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.