in the traditional seller-buyer commercial equation.
On the buy-side, outside of the large global asset and money managers that have the scale of operations to invest in internal research teams to aid their investment decision-making process, the smaller active managers are inherently unable to justify large internal research teams given the costs associated with hiring high quality analysts, and their sub-scale size. Reliance on the sell-side has therefore been disproportionately higher at these sub-scale firms, while their ability to pay for the sell-side services has been declining over the last decade due to declining management fees and greater scrutiny of their trading activities by their clients. The sell-side decline over the last 10 years, both in terms of quantity and quality, raises serious questions at smaller money managers as to how they go about meeting their investment analyses needs.
That said, and paradoxically, research itself continues to be a high-demand product. The problem lies not in investment research or in the research function but in migrating to a commercially viable future.
The news coming out of the UK and Europe on the regulatory front is not very encouraging. Both the FCA (Financial Conduct Authority) in the UK and ESMA (European Securities and Markets Authority) in Europe are of the opinion that the best interests of the end investor are not being protected under the current commercial practices. There are increasing calls for research related services to be completely unbundled with explicit price tags being attached to the research service; or far worse being taken out of the list of items that can be paid for via trade commissions. The regulatory movement to hard dollar and independent research began in the US some years ago with the decoupling of research from investment banking and the scrutiny of soft dollar payments.
On the unbundling front; a menu based pricing regime for research services? Perhaps. On both counts above, the research service providers (full service brokers and independents) stand exposed to further commercial squeeze. While the jury is still out on what will be the final outcome of such regulatory debates, no one is denying the fact that research spends (by investors) will be increasingly coming under scrutiny.
What has been untapped in this hunt for a sustainable business model is the use of smart technology and process innovation (enabled by software and technology) within the investment research business. Firms will fail to achieve strategic cost reduction targets (without significantly compromising their service promise) unless they embrace domain specific technology solutions. In order to address the long-run sustainability challenge, we believe the following areas need closer examination: research process; nature of the service; and asking if you are adding value to your client(s). All of the above criteria have a critical role for software and technology, helping to build a sustainable business model.
Research Process: It is critically important to reduce the tedium in the research process and get investment professionals to focus on the higher value-add aspects of the investment decision-making chain. The solution? Automate business processes with intelligent software solutions, in order to produce the same output with the least amount of resources, as well as at a fraction of the time. Additionally, technology solutions should focus on greater product visibility and improved branding, while reducing the resources to achieve the desired results. All of this delivered while providing for a water-tight compliance and workflow management platform that embraces new media as well as is up to speed on internal compliance and external regulatory regimes.
Nature of Service: Sell-side research firms, need to ask if the organization is geared to meet each client’s (i.e., buy-side) bespoke requirements. The days of merely delivering a research report on the desktop of a client is not good enough to get paid. The nature of the research service needs to be thought of in term of what is expected from the service providers in their order of importance – is it making recommendations, making non-consensus calls, thought leadership or diligent checks and related analysis?
Increasingly success is judged by how effectively firms become virtual extensions of their clients’ (i.e., buy-side) research organizations. If you are a buy-side research group, you need to align your service to your internal stakeholders (i.e., portfolio managers and traders) in terms of what are their expectations from the research group (e.g., ideas and/or identifying valuation anomalies).
Are you adding value? Whether you are sell-side or buy-side research analyst the concerns around transparency in the investment decision-making process when it comes to the due diligence effort, and/or data integrity checks are growing in importance. Additionally, “what if” risk assessment of high impact-low probability events on the fundamental valuation of a company is increasingly important across the capital structure of a company. It is not enough to comment on the earnings outlook on the company, but be able to talk across earnings, cashflows and balance sheet items. Transparency and granular analyses are increasingly seen as essential to the investment process. Technology solutions that meet the twin (at times conflicting objectives of greater due diligence and transparency in the investment decision making process as well as those that improve cost competitiveness of the research process will lead the way in sustaining the investment research industry.
Corporate Access while seen as part of the research team proposition, is increasingly seen as a separate offering and has come under close regulatory scrutiny in the UK and Europe with implications for the US and Asian marketplace.
There are no sacred cows in the investment research industry. Well, at least not any more. The ones that innovate and think out-of-the-box have the greatest opportunity to create sustainable business models for the future. In that context, a firm’s ability to tap intelligent analytical tools and other software-enabled building blocks in the research process to speed up investment decision-making will determine success or failure. Smart software capabilities allow a broker dealer to remain profitable and sustainable under the “new realities” of the reduce revenue opportunities while delivering on the value-add promise to the customer base.
We at ANALEC continue to build and propagate smart solutions in order to enable our clients to remain competitive long-term, and fight a good fight in the marketplace.
