After a heady rise to prominence, research fell from grace just as quickly. Now it is making a recovery – although, as Edward Russell-Walling reports, banks are ensuring that this time there are firm barriers between research and their other functions, such as sales.
Stock market research analysts have come a long way since they were known as “stats” and located next to the post room. However, after following a spectacularly high trajectory, in the past few years this has faltered, as scandal and slump have raised fundamental questions over their role.
As it became clear that many ranked analysts were serving the interests of investment bankers – rather than that of investors – researchers’ star status evaporated. The sector swapped the penthouse for the doghouse, from which it is only now beginning to re-emerge.
Alongside the loss of public esteem, research suffered a more direct physical assault, as integrated investment banks responded to the market downturn by slashing both analysts’ numbers and their pay. Industry sources reckon headcount is typically down by about one-third compared with 2000.
Things are beginning to change, however, helped by the fact that the cash equity business is once again making money. Lessons, it seems, have been learned and the research industry is now adapting its organisation, procedures and goals as it implements new conflict-of-interest rules on both sides of the Atlantic. It is motivated in this by the demands not just of regulators, but also of clients and the banks’ own business strategies.
Survival questioned
When it became clear that the links between analysts and investment banking were to be cut, some questioned whether in-house research would survive in any meaningful way: if you can’t talk to your analysts, why employ them? Independent research boutiques poised themselves for a surge of new business.
In the US, brokers are now obliged to distribute “independent” research alongside their own. In the UK, at least one smaller broker has turned exclusively to independent research and others may follow, but this is at the small-cap end of the market.
The heavyweights have reaffirmed their commitment to in-house research. “We believe that a strong differentiated research effort that is firmly aligned with the interests of our investing clients will be an important part of our equities business. We are often asked by our clients for a view on transactions in the market and you need a high quality research product to have an informed view,” says Neil Crowder, managing director, international equity research at Goldman Sachs International.
However, in the prevailing climate, many feel the subject remains too sensitive to discuss in public – few bankers are willing to comment on the record about their or others’ business models.
One indicator of the changing climate is a cautious return to hiring, at least among the biggest houses. “The mentality has changed from one of where to cut to how to grow,” confirms one US research manager. “We’re nowhere near to where we were in 2000, but we’re coming out of the doghouse as an industry.”
New regulations
As they start to breathe more easily, banks and brokers have had to implement new regulatory regimes imposed by the US Securities and Exchange Commission (SEC) and the UK Financial Services Authority (FSA), backed up by new guidelines from trade associations such as the Bond Market Association. Though US and UK rules differ in structure and scope, both are designed to manage conflicts of interest between research and investment banking, sales and trading, principally by re-erecting long-neglected Chinese walls.
So analysts are now being fenced off from investment bankers, who may no longer collaborate with them or determine their pay. Research is not allowed to participate in pitches for corporate finance business, even though many fund managers are beginning to wonder whether this is an good thing, particularly when it comes to pricing an issue. In a recent survey by Thomson Extel, more than half of the fund managers questioned felt that analysts should be involved in IPO pitches.
There are other perceived downsides. In the US, for example, analysts are now specifically forbidden to suggest transactions to investment bankers. One banker points out that, since analysts have a better grasp than most of their chosen industries, this could starve investment banking of sensible, workable corporate finance ideas.
The doghouse years and their aftermath also prompted something of a brain drain from the industry. Certain senior analysts have migrated to investment banking, while others have left the industry altogether. As fund managers continue to do more of their own basic research, they have managed to lure away some of the better sellside talents.
One of the principal differences between the SEC and FSA dispensations is that, while the former’s rules apply only to equity research, the latter’s apply across all asset classes. This has put the (largely London-based) international bond market’s nose out of joint.
Richard Britton: prohibition could damage the economy of the dealer business model
Neil Crowder, Goldman Sachs: ‘You need quality research to be able to comment on transactions’
Pain for bond dealers
Bond dealers say that fixed-interest securities are less susceptible to hype and much harder to manipulate than equities. They are especially pained at a rule that prohibits dealing ahead of the publication of new research. Theirs is a less liquid market than equities, they argue, adding that analysts needed to know a stock will be available before publishing a positive note on it.
“Firms should be allowed to pre-position themselves to meet expected customer demand, if they don’t change prices,” says Richard Britton, a consultant on international regulation to the International Securities Market Association.
He believes that this prohibition could damage the economy of the dealer business model. “London’s success is largely driven from its dealer markets,” he insists. “Their activity is research and inventory-driven. Take that away and you will make it less liquid.”
Detail aside, most in the industry accepts that a new regime was both necessary and inevitable. Research departments are working hard to restore faith by instituting new procedures and by burnishing the quality of the product. Where one set of rules differs from the other, most big houses have opted to apply the tougher variety across all jurisdictions.
Building walls
Citigroup has gone a step further and rehoused its equity research and retail broking operations in a separate Smith Barney business unit. Others have been less radical, while still erecting distinct walls between research and fee-generating units, though sometimes in different ways. The FSA has been less prescriptive than the SEC, insisting merely that firms publish a clear policy for managing conflicts, while indicating certain practices that would not be acceptable.
Dresdner Kleinwort Wasserstein (DrKW) was not part of the Spitzer/SEC global settlement, but has nonetheless extended the requisite conflict procedures across its entire business, including fixed income research. It has established ‘supervisory analysts’ who straddle communications between research and corporate finance, ensuring that any investment theses, evaluations or recommendations are stripped out. “We took the view from the beginning that this was driven by business and not regulatory imperatives,” observes DrKW research manager Rick Levitt. “We felt we had to do this to maintain the reputation of the firm and of the business.”
At Goldman Sachs, analysts are now chaperoned by a compliance officer whenever they meet with an investment banker, and no emails can be sent between the two departments.
This type of structure is now universal. But there is also a fresh focus at certain houses on improving the quality of the product itself, while asserting its independence. Some have ceased ‘maintenance’ research in written form (publishing notes when the company has released figures or made an announcement). The idea is that these add little value for institutional clients, who are themselves increasingly savvy. Instead, analysts are being pushed to generate more story-driven, creative ideas, with strategic or relative value trade recommendations.
More co-operation
There is also closer co-operation between equity and credit research at banks such as Credit Suisse First Boston and Goldman Sachs. The latter has combined its equity and debt sales and trading activities in Europe and Asia, to boost its broking business. The firm believes that a strong trading presence is necessary to obtain investment banking mandates and market intelligence. Equity and debt analysts haven’t formally merged, but work closely together and, occasionally, collaborate on reports.
The technology bust showed that trouble can show up in a company’s debt before its shares, and it can sometimes be beneficial for debt and equity analysts to compare notes. Goldman Sachs’ Mr Crowder believes, however, that debt and equity research will maintain their separate identities for the most part. For many companies’ shares, fixed interest research is of limited use, and corporate finance mandates, where the two teams might work together, are unlikely. “But in companies like Alstom and Invensys, fixed interest plays a key role in what equity markets do,” he points out.
No going back
Research may be coming back into the light, but some banks are determined not to allow any revival of the old rock star ethos – along with its celebrity remuneration packages. Morgan Stanley, Smith Barney and Goldman Sachs are all de-emphasising external rankings, such as those published by Institutional Investor and Thomson Extel, when assessing their analysts’ performance.
In the old days, being ranked among the top three in a sector would do wonders for an analyst’s income. However, the industry is beginning to understand that this type of league table tends to measure distribution rather than research quality.
Morgan Stanley says it is now emphasising research teams rather than individual analysts. Instead of using external rankings when reviewing their performance, it says it will refer to a team assessment poll by consultants Greenwich Associates.
Smith Barney and Goldman Sachs employ a combination of internal assessment and client evaluation. Many fund managers compile their own quantitative rankings to determine how much business to award each of their brokers. It is these rankings that the likes of Goldman Sachs and Smith Barney now refer to at review time. By remembering the mistakes of the past, banks are hoping not to repeat them.
