A question is haunting Wall Street. Actually, a lot of questions are haunting Wall Street, but the one
causing the most immediate angst, is: Are the sell side’s problems cyclical or secular? The answer
holds the key to thousands of careers. So let’s begin at the beginning, which for our purposes, is the
early 1970s. Back then, equity trading commissions were fixed, meaning that when Fidelity Magellan
wanted to buy a chunk of IBM, it had to pay the same 20 or so cents per share.
This cushy setup ended with 1975’s Big Bang, when trading commissions were deregulated. Active
buy-side firms were suddenly able to demand volume discounts on their trades, and the sell side’s
income stream began to evaporate. But just as the commission drought was becoming critical,
investment banking rode to the rescue. The 1990s bull market was in full swing, IPOs were booming,
and the bankers had discovered that offering influential, guaranteed-favorable research coverage was
a great way to attract new business. They invited analysts to the IPO party, and by the late ’90s,
“companies felt that (favorable coverage) was part of what they were paying for when they signed up
with an investment bank.”
This changed the goals and the nature of sell-side research. An All-American ranking from Institutional
Investor magazine was crucial as it implied to corporate customers that an analyst’s research was
widely followed. Rating banking client’s shares a buy was mandatory as favorable coverage was part
of the package. And travel-necessary to build relationships with money managers and banking clients.
Public companies, meanwhile, discovered that they could manage their coverage by “guiding” selected
analysts to the proper insights on upcoming earnings reports. The analysts with the best access got a
cut not just of trading commissions but of the much larger banking fees.
Then it all fell apart. Tech stocks imploded, the IPO pipeline dried up, and the regulators imposed a
panoply of new rules: Public companies must now release the same information to all analysts at the
same time (per the US Securities and Exchange Commission’s Regulation Fair Disclosure (Reg. FD)
Each research report must include a chart showing the analyst’s past recommendations and the
ensuing price action. Most damaging of all, analysts can no longer be paid for their contributions to the
banking deal flow.
The sell side, as a result, finds itself with temporarily lower trading volumes (which always leads to
mass layoffs in any event), still-falling commission rates, a loss of exclusive access to company
managements, and no more investment banking fees. So the answer to the cyclical/secular question
appears to be “a little of each.” Some aspects of the sell side’s good old days will return when the
next bull market sends trading volumes soaring. Some, like investment banking fees, are gone
forever. Thus, the future appears to hold the following: Fewer analysts, reduced coverage of small
and mid-cap stocks, and more research boutiques.
All the talk about analyst independence and new business models begs a crucial point, which is that
sell-side research can never be completely independent. If analysts are paid with soft dollars, they’re
biased toward whatever drives up trading volume. If they're paid by the companies they cover, they’re
driven to maintain those relationships through favorable analysis. And even if those two
considerations miraculously vanished, analysts will always feel the need to accentuate the positive in
order to maintain access to company managements. So, the sell side’s future depends less on
independence than on quality.
causing the most immediate angst, is: Are the sell side’s problems cyclical or secular? The answer
holds the key to thousands of careers. So let’s begin at the beginning, which for our purposes, is the
early 1970s. Back then, equity trading commissions were fixed, meaning that when Fidelity Magellan
wanted to buy a chunk of IBM, it had to pay the same 20 or so cents per share.
This cushy setup ended with 1975’s Big Bang, when trading commissions were deregulated. Active
buy-side firms were suddenly able to demand volume discounts on their trades, and the sell side’s
income stream began to evaporate. But just as the commission drought was becoming critical,
investment banking rode to the rescue. The 1990s bull market was in full swing, IPOs were booming,
and the bankers had discovered that offering influential, guaranteed-favorable research coverage was
a great way to attract new business. They invited analysts to the IPO party, and by the late ’90s,
“companies felt that (favorable coverage) was part of what they were paying for when they signed up
with an investment bank.”
This changed the goals and the nature of sell-side research. An All-American ranking from Institutional
Investor magazine was crucial as it implied to corporate customers that an analyst’s research was
widely followed. Rating banking client’s shares a buy was mandatory as favorable coverage was part
of the package. And travel-necessary to build relationships with money managers and banking clients.
Public companies, meanwhile, discovered that they could manage their coverage by “guiding” selected
analysts to the proper insights on upcoming earnings reports. The analysts with the best access got a
cut not just of trading commissions but of the much larger banking fees.
Then it all fell apart. Tech stocks imploded, the IPO pipeline dried up, and the regulators imposed a
panoply of new rules: Public companies must now release the same information to all analysts at the
same time (per the US Securities and Exchange Commission’s Regulation Fair Disclosure (Reg. FD)
Each research report must include a chart showing the analyst’s past recommendations and the
ensuing price action. Most damaging of all, analysts can no longer be paid for their contributions to the
banking deal flow.
The sell side, as a result, finds itself with temporarily lower trading volumes (which always leads to
mass layoffs in any event), still-falling commission rates, a loss of exclusive access to company
managements, and no more investment banking fees. So the answer to the cyclical/secular question
appears to be “a little of each.” Some aspects of the sell side’s good old days will return when the
next bull market sends trading volumes soaring. Some, like investment banking fees, are gone
forever. Thus, the future appears to hold the following: Fewer analysts, reduced coverage of small
and mid-cap stocks, and more research boutiques.
All the talk about analyst independence and new business models begs a crucial point, which is that
sell-side research can never be completely independent. If analysts are paid with soft dollars, they’re
biased toward whatever drives up trading volume. If they're paid by the companies they cover, they’re
driven to maintain those relationships through favorable analysis. And even if those two
considerations miraculously vanished, analysts will always feel the need to accentuate the positive in
order to maintain access to company managements. So, the sell side’s future depends less on
independence than on quality.
The State of the Sell Side: How cyclical and secular issues are affecting
business.
Source: CFA Magazine, Nov.-Dec. 2003
business.
Source: CFA Magazine, Nov.-Dec. 2003
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