Sell-side research has undergone profound structural changes during the past decade with far-reaching implications affecting the quality of the research and how research is generated, sold and compensated. Decimalization, Regulation FD, unbundling of trading from research and the hedge fund “brain drain” have all negatively impacted sell-side profitability, product quality and small cap coverage in today’s age of diminished sell-side research.
Decimalization. When the SEC required exchanges to narrow their bid-ask spreads from one-sixteenth, or $0.0625, to $0.01 per share effective in 2001, the profitability of trading floors collapsed amidst tremendous spread compression. While working on the sell-side, I recall hearing many times over, “when we get a trade we can all hear the cash register ring.” After decimalization, I never heard this again. Sell-side boutiques, historically adequately compensated for their research with large bid-ask spreads, now struggled to stay afloat. They reduced staff levels and often swapped higher-priced, seasoned analysts for less-experienced and less-costly researchers.
Regulation FD. Enacted during 2000, Regulation FD prevented selective disclosure to favored Wall Street analysts or large institutional investors. Those analysts (both buy and sell-side) who once enjoyed getting unique tips or first to receive management meetings before the market opened, now found it increasingly difficult to differentiate themselves from the pack. As a sell-side technology analyst, I did recall numerous times when asset managers would prefer to meet with CEOs and CFOs before the market opened such that any trades could be placed well in advance of any competitors, presumably if material information was offered during the meetings. After Reg FD I no longer heard of these requirements.
Unbundling. Historically, an asset manager may have paid $0.03 per share to a sell-side market maker for both trading and research. Few knew which portion was actually research-driven versus trading execution. Unbundling of trading from research resulted in the greater utilization of price-competitive electronic trading platforms, lowered research fees to sell-side shops and further rationalized sell-side capacity. Though several asset managers I worked with didn’t unbundle trading from research specifically, they did give preference to paying sell-side shops providing trading “best execution” or in other words, the lowest trading cost in combination with timely order fulfillment. In the end, they shifted more trading commissions toward sell-side shops capable of giving them best execution and away from shops including research fees within higher cost trades. In essence, they were paying less for research.
Hedge Funds. Heavy turnover throughout the sell-side ranks, reflecting economic pressures as well as a “brain-drain” to highly compensated hedge funds (often paying mid-level analysts as much as three-to-five times their base salary in good years) and private equity firms has left the Street with much less experience than in prior times. Higher salaries are a direct function of higher fees. Whereas traditional asset managers may charge 1% of net asset value at year end, hedge funds will typically charge “2 and 20” meaning 2% of net asset value at year end plus an additional 20% of the realized and/or unrealized profits resulting from trading during the period. Also, because sell-side analysts historically have had shorter one- or two-quarter investment horizons, this near-term outlook parallels that of hedge funds -- thus striking a good match.
Given today’s profit-constrained, under-capitalized, and less-experienced Street, investor relations strategies should be cognizant of these challenges when setting annual sell-side coverage goals. Multiple sell-side analysts may wish to cover a micro- or small-cap security, but the economics of their firms could prevent this. A well conceptualized and implemented investor relations strategy including an aggressive outreach program directly contacting buy-side investors, executive participation at trade events or holding analysts days coinciding with major investor events can all help to raise corporate profiles and counter sparse sell-side research coverage.
Sharon Merrill
Chairman & CEO
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