Spotlight On Independent Research

Independents rising in the new regulatory landscape

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For professional investors only

Not for onward distribution

A CONFERENCE, HELD ON 27th JANUARY 2016 AT BLOOMBERGS UK HEADQUARTERS IN

LONDON, WAS HOST TO A SPOTLIGHT SESSION ON THE ARRIVAL OF MiFID II AND ITS PAST
AND FUTURE IMPACT ON BOTH THE REGULATION FOR INDEPENDENT RESEARCH AND
THE STRUCTURE OF HOW THAT RESEARCH IS PRICED AND DELIVERED. SIX RESEARCH
EXPERT SPEAKERS DEBATED IN FRONT OF AN AUDIENCE OF 170 BUY AND SELL-SIDES.
The main theme that ran throughout the discussions was that a lack of clarity and
decision-making by regulators has caused confusion among independent research
firms and concern for what will happen next. We find ourselves in regulatory limbo.

ESMAs concern is that if research is provided

as a bundled product, funds will receive
duplications of research that they would not
necessarily select if they were paying for it
themselves.
- Sarah Jane Mahmud, Bloomberg Intelligence

EU securities regulator ESMA submitted its proposals, which are relatively simple, to
the European commission for endorsement in December 2014, but the commission
has not yet taken action. It should have published its delegated act in June 2015,
which would adopt some or all of ESMAs proposals, but silence still reigns. MIFiD II
was expected to take affect across the EU in January 2017, but implementation may
be delayed by a year, though ESMA recently indicated that a years grace may not be
sufficient.

Conflicts of Interest
MIFiD II aims to restrict conflicts of interest by requiring any benefit passed to an
investor that might be interpreted to an inducement to trade, to be paid for by the
client. ESMA uses investment research as an inducement to trade, thus seeking to
separate dealing commissions from payments for investment research. The bundled
pricing of research and execution services is seen as a barrier to transparent price
formation and competition.
In forcing the brokers to price research and charge for their services separately
regulators hope to minimise any potential conflict of interest, increase price
transparency and boost best execution.

Broker Votes
Broker votes are an important component for most independent research firms and on
average represent approximately 23% of revenue.
The audience of the more than 170 attendees at the spotlight session were asked
What percentage of IRP revenues come from cash payments on average? The results
are below.

Audience Question:
What percentage of IRP revenues come
from cash payments on average?

31%

19%

less than 10%

15%-20%
20%-30%
more than 40%

25%
25%

The results of the Integrity Research survey indicate that the true answer is more than
40% of independent research revenues come from cash payments. In addition, 90%
of revenues were paid through CSAs or cash, equally weighted. Only 10% of revenues
came through in-house trading desks as directed commissions, while average
revenues per buy side client were $55,793.

End of the Regulatory Tunnel

Eight years after the financial crisis, regulation is still being worked out, but the
uncertainty may be drawing to a close as end of the regulatory tunnel moves into sight.
When MiFID II was originally announced it appeared to present two potential opposing
outcomes: the death of Commission Sharing Agreements (CSAs) or, conversely, the
prevalence of CSAs across Europe. The latter of these two seems to be the path that
the market is taking and Sandy Bragg, CEO Integrity Research, sees MIFID II as
essentially a mandate to use CSAs and will be a tremendous boon for CSA adoption.
CSA adoption does vary by country, for instance France already has a well established
CSA culture, where as Italy and Spain have no CSA adoption and will take longer but
will increase eventually.

MIFID II is essentially a mandate to use CSAs

and will be a tremendous boon for CSA adoption.
- Sandy Bragg, Integrity Research

How Will Research Be Paid For?

The proposals put forward by ESMA would require investment research to be paid for
in one of two ways: either from the fund managers own account, which may be
recoverable for raising management fees, or through client research payment account
(RPA). But this comes with some strict conditions, for example, payments would need
to be based on a pre-agreed budget, clients would need to consent to any budget
increase and receive annual updates. And it is not permitted for the account to be used
for internal research. To avoid a drawn out negotiation with each client for a pre-agreed
research budget, some may opt to pay for research out of their own P&L rather than
affect the regulatory relationship with each client.

Audience Question: How do you plan to pay for research?

15%

28%

57%

RPA collected alongside transaction commission (CSA)

Direct out of the P&L
RPA collected separately at specified times

ESMA may allow dealing commissions to be used to fund a research payment account,
but their current draft is ambiguous on this point. ESMA has only stated that there
should be no link to transaction value or volume.

Fee Structures
The fee structure most prevalent among independent research firms is one in which
fees are tiered by product/ service level.
There are strong incentives for both the buy side and sell side to continue paying for
research using client commissions. Pressure on research payments will continue and
thus fees will become more transparent.
Paradoxically in the long tail of research, the lower revenues of set pricing are
counterbalanced by the lower volatility of cash payments. For research firms that have
these fee structures dependent on asset manager largesse.
This business model often has many more fallow periods than fertile ones and if
pledging puts a cap on research spending the volatility of revenues will be skewed to
the downside.

Most popular fee structures

Tiered by Product

21%

Menu Pricing

19%

Fixed Price

13%

Minimum Fee/No cap

10%

Tiered by Client AuM

10%
9%

Tiered by AuM & Product

Per User

7%

Priced by Project

7%

Price Taker

4%

Source: Integrity Research Associates, 2015 Research Pricing Survey

Transparent Pricing
There has long been concern that transparent pricing will cut the funding mechanism
for research. Since 2006, CSAs have been increasing the transparency around
independent research costs. However, the least successful independent research firms
are those using transparent pricing. Thus, the market it is being pushed in a direction
that is decreasingly profitable for research firms. According to Bloombergs long-term
survey on independent pricing, founded in 2003, the most lucrative firms utilise a client
driven fee structure with an average client revenue of over $80,000, while the least
lucrative firms employ a set pricing structure with an average client revenue of $31,000.
In addition, the set pricing model is mostly employed by smaller firms.

For smaller firms, lower revenues is an acceptable

trade-o in return for the certainty of regular,
predictable cash payments.
This is one of the reasons we do not see the level
of consolidation amongst firms that might
reasonably be expected.

So, why do these generally smaller firms use such an apparently impractical approach
and how can they survive in the hyper-competitive, over-supplied world of customer
research? The answer maybe be primarily due to a desire for stability. For small
boutique firms that cannot cross-subsidise research with other research-related
products, lower revenue count volatility means a higher chance of survival when
commissions decline. For smaller firms, lower revenues is an acceptable trade-off in
return for the certainty of regular, predictable cash payments. This is one of the reasons
we do not see the level of consolidation amongst firms that might reasonably be
expected.

There is a growing range of alternatives for buying

research and accordingly a greater range of prices.
This is partly due to the fact that asset managers are
discovering the variety of options for research pricing.
- Neil Shah, Edison

In the UK, 85% of asset managers already have CSAs in place, but current throughput
usage of those CSAs is significantly less than that figure and it will take some time for
the throughput to catch up.
IRPs receive high portion of revs *(45%) paid from asset managers wallets, a mixed
blessing. On the plus side, revenues are not subject to vagaries in commissions. The
downside is lower revenues. Most lucrative fee structures are those dependent on the
generosity of the buy side.
There is a strong correlation between fee transparency and product innovation. It is no
accident that independent research is where there is the most innovation. Research
providers relation on bundled pricing find it hard to get paid incrementally for
incremental services. In 2008 and 2009 many research analysts were laid off, so they
set up on their own which created an environment where wider and more esoteric
research was likely to occur.

It is no accident that independent research

is where there is the most innovation.
Research providers relation on bundled pricing
find it hard to get paid incrementally for
incremental services.

Investment banks have recently started to embrace transparent pricing. Independent

research will be place for experimentation in pricing. Performance based fee structures
will form part of the negotiation between buy and sell side and this dialogue will
become sharper and more transparent, but it will take several years and iterations for
this to evolve in to a firm model.
For funds that have large assets it is not a significant financial burden to fund out of
their own P&L, unless they require a great deal of research. Research is becoming a
global market, and as this is becoming more acceptable and common in the US and
Asia, so Europe will have to keep up with those competitors. European research firms
will be unable to afford to make themselves unprofitable when their international
competitors do not have to. It is for this reason that Sandy Bragg believes CSAs will be
the adopted method.

When there are more pricing options, buyers can

make more informed and better choices, thus
driving the competitiveness of the market and
allowing both buyers and sellers to monetise
peoples time.
- Laurence Herman, Gerson Lehrman Group

Future Market
The attendant audience at the spotlights session were asked if they expect the total
amount paid by firms for research to increase or decrease and by what amounts. The
results were as follows:

Audience Question:
Do you expect the total amount paid by firms for research to

4%
12%

26%

Decrease by 10%-20%
Decrease by 20%-30%
Stay the same
Decrease by more than 30%
Increase by 10%-20%
Increase by more than 30%

15%

16%

26%

The majority consensus is that fees for research will decrease. The driving force behind
this change could be that increased transparency in pricing means that the people
writing the cheque now know exactly what they are paying for. The FCA and FSA
previously thought there was too much money being spent on research and that it is
not being properly managed. Asset owners have realised they are paying too much, so
they are scrutinising what they are paying for, which leads to a decrease in overall
commission. This can actually give independents an advantage because they are able
to provide a good service for a lower price. The larger firms are less flexible in pricing
because of their larger overheads.

Non-Broker Research
Market share of non-broker research in the US is 15%-20%, whereas in Europe it is
closer to 5%. Europe market share will probably increase, partly through MiFID and
partly through market evolution. It is a tough market to set up as an independent
research firm, but more people keep trying. The lemmings keep falling off the
cliff. (Sandy Bragg). This increased competition for the CSA pot of money has made
companies retool their businesses (Neil Shah).

But if we end up in a situation where RPAs are

supercharged by CSAs that might actually help
Europe adopt CSAs, which in turn could boost the
independent sector.
- Peter Allen, Euro IRP

However, there is no correlation between where commissions are generated and where
they are spent (Nick Anderson, Head of Equity Research, Henderson Global Investors).
Overall revenue is going down and yet the expectation is that the number of
researchers will increase. Market pressures will eventually cause closures and
consolidation. Many researchers chose being an independent because they love their
job and want independence. They are not necessarily good business people and do
not want to work with too many other people. Interestingly, although larger institutions
have the financial resources to hire a bank of researchers, it is almost impossible to
replicate external research in house. In addition, fund managers used to depend on
what they got for free, but they are not getting that any more so they are turning to
smaller independent research firms.

Audience Question:
Do you expect the number of different research providers to

15%

Increase
Decrease
Stay the same

16%

69%

Independent research firms will be on the leading

edge of price discovery because they have the
least to lose and most to gain.
- Sandy Bragg, Integrity Research

VAT
A UK-specific tax is causing some independent researchers to change because the
client is not willing to reimburse the 20%, so the researches will take the hit on their
revenue. There is a disconnect in the understanding of this situation as HMRC, the UK
tax authority, believes that execution is unbundled with research, while industry
authorities see the two as bundled. It is difficult to claim that is excluded from VAT
charges and HMRC may well revisit this issue.

It is important to acknowledge that revenue streams and

pricing structures are not the only factors aecting
independent research firms. There are those who are
passionate about their work and creating quality research for
their clients.
- Peter Allen, Euro IRP

In Summary
So, where do we stand today? There is still much confusion among independent
research firms because of a lack of clarity and decision-making from regulators. The
last two or more years of uncertainty have been a drain on resources and focus for
researchers as it is impossible to plan for unknown regulation. It is not yet clear how
research will be paid for, but there are two clear options; either out of the asset
managers P&L or through pre-agreed annual budgets for each client. Both may coexist and the choice of which to go with will depend on a variety of factors including the
size and type of both the research firm and the asset manager and the relationship
between the buy and sell side.

It seems highly likely that overall research spending will reduce and with more
researchers entering the market it will become over-competitive, thus forcing an
increasing number of research firms, particularly new entrants, to go out of business. In
combination, there is too much research that is too similar. This is a status quo that
cannot be maintained. Regulatory and market pressures will force change and
consolidation.
The largest cohort (44%) of independent research firms achieve annual revenues of
$1m or less. This is not a business model that is based on significant profits and
scalability. Passion for the work is an important contributing factor.

IRPs 2014 Revenue Distribution (in USD)

22%

22%

14%

13%

12%
10%

7%

< 0,5m

0,5 - 1m

1 - 2,5m

2,5 - 5m

5 - 10m

10 - 20m

> 20m

One thing that remains constant throughout is that asset managers are looking for the
highest quality research at the lowest reasonable price. Asset managers are becoming
ever more selective about what they buy, and are thus placing ever greater scrutiny on
the quality of research. A la carte investment research may be on the rise as asset
managers opt for more tailored coverage over paying a lump some for wider
research (Sarah Jane Mahmud, Bloomberg Intelligence). Nick Anderson, Head of
Equity Research, Henderson Global Investors, asserts that research is really an advisory
service and its price is ultimately determined by the value of that service to its clients.
The incentive to generate value for clients will continue. It is clear that fee structures are
still evolving and we can expect more change.

AUTHOR
Fabrice Bouland, Co-Founder & CEO, Alphametry

SPEAKERS
Sandy Bragg, CEO, Integrity Research
Peter Allen, Chairman, Euro IRP
Nick Anderson, Head of Equity Research, Henderson Global Investors
Laurence Herman, General Counsel and Managing Director, Gerson
Lehrman Group
Neil Shah, Director of Research, Edison
Alexander Clode, Global Product Manager Sales and Trading,
Bloomberg

WITH THANKS TO
Sam Fazeli, Director, Bloomberg Intelligence
Sarah Jane Mahmud, EU Regulatory Analyst, Bloomberg
Intelligence

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