We can have an impenetrable Chinese Wall or equity research, not both

The largest, most prominent investment bank I worked for used revenue per employee as the primary means of measuring internal profitability. The commission revenue from each group or cost center was divided by the number of employees in that group to determine the most efficient allocation of human resources. If your group’s revenue declined significantly, help in the form of balance sheet allocation, expertise or other support was offered to restore higher levels. Eighteen months after that, if things were still bad people would start getting whacked or moved to where the money was coming in.

You would assume that given the public prominence of investment analysts and the likely $50 million per year in salaries and costs it took to pay for them, this process would also apply to their department but it did not. The reason for this was that, outside of investment banking profits, there is no revenue stream attached to equity research.   Think about that for a second – no direct revenue for a $50 mill annual cost outlay.

Epicurean Dealmaker noted that the banking fees for the Groupon partial IPO were about $49 million, 7% of the $700 million deal size and I think we can all agree this is a decent pile of cake. Rest assured, every investment bank pitching its services to Groupon management had their analysts “behind the [Chinese] Wall” telling Andrew Mason whatever he wanted to hear about how great his company is and, most importantly, how high an initial price they could get they deal off at. For the record, none of the bankers or analysts in this room gave a rat’s ass what happened to the stock price after issue and neither would you if you were waiting on your share from the $50 mill pig trough.*

Banking is where the big money comes from to fund equity research.  There are indirect revenues arising from analysts talking to PMs about their stocks and then trading through the Desk, but it takes a lot of trades to add up to $49 mill in commission.

Notice that retail investors are nowhere involved with the math here despite forming the largest readership for research reports. Good analysts making good calls do help the firm, but 98% of the commission generated by retail trades goes to some combination of the company and the broker, not the analysts. So, the next time you find yourself complaining about the quality or bias in equity research reports remember that the analyst is in no monetary way incentivized to make you happy.
This was all supposed to change after Blodgettgate, but there’s a problem; if you fully separate investment banking from equity research there islittle or no financial reason to provide research. There may, if you move the math around, be enough benefit to provide the odd report but certainly the notional $50 million budget for the research department gets slashed to pieces,  with salaries attracting much less ambitious and talented people. (I would love, btw, to be in the meeting where brokers are informed that their commission payouts are getting cut with the difference going to the analysts. There’d be a wall of burly security guards between them and management in that meeting).
For all their faults and for all the complaining I have done, if read correctly and with an understanding of potential biases there remains a wealth of information about companies in the average research report. Access to multiple sources, as I had, allowed for comparisons between the projections of different analysts and left me with few excuses for bad investment decisions**.  The system as it stands was workable, at least for me.

We have to decide in the end whether we want to continue things as they are or to build an impenetrable Chinese Wall that prevents analysts from benefitting from banking deals. We can’t have both. The latter course will almost inevitably lead to a drastic reduction in the quality of equity research reports regardless of what you think of them now. It could very well be a case of “be careful what you wish for”.




*this doesn’t apply to the rare cases where an analyst behind the Wall takes stock down personally, but that isn’t a great indicator. As a Head of Research once told me “I like to judge the frothiness of markets by how many of my analysts are taking part in private placements”.


** The one area that is impossible to defend the status quo are cases where unbeknownst to the general public, a major banking deal is about to get done. All of the research reports written by the investment banks vying for banking business go more positive as part of the pitch. In some cases, the newfound “optimism” can be indistinguishable from a change in the company that makes it a good investment.  Few things could piss me off like advocating a stock or sector right before the announcement of a big secondary offering.

11 thoughts on “We can have an impenetrable Chinese Wall or equity research, not both

  1. JMac says:

    Changing the recommendation system would be more beneficial than any wholesale changes. Retail clients should never accept blanket “buy” recommendations from an analyst (or a “sell”, not that they would see one), or anyone else that doesn’t completely understand their unique financial objectives and constraints.

    The other (more important) destination for the research are institutional buyers, and they don’t give two shits what the recommendation is anyway, they are just mining the report for information.

    Treat the reports as what they are, and consider the source.

  2. Jonas says:

    I agree. Most of the dot-com bubble reactions were over-reactions (Sarbox, Chinese wall), leading to the far worse situation of the 2008 financial crisis.

    It contributed to the whole industry focusing more debt rather than equity and catering to hedge funds rather than retail business.

    You will see the same thing now in making high profile insider trading prosecutions a priority over other wall street abuses. It’ll drive the trend towards algorithmic trading, and the last thing we need now is where even more investments decisions are detached from research or reality.

    Not that I defend insider trading entirely but at least it involves some collision with reality. Being too aggressive in expanding the scope of it will impinge research, as old Supreme Court cases have recognized.

  3. [...] Interloper, “Banking is where the big money comes from to fund equity research.”  (Interloper) [...]

  4. rpseawright says:

    “Banking is where the big money comes from to fund equity research. There are indirect revenues arising from analysts talking to PMs about their stocks and then trading through the Desk, but it takes a lot of trades to add up to $49 mill in commission.”

    You’re correct, of course. But I also think some of this discussion isn’t sufficiently focused on branding (as distinguished from marketing). Being perceived as having a quality research team (think II ranking, for example) is part of being branded as “a” or “the” top firm. It can’t compete with hard-dollar revenue, but it is still a factor I think.

    • Interloper says:

      I agree to a point, but decisions in Research are made in terms of banking commission, so in actual fact it’s usually a matter of building a great team for generating banking and THEN worry about enhancing rep. Chicken and egg. Both is better though, sure.

  5. [...] On the relationship between equity research and banking, the truth as told from the inside.  (Interloper) [...]

  6. [...] On the relationship between equity research and banking, the truth as told from the inside.  (Interloper) [...]

  7. Why have research reports? For example, if they tell Groupon whatever they want to hear and generate no revenue, what is the point? If institutions just mine them for data and don’t value the actual rating, again, what is the point?

    It seems to me that if they are just there to con the common man into buying. If that is the case, they should be eliminated. Or maybe the solution is to have the research rating not be something they could change or choose to set without money behind it. So the bank issuing a buy would have to hold and accumulate more shares up to the price target. They must sell all their shares if they put a sell on it. If they have a hold, then they should have to not have any sales or purchases. It should be a reflection of what the company is ACTUALLY doing and not what they think will happen in the future with no money at stake.

    • Interloper says:

      Research is useful 95% of the time, when there’s no big banking deal. In those cases there is good insight about “what the company is actually doing”. Ignore the ratings and targets, use the details for info into investment decisions, but not as instructions.

  8. [...] We can have an impenetrable Chinese Wall or equity research, not both (Interloper) The Red Giant (TRB) [...]

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