The Extinction of Sell-Side Research

Frost
Consulting
The Extinction of Sell-Side Research
And What It Means to Asset Managers
Frost Consulting
May 2013
Frost
Consulting
The Leading Authority on Global Unbundling

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
Events/Presentations/Publications
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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 Extinction of Sell-Side Research – London, May 2013

Inflection Point for Institutional Equities? – London, Feb. 2013
Publications:
The Changing Face of Research Procurement – Nov. 2012
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Frost
Consulting
Key Questions
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”
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Frost
Consulting
Nuclear Winter?
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 asset
management research spending.
- Significant reduction in the number of equity execution
counter-parties.
- CSA research payments at lower levels than research
commission payments via equity execution.
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Frost
Consulting
Overview of the Global Commission Market
Institutional Secondary Equity Commissions
Global Total 2011e - US$33 Billion
Change has happened.
Change just beginning.
Best X, Exchange Competition
CSAs, New ERISA/FSA Rules
Non-Execution
Execution
33%
Regulatory Regimes:
“Best Execution”
Reg. NMS
$ 10.9 Bln
67%
$ 22.1 Bln
Regulatory Regimes:
Historic:
None
Commencing: ERISA/FSA
Plan Sponsor Scrutiny:
Plan Sponsor Scrutiny:
Level:
Level:
High
Low
Means: TCA
Means: None
Penetration: ~85%
Penetration: ~0%
Plan Performance
Risk: Moderate
Plan Performance
Risk: High
0-200 Bps per annum
0000s Bps over time
Non-execution commission spending is entering the regulatory spotlight.
*Frost Consulting Estimates
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Consulting
CSAs: Mechanics (Europe)
Typical Trade
Client CSA Account
3rd Party Research
(Held by CSA Broker)
Research
Commission – 67%
$21.4 Bln
$9.1 Bln
CSA Execution Broker
Execution
Commission – 33%
Ends the investment bank
monopoly over asset manager
research spending.
Research payment for execution broker:
Part of the research commission is often
allocated to the CSA execution broker.
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Frost
Consulting
Unbundled Commissions: Regional Penetration
Percentage of Total Volume Traded
Europe (Ex-UK)
UK
70%
50%
US
40%
*Frost Consulting Estimates
Large asset managers using CSAs: UK 90%, Europe (ex-UK) 60%, US, 80%
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Frost
Consulting
Global Perspective
Unbundled Commissions – Penetration by Market
> 50%
20 - 50%
< 20%
Game Over for Bundled Model
Growing Rapidly
Emerging
UK: Global
US: Fastest
Regulatory
growth
Leader
globally.
France
EU: Varies by
Japan
Sweden
country
Switzerland
Germany
Canada
Netherlands
Hong Kong
Australia
Managers in geographies where there are impediments to unbundling are at a competitive disadvantage globally.
*Frost Consulting Estimates
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Frost
Consulting
Avg. Number Execution Counter-Parties*
(European Asset Managers - Ex Bulge Bracket)
European Cash Equities
28.3
16.5
- 41.7%
16.5
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CSAs will continue to encourage asset managers to reduce execution counter-party lists.
* Greenwich Associates – Average: Large Asset Managers
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Frost
Consulting
The UK CSA Experience:
Extinction in Action
Small/Mid-Cap Brokers
Secondary commissions available to the
UK small/mid-cap brokers have fallen by
an estimated 80% since 2007.
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Frost
Consulting
Global Asset Manager Perspective – UK Equities
Market Weights – Global Equity Index
Widely used global benchmark.
How many dedicated UK
small/mid-cap execution
relationships are necessary
for a global asset manager?
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Frost
Consulting
Bundled Environment - UK Small/Mid-Cap
Multiple Direct Dealing Relationships
UK Small/Mid-Cap Broker Universe 2008
Global
Asset Manager
In a bundled commission environment each research relationship
requires a separate execution relationship. Execution Relationships: 22
Is this sustainable?
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Frost
Consulting
Intensity of Investment Banking Competition
Average Number of Brokers per 1% of Global Market Cap
17.8
*
2008
5.8
4.2
0.7
*Frost Consulting Estimates
0.9
1.1
1.9
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Consulting
Commission Unbundling “End-Game:
The Perfect Storm
Disintermediation in Mid/Small Cap UK Equities
2007
Traditional Market
% of Total Commissions
2012
Impact
Market Depreciation
Traditional Market
% of Total Commissions
Evaporated
CSA Market
Bulge
Bracket
Shift to CSAs
Remaining Available
Commission
Execution Commission
Portion of Compensation via
CSA payments: not execution.
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.
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Frost
Consulting
Investment Bank Research:
Declining Sell-Side Coverage
Evidence From Multiple Sources
estimates that 35-40% of publically listed companies have no analyst coverage.
Large
Research
Aggregator
Average number of analysts per equity:
2005
2012
4.01
2.02
London-based firm providing “issuer sponsored” research.
Clients include:
Market Cap: $5.1 billion
# of Sell-Side Analysts: 18
Market Cap: $17.3 billion
# of Sell-Side Analysts: 12
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Consulting
Transition to the Unbundled Environment
Old Model: “Information Bunker Mentality”
Asset Manager Approved List: Firewall for Alpha
Specialized
Research
Quants/
Databases
Management
Consultants/
Expert Networks
Investment Bank
Research
Specialist
Investment
Banks
Regional
Brokers
$21.4 Bln
$9.1 Bln
Average asset manager content selection
limited to >100 brokers on the manager’s
“Approved Broker List”.
Global
Investment
Banks
Independent
Fundamental
Research
Sustainability/
SRI
Research
Managers bombarded by unsolicited input
from 250+ brokers. Reluctant to accept
content from new sources as each would
require an additional (unwanted) execution
relationship.
Research Procurement: Asset Managers
Frost
Consulting
Traversing the “Alpha Gap”
%
$ Billions
10.0
9.0
$8.2 billion
Aggregate global
investment bank
research budget.
(~600 firms)
(Right Scale – Red Line)
8.0
~40% reduction in
capital allocated to
sell-side research.
2008 – 2013.
7.0
Alpha Gap
6.0
5.0
$4.8 billion
4.0
3.0
2.0
CSA % of Global
Equity Trade
1.0
(Left Scale- Blue Bars)
Asset managers that do not unbundle are at a competitive disadvantage.
*Frost Consulting Estimates
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Consulting
Asset Manager
Plan Sponsor
CSAs: Asset Manager View
Exploding the Asset Manager Content Universe
Client CSA Account
(Held by CSA Broker)
Universally Distributed
Historic Inputs
Portfolio Process
New Inputs
Research
Commission
$22
Billion
Globally
$21.4 Bln
CSA Broker
Execution
Commission
Key Questions:
1.How do asset managers find nonbrokerage research content?
$9.1 Bln
Proprietary Network
$11
Billion
Globally
2. How do research producers penetrate
asset manager content firewalls?
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Frost
Consulting
Investment Banking Research Perspectives
I.I. European CIO Roundtable – Amsterdam March 2012
Asset Managers Know That Investment
Bank Research Budgets are in Decline
Investment Banking Research Budgets:
Expected % Change through 2015 Asset Manager CIO Responses
It Is Less Clear What They Are
Doing To Find Alternative Solutions
How dependent are asset managers on brokerage research?
“Percentage of Total Research from Investment Banks” Asset Manager CIO Responses
Asset managers remain dependent upon investment banking research.
Questions for Pension Funds: What are the implications for asset manager performance?
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Frost
Consulting
Future Alpha Generation:
Leveraging the Wider Universe
Unbundled Research Universe
Bundled Research Universe
Research
Aggregators
~4,600
Question for Pension Funds:
Where are your
asset managers
on this spectrum?
Most asset managers buy research
from < 100 investment banks.
This is the new battleground for
differentiated asset manager alpha.
Frost
Consulting
$ Billions
Operating
Cost
Asset Managers/Investment Banks:
Profitability Comparison – Global P&Ls
Operating
Profit
Operating
Cost
Operating
Profit
Investment banks are losing money in cash equities
in part because of research costs.
$21.4 Bln
$9.1 Bln
(5.0)
35.0
Research
Cost
PT Margin: 23.4%
20.0
10.7
5.7
-2.5
Asset Managers – Active Equities
Margin: -11%
Investment Banks – Cash Equities
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Consulting
$ Billions
Operating
Cost
Asset Managers/Investment Banks:
Profitability Comparison – Global P&Ls
Operating
Profit
Operating
Cost
Operating
Profit
What if the cost of sell-side research migrated to the buy-side?
Impact on Investment Banks.
5.0
$21.4 Bln
Cash equities become profitable.
$9.1 Bln
Research
Cost
5.0
35.0
PT Margin: 23.4%
10.7
15.0
5.7
2.5
-2.5
Asset Managers – Active Equities
Margin: -11%
Investment Banks – Cash Equities
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$ Billions
Operating
Cost
Asset Managers/Investment Banks:
Profitability Comparison – Global P&Ls
Operating
Profit
Operating
Cost
Operating
Profit
What if the cost of sell-side research migrated to the buy-side?
5.0
Impact on Asset Managers.
Impact on Investment Banks.
5.0
40.0
$21.4 Bln
$9.1 Bln
Shifting the I.B. research cost
to the asset management P&L
would reduce asset manager
operating margins by ~50%.
Research
Cost
Are there ways to avoid this outcome?
PT Margin: 23.4%
PT Margin: 12.4%
15.0
5.7
2.5
-2.5
Asset Managers – Active Equities
Margin: -11%
Investment Banks – Cash Equities
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Consulting
Investment Bank Research:
Is It Finally Time To Discuss Price?
Analyzing Industry Change
Reality Check
Institutional equities is a very unique market - ~$20 billion worth of
product is distributed without any contracts or pricing mechanism.
When the cash equity businesses of investment banks were
profitable, this was sustainable.
Will investment banks be willing to provide unpriced research to
asset managers produced by chronically unprofitable cash equity
businesses - forever?
What will their shareholders say? (Who, by the way, are asset
managers).
Asset managers are suddenly looking for benchmarks for research
spending.
This is in response growing pressure from regulators and
clients to gain a greater understanding of asset manager
research spending.
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Consulting
Accelerating Regulatory Change
FSA “Conflicts of Interest for Asset Managers” – Nov. 2012
New Commission Rules: Groundbreaking Implications
Frost
Consulting
The “Regulatory Revolution”
In Feb. 2013 the CEOs of 195 UK asset managers had
to personally sign-off to the FSA that their firms were
compliant with new FSA commission rules. Most thought
that would mark the end point of the FSA initiative.
They were wrong.
UK asset managers are in unknown territory. It’s not clear
how vigorously “Conflicts of Interest” will be enforced. But,
having given personal guarantees, managers won’t want to
take that risk - and will very likely implement it themselves.
Commissions allocation regulatory issues have real world
consequences:
Frost
Consulting
UK Regulators: Raising the Stakes
November 2012
Commission for corporate access is banned …
Increased CSA usage is a given …
but there is one more major wild card -
If this “Best Practice” is enforced it will require UK asset managers to set actual research budgets
by provider. This moves towards a quasi-priced research environment…….
….. and may precipitate a global restructuring of the institutional equity business.
Frost
Consulting
Equity commissions are very cyclical.
Research Spending Evolution
Regulatory Impact
Historically, the research component of the commission has mirrored this.
Impact:
“Conflicts of Interest”
- Eliminates “tidal” increase in research
commission spending. Fixed research
budgets per producer will reduce
overall research budgets.
- Forces asset managers to be more
focused, selective and disciplined in
research commission spending.
- Likely leads to a “priced” market for
research from investment banks.
- Lowers cross-cycle ROEs for I.B.
research producers.
- Further reduction in I.B. research
budgets. Produce and deliver only
what research is demanded.
- Producers must distinguish access/
service levels between purchased and
unpurchased research products.
- Asset managers must diversify sources
of research.
- Compliance will force managers to use
research budgeting system globally.
2007
Total Commission Spending
(Cyclical)
2013
Research Commission Spending
(Suddenly Uncyclical)
Frost
Consulting
Asset Manager Research Procurement
Evolving Commission Allocation Process
Equalizing Apples and Oranges
Pricing
Bundled
Universe
Unbundled
Universe
Unpriced
Priced
Payment
Mechanism
Equity Trades
Cash
Allocation
Mechanism
Broker Vote
????
Monetary
Value
Variable
Specific
(CSA)
Research “Pricing”
Evolution
Have on this universe?
What impact does
buying products
from this universe
Asset Manager Challenge:
Creating a consistent research valuation framework.
Why does this matter?
1. Regulators – (FSA/SEC/ERISA)
2. Clients
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Consulting
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Looking Ahead
2013
2015?
Evolving Asset Manager Process
Likely Future State
Consuming “priced” research creates an informal price
framework for “unpriced” research.
This is already happening – paying brokers via CSA
requires the asset manager to assign a specific price to
“unpriced” products and services.
Ends the binary ON/OFF investment
bank research entitlement process..

Establishing a fixed research budget per provider will lower
overall research spend, particularly in up markets.

It will no longer be practical for even the largest asset
managers to “get everything from everybody”.

Managers will have to be more selective - some are already
limiting the number of sector research teams that PMs/analysts
can vote for/(purchase).

Managers will continue to dictate research prices – but will
specifically identify which products they wish to buy.

Previous vote/spending patterns will evolve into a price list
managers are willing to pay for varying levels of research
services.
Future Research Procurement Negotiating Framework
Asset Manager:
“We would like to buy Tier One Research coverage in sectors A-B-C at $100K each and
Tier Two coverage in D/E/F/G for $50K each”.
Questions for the Research Provider:
1.
Is this profitable at this price (what is the cost and ROI)?
2.
What is the policy on providing products/services to this
asset manager that they have not purchased?
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Consulting
“Broker Vote”
Changing Research Procurement
Votes
Result
Payment Mechanism
Bank #1
PMs
Analysts
Commission
Budgeting
Bank #1
Commission
Allocation
System
Purchases
Bank #1 on
Approved
List
All Bank 1 Research ON
Purchase Offers
Payment Mechanism
Bank #2
PMs
Analysts
Auto Sector:
Tier 1 Service
Bank #3
Pharma Sector:
Tier 2 Service
Equity Orders
Equity Orders
Commission
Allocation
System
Tier 1 Price
Bank
#1
Bank
#2
Bank 2 Auto Research ONLY
Tier 2 Price
CSA Payment
Bank 3 Pharma Research ONLY
Bank
#3
Implications
Banks will only produce research someone is willing to pay for.
Banks will have to restrict access to research that hasn’t been purchased – to protect research that has been.
Asset managers will only get research they are willing to pay for - but will want to see what else is available.
Current research paradigm – Asset managers turned ON or OFF.
Coming environment – Premium services for paying subscribers, Freemium products to attract new customers.
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Frost
Consulting
Cyclical Considerations
Global Institutional Equity Commissions
($Billions)
USA
Peak
17.1
Japan/Asia/EM
2012
Peak
2012
Europe
Peak
2012
-29%
12.3
12.1
12.0
-48%
-58%
6.4
Key Question:
5.0
Global Peak to 2012 Decline: ~43%
What is the base
level for research
budgeting?
Commissions more volatile in “ad valorum” markets: (ex-North America)
Frost
Consulting
The Future Is Now
The Unbundled Services Vertical
Oversight/benchmarking of ~$20 billion per annum in asset manager
equity research spending – New ERISA, FSA rules.
New research aggregation platform featuring wide content universe
and groundbreaking search. Links to commission allocation/CSA
tools.
Multi-party reporting, management and reconciliation of CSA
commissions. Links to commission allocation tools.
CSA Payment Custodian - CSA “PayPal” for asset managers.
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Conclusion
The asset management industry has the
unusual luxury of using client money to buy
the main raw material in its industrial process.
?
Change Required

Many asset managers are trying to adapt research procurement
processes that were designed primarily for consuming investment
banking products to accommodate a wider universe.

This is changing decades-old payment methodologies.

Economic and regulatory pressures will force a more transparent
discussion between asset managers and research producers as
to precisely which products are demanded and purchased – and
at what price.

The post-Glass-Steagall “waterfront” sell-side research coverage
model is likely unsustainable.

Asset managers must do a better job of identifying which sell-side
research they truly value and make sure that they pay enough for
it that it remains profitable to produce.

Asset managers need research spending benchmarks to help
better explain research commission spending to clients,
regulators and themselves.
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Consulting
For more information please contact:
Neil Scarth
UK cell +(44) 774 865 2356
[email protected]
Susan Walton
UK cell +(44) 774 865 2456
[email protected]
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