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The Extinction of Sell-Side Research And What It Means to Asset Managers Frost Consulting Frost Consulting May 2013
The Extinction of Sell-Side ResearchAnd What It Means to Asset Managers
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Frost ConsultingMay 2013
Head Trader Forum – Amsterdam, September 2010
German and Swiss Pension Forum – Luzern, November 2010
European Chief Investment Officer Roundtable – London March, 2011
Head Trader Forum – Barcelona, September 2011
European Chief Investment Officer Roundtable – Amsterdam April, 2012
Benelux Pension Roundtable – Noordwijk, April 2012
Nordic Pension Roundtable – Stockholm, May 2012
Asset Manager COO/CFO Conference – Frankfurt, June 2012
European Head Trader Forum – Madrid, September 2012
US Head Trader Forum – New York, January 2013
US Chief Investment Officer Roundtable – New York, February 2013
The Leading Authority on Global UnbundlingFrostConsulting
Frost Consulting is a London-based firm specializing in the equity research procurement value chain.
Strategic Consulting: Asset Managers/Plan Sponsors – Alpha Generation- Research Benchmarking- Regulatory/Operational Risk Mitigation
Research Content Producers – Digital distribution/optimization
Investment Banks/Exchanges/Technology Companies – Revenue Opportunities- Unbundled Strategies
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Publications:
The Changing Face of Research Procurement – Nov. 2012
The Extinction of Sell-Side Research – London, May 2013
Inflection Point for Institutional Equities? – London, Feb. 2013
Events/Presentations/Publications
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Could sell-side research really disappear?
Is this what asset managers really want?
Would it matter to asset managers if this happened?
- from an information/alpha generation perspective?
- from an asset manager profitability perspective?
How is regulatory change likely to influence the asset manager research/spending process?
Is there anything that asset managers can do to ensure the sell-side research they want and use - survives?
Potential Impacts of “Conflicts of Interest”
Key Questions
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Investment Banks
Higher cost of capital.
Higher regulatory capital requirements.
Less leverage – lower returns.
ROEs substantially below cost of equity.
Equities
Cyclical bear market in cash equities, M&A, IPOs.
Cyclical/Structural? shift out of active cash equity products.(rise of ETFs, programs, private equity, derivatives).
CSAs – Structural – not cyclical. Impacts:
- Ends the monopoly of investment banks over assetmanagement research spending.
- Significant reduction in the number of equity executioncounter-parties.
- CSA research payments at lower levels than researchcommission payments via equity execution.
Nuclear Winter?
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33%
$ 10.9 Bln
Execution
67%
$ 22.1 Bln
Non-Execution
Regulatory Regimes:
“Best Execution”Reg. NMS
Plan Sponsor Scrutiny:
Level: High
Means: TCA
Penetration: ~85%
Plan PerformanceRisk: Moderate
0-200 Bps per annum
Regulatory Regimes:
Historic: NoneCommencing: ERISA/FSA
Plan Sponsor Scrutiny:
Level: Low
Means: None
Penetration: ~0%
Plan PerformanceRisk: High
0000s Bps over time
Institutional Secondary Equity Commissions
Change has happened.Best X, Exchange Competition
Change just beginning.CSAs, New ERISA/FSA Rules
Global Total 2011e - US$33 Billion
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Non-execution commission spending is entering the regulatory spotlight.
*Frost Consulting Estimates
Overview of the Global Commission Market
$21.4 Bln $9.1 Bln
3rd Party Research
Research payment for execution broker:Part of the research commission is oftenallocated to the CSA execution broker.
CSAs: Mechanics (Europe)
Typical Trade Client CSA Account(Held by CSA Broker)
CSA Execution Broker
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ResearchCommission – 67%
ExecutionCommission – 33%
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Ends the investment bankmonopoly over asset managerresearch spending.
Percentage of Total Volume Traded
50% 40%
Unbundled Commissions: Regional Penetration
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70%
Europe (Ex-UK) USUK
Large asset managers using CSAs: UK 90%, Europe (ex-UK) 60%, US, 80%*Frost Consulting Estimates
Global Perspective
Unbundled Commissions – Penetration by Market
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Managers in geographies where there are impediments to unbundling are at a competitive disadvantage globally.
UK: Global US: Fastest
Regulatory growth Japan
Leader globally.
France EU: Varies by Sweden
country
Switzerland Germany Canada
Netherlands Hong Kong Australia
> 50% 20 - 50% < 20%
Game Over for Bundled Model Growing Rapidly Emerging
*Frost Consulting Estimates
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Avg. Number Execution Counter-Parties*FrostConsulting
* Greenwich Associates – Average: Large Asset Managers
28.3
16.5
- 41.7%
(European Asset Managers - Ex Bulge Bracket)
16.5
European Cash Equities
CSAs will continue to encourage asset managers to reduce execution counter-party lists.
The UK CSA Experience:
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Extinction in Action
Secondary commissions available to theUK small/mid-cap brokers have fallen byan estimated 80% since 2007.
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Small/Mid-Cap Brokers
Global Asset Manager Perspective – UK EquitiesMarket Weights – Global Equity Index
How many dedicated UKsmall/mid-cap executionrelationships are necessaryfor a global asset manager?
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Widely used global benchmark.
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GlobalAsset Manager
UK Small/Mid-Cap Broker Universe 2008
Bundled Environment - UK Small/Mid-CapMultiple Direct Dealing Relationships
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In a bundled commission environment each research relationshiprequires a separate execution relationship. Execution Relationships: 22
Is this sustainable?
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17.8
5.8
0.90.7
4.2
Average Number of Brokers per 1% of Global Market Cap
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1.11.9
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Intensity of Investment Banking Competition
* 2008
*Frost Consulting Estimates
Disintermediation in Mid/Small Cap UK Equities
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Market Depreciation
Shift to CSAs
Remaining AvailableCommission
% of Total Commissions
Traditional Market
CSA Market
2012
Most UK small and mid-cap brokers chose not to participate in the CSA market. They were rapidly disintermediated.Available commissions for this group fell by an estimated 80% from 2007 to 2012.
Portion of Compensation via
CSA payments: not execution.
2007
Evaporated
Execution Commission
% of Total Commissions
Traditional MarketImpact
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BulgeBracket
Commission Unbundling “End-Game:The Perfect Storm
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Evidence From Multiple Sources
estimates that 35-40% of publically listed companies have no analyst coverage.
Average number of analysts per equity: 2005 4.012012 2.02
London-based firm providing “issuer sponsored” research.Clients include:
Investment Bank Research:Declining Sell-Side Coverage
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Market Cap: $5.1 billion
# of Sell-Side Analysts: 18
Market Cap: $17.3 billion
# of Sell-Side Analysts: 12
LargeResearch
Aggregator
$21.4 Bln $9.1 Bln
SpecializedResearch
Investment BankResearch
Average asset manager content selectionlimited to >100 brokers on the manager’s“Approved Broker List”.
Managers bombarded by unsolicited inputfrom 250+ brokers. Reluctant to acceptcontent from new sources as each wouldrequire an additional (unwanted) executionrelationship.
Transition to the Unbundled EnvironmentOld Model: “Information Bunker Mentality”
Asset Manager Approved List:
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Firewall for Alpha
Quants/Databases
ManagementConsultants/
Expert Networks
IndependentFundamental
Research
Sustainability/SRI
Research
GlobalInvestment
Banks
SpecialistInvestment
Banks
RegionalBrokers
Aggregate globalinvestment bankresearch budget.
(~600 firms)(Right Scale – Red Line)
%
CSA % of GlobalEquity Trade
(Left Scale- Blue Bars)
Research Procurement: Asset ManagersTraversing the “Alpha Gap”
~40% reduction incapital allocated tosell-side research.2008 – 2013.
*Frost Consulting Estimates
6.0
7.0
8.0
1.0
3.0
2.0
4.0
5.0
9.0
$ Billions
10.0
$8.2 billion
$4.8 billion
Asset managers that do not unbundle are at a competitive disadvantage.
Alpha Gap
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$21.4 Bln $9.1 Bln
CSAs: Asset Manager ViewExploding the Asset Manager Content Universe
ResearchCommission
ExecutionCommission
18
$22Billion
Globally
Historic Inputs
New Inputs
$11Billion
Globally
Universally Distributed
Proprietary Network
Asset Manager Plan Sponsor
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Portfolio Process
Client CSA Account(Held by CSA Broker)
CSA Broker
Key Questions:
1.How do asset managers find non-brokerage research content?
2. How do research producers penetrateasset manager content firewalls?
Questions for Pension Funds: What are the implications for asset manager performance?
How dependent are asset managers on brokerage research?“Percentage of Total Research from Investment Banks” -
Asset Manager CIO Responses
Investment Banking Research Budgets:Expected % Change through 2015 -
Asset Manager CIO Responses
Investment Banking Research PerspectivesI.I. European CIO Roundtable – Amsterdam March 2012
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Asset Managers Know That InvestmentBank Research Budgets are in Decline
It Is Less Clear What They AreDoing To Find Alternative Solutions
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Asset managers remain dependent upon investment banking research.
Bundled Research Universe
Unbundled Research Universe
Most asset managers buy researchfrom < 100 investment banks.
This is the new battleground fordifferentiated asset manager alpha.
ResearchAggregators
Question for Pension Funds:
Where are yourasset managerson this spectrum?
~4,600
Future Alpha Generation:Leveraging the Wider Universe
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$21.4 Bln $9.1 Bln
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Asset Managers/Investment Banks:Profitability Comparison – Global P&Ls
35.0
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Asset Managers – Active Equities Investment Banks – Cash Equities
OperatingCost
OperatingProfit
OperatingCost
OperatingProfit$ Billions
10.7
5.7
20.0
(5.0)
PT Margin: 23.4%
ResearchCost
-2.5 Margin: -11%
Investment banks are losing money in cash equitiesin part because of research costs.
$21.4 Bln $9.1 Bln
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Asset Managers/Investment Banks:Profitability Comparison – Global P&Ls
35.0
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Asset Managers – Active Equities Investment Banks – Cash Equities
OperatingCost
OperatingProfit
OperatingCost
OperatingProfit$ Billions
10.7
5.72.5
5.0
PT Margin: 23.4%
ResearchCost
15.0
-2.5 Margin: -11%
What if the cost of sell-side research migrated to the buy-side?
Impact on Investment Banks.
5.0
Cash equities become profitable.
$21.4 Bln $9.1 Bln
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Asset Managers/Investment Banks:Profitability Comparison – Global P&Ls
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Asset Managers – Active Equities Investment Banks – Cash Equities
OperatingCost
OperatingProfit
OperatingCost
OperatingProfit$ Billions
5.72.5
5.0
PT Margin: 23.4%
ResearchCost
PT Margin: 12.4%
Shifting the I.B. research costto the asset management P&Lwould reduce asset manageroperating margins by ~50%.
15.0
-2.5 Margin: -11%
What if the cost of sell-side research migrated to the buy-side?
Impact on Investment Banks.5.0
40.0
5.7
Impact on Asset Managers.
Are there ways to avoid this outcome?
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Institutional equities is a very unique market - ~$20 billion worth ofproduct is distributed without any contracts or pricing mechanism.
When the cash equity businesses of investment banks wereprofitable, this was sustainable.
Will investment banks be willing to provide unpriced research toasset managers produced by chronically unprofitable cash equitybusinesses - forever?
What will their shareholders say? (Who, by the way, are assetmanagers).
Asset managers are suddenly looking for benchmarks for researchspending.
This is in response growing pressure from regulators andclients to gain a greater understanding of asset managerresearch spending.
Investment Bank Research:
Analyzing Industry Change Reality Check
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Is It Finally Time To Discuss Price?
Accelerating Regulatory Change
FSA “Conflicts of Interest for Asset Managers” – Nov. 2012
New Commission Rules: Groundbreaking Implications
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The “Regulatory Revolution”
UK asset managers are in unknown territory. It’s not clearhow vigorously “Conflicts of Interest” will be enforced. But,having given personal guarantees, managers won’t want totake that risk - and will very likely implement it themselves.
In Feb. 2013 the CEOs of 195 UK asset managers hadto personally sign-off to the FSA that their firms werecompliant with new FSA commission rules. Most thoughtthat would mark the end point of the FSA initiative.
Commissions allocation regulatory issues have real worldconsequences:
They were wrong.
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FrostConsulting UK Regulators: Raising the Stakes
November 2012
If this “Best Practice” is enforced it will require UK asset managers to set actual research budgetsby provider. This moves towards a quasi-priced research environment…….….. and may precipitate a global restructuring of the institutional equity business.
but there is one more major wild card -
Increased CSA usage is a given …
Commission for corporate access is banned …
Total Commission Spending Research Commission Spending
2007 2013
“Conflicts of Interest”
Research Spending EvolutionRegulatory Impact
Impact:
- Eliminates “tidal” increase in researchcommission spending. Fixed researchbudgets per producer will reduceoverall research budgets.
- Forces asset managers to be morefocused, selective and disciplined inresearch commission spending.
- Likely leads to a “priced” market forresearch from investment banks.
- Lowers cross-cycle ROEs for I.B.research producers.
- Further reduction in I.B. researchbudgets. Produce and deliver onlywhat research is demanded.
- Producers must distinguish access/service levels between purchased andunpurchased research products.
- Asset managers must diversify sourcesof research.
- Compliance will force managers to useresearch budgeting system globally.
(Cyclical) (Suddenly Uncyclical)
Equity commissions are very cyclical. Historically, the research component of the commission has mirrored this.
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Asset Manager Research ProcurementEvolving Commission Allocation Process
Payment Allocation MonetaryPricing Mechanism Mechanism Value
BundledUniverse
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Equalizing Apples and Oranges
Why does this matter?
UnbundledUniverse Priced ???? Specific
VariableBroker VoteEquity TradesUnpriced
Research “Pricing”Evolution
What impact doesbuying productsfrom this universe
Have on this universe?
Creating a consistent research valuation framework.
Cash(CSA)
Asset Manager Challenge:
1. Regulators – (FSA/SEC/ERISA)
2. Clients
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Evolving Asset Manager Process
Consuming “priced” research creates an informal priceframework for “unpriced” research.
This is already happening – paying brokers via CSArequires the asset manager to assign a specific price to“unpriced” products and services.
Likely Future State
Establishing a fixed research budget per provider will loweroverall research spend, particularly in up markets.
It will no longer be practical for even the largest assetmanagers to “get everything from everybody”.
Managers will have to be more selective - some are alreadylimiting the number of sector research teams that PMs/analystscan vote for/(purchase).
Managers will continue to dictate research prices – but willspecifically identify which products they wish to buy.
Previous vote/spending patterns will evolve into a price listmanagers are willing to pay for varying levels of researchservices.
Asset Manager: “We would like to buy Tier One Research coverage in sectors A-B-C at $100K each andTier Two coverage in D/E/F/G for $50K each”.
Questions for the Research Provider: 1. Is this profitable at this price (what is the cost and ROI)?
2. What is the policy on providing products/services to thisasset manager that they have not purchased?
Looking Ahead
2013 2015?
Future Research Procurement Negotiating Framework
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Ends the binary ON/OFF investmentbank research entitlement process..
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Changing Research Procurement
Implications
Banks will only produce research someone is willing to pay for.
Banks will have to restrict access to research that hasn’t been purchased – to protect research that has been.
Asset managers will only get research they are willing to pay for - but will want to see what else is available.
Current research paradigm – Asset managers turned ON or OFF.
Coming environment – Premium services for paying subscribers, Freemium products to attract new customers.
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“Broker Vote”
PMs
Analysts
Votes
Bank #1
Bank #1
Result
Bank #1 onApproved
List
CommissionAllocation
System
Bank# 1
Equity Orders
All Bank 1 Research ON
PMs
Analysts
Purchases
CommissionAllocation
System
Bank #2
Bank #3
Auto Sector:Tier 1 Service
Pharma Sector:Tier 2 Service
Purchase Offers
Payment Mechanism
Payment Mechanism
Bank# 2
Bank# 3
Tier 1 Price
Tier 2 Price
Equity Orders
CSA Payment
Bank 2 Auto Research ONLY
Bank 3 Pharma Research ONLY
CommissionBudgeting
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($Billions)USA Japan/Asia/EM Europe
17.1
12.1
12.3
6.4
12.0
5.0
Peak 2012 Peak 2012 Peak 2012
Global Institutional Equity Commissions
Cyclical Considerations
-29%
-48% -58%
Global Peak to 2012 Decline: ~43%
Key Question:
What is the baselevel for researchbudgeting?
Commissions more volatile in “ad valorum” markets: (ex-North America)
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New research aggregation platform featuring wide content universeand groundbreaking search. Links to commission allocation/CSAtools.
Multi-party reporting, management and reconciliation of CSAcommissions. Links to commission allocation tools.
Oversight/benchmarking of ~$20 billion per annum in asset managerequity research spending – New ERISA, FSA rules.
CSA Payment Custodian - CSA “PayPal” for asset managers.
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The Unbundled Services Vertical
The Future Is Now
FrostConsulting Conclusion
The asset management industry has theunusual luxury of using client money to buythe main raw material in its industrial process. Change Required
Many asset managers are trying to adapt research procurementprocesses that were designed primarily for consuming investmentbanking products to accommodate a wider universe.
This is changing decades-old payment methodologies.
Economic and regulatory pressures will force a more transparentdiscussion between asset managers and research producers asto precisely which products are demanded and purchased – andat what price.
The post-Glass-Steagall “waterfront” sell-side research coveragemodel is likely unsustainable.
Asset managers must do a better job of identifying which sell-sideresearch they truly value and make sure that they pay enough forit that it remains profitable to produce.
Asset managers need research spending benchmarks to helpbetter explain research commission spending to clients,regulators and themselves.
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?
For more information please contact:
Neil Scarth
UK cell +(44) 774 865 2356
Susan Walton
UK cell +(44) 774 865 2456
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