After its five year run Elliot Spitzer's Global Research Analyst Settlement has allowed independent equity research to flourish.
Born out of New York attorney general Elliot Spitzer’s investigation into conflicts of interest among research analysts at investment banks, the Global Research Analyst Settlement – or simply the global settlement – has been described as ‘the nail in the coffin of sell-side research’ as well as a ‘pot of gold’ for independent research providers. After all the ink and talk, the settlement ended its predetermined five-year run on July 31.
In addition to imposing $1 bn in penalties, greater analyst disclosure and Chinese walls between banking and research at 12 major investment banks, the global settlement compelled the dirty dozen to cough up $460 mn to fund third-party independent research reports for retail clients.
While few observers credit the settlement itself with significant impact beyond the terms of the agreement, the controversy shone a spotlight on independent research and increased coverage among major independents. ‘In many ways I feel like the world has come around to our way of thinking, recognizing the potential conflicts and mixed motivations’ of traditional brokerage research,’ says Morningstar CEO and founder Joe Mansueto.
In ramping up to provide research to half a dozen banks under the settlement, Morningstar quadrupled its research universe to 2,000 companies, trebled its research staff to more than 100 analysts and expanded its research focus outside the US.
Standard & Poor’s (S&P) sold research to 11 of the 12 banks in the settlement and expanded its research universe from 1,300 companies to 1,600 before settling back to 1,520 today, according to Stephen Biggar, S&P’s vice president of equity research. As evidence of the continued value of independent research, Biggar points out that only 25 percent of companies covered by S&P rate a ‘buy’ or ‘strong buy’ recommendation, compared with a typically higher proportion in traditional sell-side coverage. ‘It’s difficult for 50 percent of stocks to outperform the market,’ he observes dryly.
Hold means hold
One tangible result of the settlement was that ‘the language of the street became more transparent for investors’ with required disclosures of banking relationships, analyst track records and affirmations of their opinion, according to John Eade, director of research at Argus Research. ‘Sell, buy and hold ratings started to mean something again,’ he adds. With 10 of the 12 settlement banks distributing its reports, Argus expanded its research universe from 300 companies to 700 at the height of the settlement.
The controversy that sparked the settlement also brought independents together. Recognizing that Spitzer and the SEC were going to take drastic action involving the research industry, five firms formed the Investorside Research Association, a trade group, in 2002. ‘We wanted to make sure our industry had a seat at the table,’ Eade says. The association now numbers nearly 80 firms and certifies the independence of members’ research processes.
As Spitzer’s investigation was picking up momentum in the US, the UK was developing a self-regulatory approach to commission allocations between research and execution, putting the issue of independent research front and center across the European business press and fueling a growing independent research industry in Europe. In 2006 the European Association of Independent Research Providers, a sister trade association to Investorside, was formed to serve the developing European scene.
‘Independent research is not an easy product to buy,’ says Nicholas Mather, CEO of UK-based Trusted Sources, which focuses on macroeconomic research in emerging markets. Portfolio managers need to push the case for a particular product through their internal bureaucracy, and independents need to stay visible to ensure they get paid. In addition, independent research ‘lacks the sales and management firepower to compete, especially in Europe, with a UBS or Goldman Sachs,’ Mather observes.
Despite these challenges, Mather remains bullish. ‘It’s a long haul, independent research, but I definitely believe it’s a growth industry,’ he says. He sees the Asian institutional investment community as his biggest growth opportunity and an easier sell, because Asia lacks the ‘regulatory drag around getting sales’ that he faces elsewhere.
New categories
The proliferation of independent firms has created whole new categories of equity research. Michael Mayhew, chairman and global director of research at Integrity Research Associates, cites as one example ‘web-scraping firms’ deploying software robots to collect data or process text.
Mayhew founded his firm during the pre-settlement turmoil to help institutions find new research providers and monitor existing ones. Integrity ‘developed a whole taxonomy around different types of research’ beyond traditional fundamental research, to include expert networks, channel checks, forensic accounting, quant firms, macroeconomics and Washington policy, among others, says Mayhew.
Mayhew expects boutique research firms to continue to proliferate. An analyst with a reasonable name and following can build a research business at low cost, which Mayhew describes as ‘more of a lifestyle business’. He wonders whether the traditional sell side will unintentionally drift back to a more biased research process. ‘Reg FD eliminated a lot of the competitive advantage of sell-side research’ and the settlement was merely ‘the nail in the coffin’ for the old model, he believes.
So what’s the future for independent research? Not all settlement signatories have stopped offering third-party research to their retail clients. Merrill Lynch and Morgan Stanley have announced they are continuing to do so, and discussion is reportedly underway with other sell-side firms. Low-cost or no-cost options proliferate for individuals, from Morningstar and Yahoo! Finance to new online research tools such as Wikinvest. The biggest challenge for individuals may be evaluating the options.
Some settlement firms are trying to tap the appetite for independent research among their institutional clients. Credit Suisse, UBS and Goldman Sachs have all made investments in or established alliances with independents to bolster their institutional research offering. The Bank of New York Mellon, while not a signatory, has developed an independent research network and consultancy, Jaywalk Research, to service settlement firms as well as buy-side clients.
Exchanges fill the breach
The biggest challenge following the end of the settlement may be for IROs of research-starved small and mid-cap companies. Recognizing this, the exchanges are getting in on the act, developing partnerships with independents to provide either exchange-sponsored or issuer-sponsored research for listed companies. NASDAQ OMX partnered with Morningstar, while the London Stock Exchange teamed up with Argus; NYSE Euronext has a deal with software firm Virtua Research to provide do-it-yourself financial modeling and valuation tools, but no qualitative research.
Spitzer will be remembered for many things, but the global settlement may turn out to be his most lasting legacy. ‘The sell side as we knew it is gone forever,’ concludes Richard Leggett, chair of Investorside and CEO of behavioral research firm Business Intelligence Advisors. The settlement ‘brought mainstream awareness for the potential of independent research and created a wonderful backdrop,’ he says, and this catalyzed professionalism and a rising meritocracy.
Leggett adds that he saw the quality of research rise as some of best talent exited traditional sell-side firms to start their own independent research firms. On the other hand, as a former sell-side analyst, he laments the ‘collateral damage’ that ‘tainted the broader research industry’ because of the negative stereotype created by the settlement.
