A Brave Call Is It Time for Investment Banks to Explore Alternative Research Models Post-Mifid Ii?

A BRAVE CALL IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II?

PUBLICATION DATE June 2017 ABOUT THE AUTHORS

BENJAMIN QUINLAN YVETTE KWAN CEO & MANAGING PARTNER PARTNER

Benjamin Quinlan is the CEO and Managing Yvette Kwan is a Partner at Quinlan & Associates. Partner of Quinlan & Associates. Prior to joining Quinlan & Associates, Yvette Prior to founding Quinlan & Associates, was the Regional Operating Officer (COO) for Benjamin was the Head of Strategy for Deutsche UBS AG’s Corporate Client Solutions division in Bank AG’s Equities business in Asia Pacific and Asia Pacific, which included UBS’s Investment its Investment Bank in Greater China, and sat Banking, Capital Markets and Financing on a number of the bank’s global and regional Solutions businesses, including its China executive committees. He was also the global onshore securities joint venture. strategy lead for several of Deutsche Bank’s Before taking up her position as Regional landmark projects executed out of London and Operating Officer, Yvette was an Executive New York. Director in UBS’s Group Strategy and M&A Prior to Deutsche Bank, Benjamin worked as departments in Zurich, Sydney and Hong Kong. a Management Consultant at Oliver Wyman. She also worked in the Greater China and Before joining Oliver Wyman, Benjamin worked Corporate Finance team at Credit Suisse First at UBS AG in the bank’s Asia Pacific Client Boston in Hong Kong. Yvette began her career Coverage and Group Strategy departments. He in Emerging Business Services and Corporate began his career in M&A and Capital Markets Tax at PwC in Sydney. Advisory at PwC in Sydney.

SPECIAL THANKS

We would like to thank our intern, Samuel Frampton (Master’s in International Political Economy, University of Leeds), for his extensive help in the preparation of this report. CONTENTS EXECUTIVE SUMMARY 4

SECTION 1 THE SELL-SIDE RESEARCH DILEMMA 5

SECTION 2 RISE OF THE IRPs 10

SECTION 3 INDEPENDENT RESEARCH: A BETTER MODEL? 16

SECTION 4 ALTERNATIVE RESEARCH MODELS 25

SECTION 5 CASE STUDY 33

SECTION 6 P&L IMPLICATIONS FOR BROKERS 39

SECTION 7 HOW CAN WE HELP? 41 EXECUTIVE SUMMARY

With just over six months until MiFID II goes live, the From a consumer perspective, beyond providing global investment research industry is on the cusp of highly specialised content, IRPs have relatively major disruption. While a plethora of issues confront flexible payment models (from annual subscription both the buy- and sell-sides in the lead up to the fees to one-off charges for bespoke reports). implementation in January 2018, pricing appears to Smaller managers are also able to afford investment remain the key area of contention for the industry, research, as pricing schedules of IRPs are given the substantial misalignment between broker considerably cheaper. Most importantly, the ability and manager expectations. to provide unconflicted, independent analyses sets many IRPs apart from the investment banks, where While many managers still have much to do to conflicts still pervade. meet their obligations under the new regulatory regime, we believe it is the sell-side that is facing the The continued migration of research spend from biggest competitive disruption, with downside risks incumbents to IRPs, coupled with the high costs greatest for the global investment banks. Burdened associated with sustaining research divisions, is by inherent conflicts between their research and putting increasing pressure on the P&Ls of large investment banking departments, as well as investment banks. We believe some investment stubbornly high costs due to complicated cost banking research departments are facing potential structures, managers are increasingly looking for losses of up to USD 240 million by 2020 under their alternative content providers in their quest for high- current structures. quality, cost-effective research. To evade these pressures, brokers can opt to Independent research providers (IRPs), in particular, transition from the current “fully-integrated” model have been steadily gaining traction in the lead- to alternative research models – namely, operating up to MiFID II. Much of this reflects their capacity research out of a separately-owned entity, such as to produce high-quality, independent analyses a joint venture (JV), or outsourcing research to IRPs at a considerably lower cost than major sell-side (either directly or via online research marketplaces players. Recently, we have seen a host of new (ORMs)), such as Société Générale’s (SocGen’s) IRPs emerge, with analysts from bulge bracket partnership with Smartkarma. firms capitalising on low barriers to entry to set up With the MiFID II regulatory go-live around the their own firms. Industry consolidation is also on corner and a largely negative outlook for major the rise as incumbent IRPs look to consolidate their sell-side players on the horizon, we believe some competitive edge and capture economies of scale. brokers will need to make a brave call around their From a provider perspective, many analysts we future business models. spoke to cited improved work-life balance and greater intellectual freedom as benefits of working at IRPs, including significantly less focus on producing maintenance research. Some IRPs also adopt revenue share compensation arrangements that are closely tied to individual performance.

4 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES SECTION 1 THE SELL-SIDE RESEARCH DILEMMA

As we have highlighted in our previous reports, In the aftermath of the dot-com collapse, a number MiFID II’s unbundling provisions are likely to cause of new regulations relating to investment research considerable disruption to the global investment were implemented by the Financial Industry research industry, particularly with respect to Regulatory Authority (FINRA). New provisions that competitive dynamics on the sell-side. We think focused on research analyst conflicts of interest the largest global waterfront brokers are facing the were also incorporated into the Sarbanes-Oxley Act. greatest downside risks. Specific regulatory changes included:

In this section of the report we identify three key 1. De-linking compensation for research and challenges full-service integrated sell-side brokers investment banking departments; will face in a post-MiFID II world: 2. Prohibiting investment banking departments 1. Ongoing conflicts of interest between a full- from having an input into research analysts’ service investment bank’s investment research compensation; and investment banking business; 3. Creating a new investment review committee 2. High costs of research teams; and responsible for approving all research recommendations; and 3. Structural changes in the operating environment, including the impact of MiFID II, CSA allocations 4. Disclosing any compensation received from a for best execution, and the expectation that more covered company over the preceding 12 months. independent analysts will enter the fray. Despite the regulatory changes, we have still witnessed a number of cases in recent years where 1. CONFLICTS OF INTEREST conflicts of interest have arisen between a bank’s The bursting of the dot-com bubble in the early 2000s primary and secondary businesses. One of the exposed problems associated with the provision of more notable incidents occurred in December 2014, investment research by integrated investment banks when FINRA slapped 10 major banks with a total – namely, the conflicts that faced many investment fine of USD 43.5 million for offering favourable stock banking research analysts, who were encouraged research in the hope of securing an underwriting 1 to write favourable coverage of particular issuers or role in the IPO of Toys ‘R’ Us Inc. securities to support the banks’ primary deal-making businesses and generate orders through their execution desk.

1 FINRA, ‘FINRA Fines 10 Firms a Total of $43.5 Million for Allowing Equity Research Analysts to Solicit Investment Banking Business and for Offering Favorable Research Coverage in Connection With Toys ‘R’ Us IPO,’ 11 December 2014, available at: http://www. finra.org/newsroom/2014/finra-fines-10-firms-total-435-million

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 5 Perceived conflicts can also extend beyond the The consultation paper acknowledges that coverage of corporations, especially where there ‘[f]eedback from buy-side investors was unanimous are undue expectations from other parties. In in supporting our aim to create the necessary August 2015, JP Morgan lowered its rating on conditions for unconnected research to feature in Indonesian government bonds from “overweight” to the IPO process,’ and that the buy-side was willing “underweight.” As a result, the Indonesian central to pay, and had in the past paid for, unconnected bank governor accused JP Morgan of ‘spreading research. As a result, the paper proposes that panic’ and the then-finance minister said the bank unconnected analysts also gain access to an would be ‘sanctioned’.2 After JP Morgan released issuer’s management before any connected a report downgrading Indonesia’s equity rating to research is released, in order to improve the range “underweight” in November 2016, officials said the of information available to investors at an early Ministry of Finance stopped using JP Morgan as a enough stage in the IPO process to support ‘more primary dealer and underwriter for sovereign bonds.3 balanced investor education and price discovery.’ Subsequently, in January 2017, the Indonesian Even today, we still find there to be a heavy bias government said it had severed all ties between the towards the provision of positive ratings by integrated finance ministry and JP Morgan, due to the equities brokerage houses. When examining analyst rating downgrade.4 recommendations across all major investment A recent consultation paper released by the UK’s banks, an average of 43% of stocks covered by tier- Financial Conduct Authority (FCA)5 on the availability 1 banks and 48% of stocks covered by tier-2 banks of information in the UK equity IPO process explicitly were given a “buy” recommendation, with a mere highlights the potential bias associated with 12% and 7% tagged with a “sell” recommendation connected research produced by analysts within respectively. For tier-1 brokers, this translates investment banks that are part of the IPO’s book- to an average buy-to-sell ratio of 3.6:1, with the running syndicate, including the ‘significant pressure’ corresponding figure for tier-2 brokers being 7.2:1. placed on analysts to produce favourable research In fact, the lowest buy-to-sell ratio among all global if their bank is to win a role in the book-running tier-1 players is 2:1 (see Figure 1). syndicate. It also expresses concerns that analysts in non-syndicated banks and independent research providers lack access to the information they need to produce unconnected research on an offering.

2 Reuters, ‘Indonesia finmin says JPMorgan “sanctioned” for negative research note’, 27 August 2016, available at: http://www.reuters. com/article/indonesia-jpmorgan-idUSL4N1121HH20150827

3 Financial Times, ‘JPMorgan in row with Indonesia over equities rating’, 5 January 2017, available at: https://www.ft.com/ content/0d7b302c-d1a2-11e6-b06b-680c49b4b4c0

4 Wall Street Journal, ‘Indonesia Cuts Ties With J.P. Morgan Over Downgrade’, 3 January 2017, available at: https://www.wsj.com/ articles/indonesia-cuts-ties-with-j-p-morgan-over-downgrade-1483434650

5 Financial Conduct Authority, Consultation Paper CP17/5**, ‘Reforming the availability of information in the UK equity IPO process,’ March 2017.

6 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 1: BROKER STOCK RECOMMENDATIONS

ANALYST STOCK RECOMMENDATIONS RATIO OF BUY-TO-SELL RECOMMENDATIONS TIER-1 VS. TIER-2 BROKER AVERAGES TIER-1 VS. TIER-2 BROKERS

100 12 7 0 MIN AVG MAX 80 0 45 44 60 Tier-1 2.0 3.6 15.5 50 40 30 48 20 43 Tier-2 1.4 7.2 51.0 10 0 Tier-1 Tier-2 Buy Neutral Sell

Note: data as at May 2017

Source: Investar, Quinlan & Associates analysis

Given the greater ability to generate commission Whilst the compensation of star analysts has been income off the back of a “buy” rating (as the potential substantially reduced since the heady days of the trade applies to all investors), it is unsurprising these 2000s dot-com bubble, salaries for equity research rating biases remain. analysts still remain relatively high, given research is viewed as a “front office,” revenue-generating 2. HIGH COSTS function. Our discussions with numerous industry professionals indicate sector heads can command The costs of investment banking research base salaries in excess of USD 300,000, with departments remain stubbornly high. bonuses of 50-100% of base salary. Our interviews with industry professionals suggest a number of star research analysts are still paid total compensation near USD 1 million p.a., though this is becoming increasingly rare.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 7 Beyond high fixed compensation costs, most More critical than high fixed costs and duplicative research divisions of brokers still operate as quasi- overheads between departments, however, is the cost centres, where the prerogative is to allocate problem of allocated costs; all business divisions the costs of the research division to the trading within investment banks are regularly saddled and investment banking business, rather than to with costs from central group functions, such as generate a return on equity comparable to other compliance, operations, and technology, as well as businesses. In fact, many research arms receive cost allocations from other “connected” business “subsidies” from other departments. Moreover, divisions. Based on our discussions with senior the separation of research from trading, coupled management at a number of tier-1 global firms, with the firewalls that exist between research allocated costs can represent up to 75% of the total and investment banking, has led to the creation costs of a global bank’s markets business (see of separate and duplicative overheads, as well as Figure 2). Given such constraints, investment banks various compliance and control frameworks that are need to price their research considerably higher costly to maintain. than IRPs, whose costs are direct and controllable.

INVESTMENT BANKS NEED TO PRICE THEIR RESEARCH CONSIDERABLY HIGHER THAN IRPS, WHOSE COSTS ARE DIRECT AND CONTROLLABLE.

8 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 2: DIRECT VS. ALLOCATED COSTS (GLOBAL BANK – EQUITIES BUSINESS)

DIRECT COSTS ALLOCATED COSTS 25 • Salaries • Legal 30 • Benefits • Compliance • Rent 40 • Technology

• Utilities 60 • Operations

• Depreciation 70 • Other usiness allocations

Outer Circle Maximum Allocated Cost 75 Middle Circle Average Allocated Cost Inner Circle Minimum Allocated Cost

Source: Quinlan & Associates proprietary data

3. COMPETITIVE ENVIRONMENT This typically involves charging a very low fee for access to their online content in order to compete MiFID II is likely to cause considerable disruption to with IRPs, with the hope of offsetting any revenue the global competitive landscape for research. shortfall through the sale of premium services (e.g. We foresee investment banking research revenues analyst meetings, conferences). This is especially coming under significant pressure as managers the case for some of the non-bulge bracket become more prudent in their research consumption, investment banks. and wallet share is increasingly captured by a new While discounted subscription pricing might be wave of cost-effective and high quality IRPs (see a sensible way to attract a larger user base, we Section 2). believe efforts to “loss lead” may result in several In the face of the growing competition from IRPs and brokers’ P&Ls being underwater come 3 January greater selectivity around manager spend, there is 2018, with costs of production significantly early evidence that some brokers might be looking exceeding revenues. As a result, an entire research to “loss lead” with access to their written work. platform could potentially be seen by regulators as an “inducement”, contradicting the very essence of MiFID II’s unbundling regulations.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 9 SECTION 2 RISE OF THE IRPS

INTRODUCTION Cutbacks in banks’ research functions – such as Nomura in Europe, which announced in April 2016 Independent research providers (IRPs) have been that it was closing its European equities business – steadily gaining traction in recent years, underpinned led to a number of senior analysts launch their own by their capacity to produce high-quality, in-depth research firms. In 2016, Des Supple, Nomura’s ex- independent analyses at a considerably lower cost global head of research, founded Event Horizon, than major sell-side brokerages. When taking a while Jens Nordvig, ex-head of fixed income holistic view of IRPs, we have identified a number of research, launched Exante Data, a big data firm key industry trends. targeting hedge funds. Phil Rush, Nomura’s former UK chief economist, also founded a firm called GROWING COMPETITION Heteronomics (see Figure 3). We are seeing a strong correlation between the The trend to set up shop alone has not been impending MiFID II reforms and the growth of new limited to Europe. In Asia, a number of senior entrants in the IRP market. research analysts have launched their own IRPs. Many of the new IRPs are headed by prominent In 2016, Athaporn Arayasantiparb, UOB’s ex-head analysts, coveted for their high-quality coverage of research in Thailand, set up M Corp Review, after having built up a substantial investor following specialising in Thailand thematic equity. A few during their sell-side careers. For example, in 2016, years earlier, PK Basu, ex-global head of Malaysia Mark Pacitti, a former Goldman Sachs researcher research at Macquarie Group, established REAL- and quant at hedge fund Citadel, founded research Economics.com, focusing on Asia macro and firm Woozle, and Rod Manalo, a former M&A director thematic research. at Jefferies, launched the research firm Manalo LLP. A number of analysts have also gone on to produce research independently as “free agents”, either alone or via centralised platforms, including ex-CSLA bank analyst Mike Mayo, ex-CLSA China analyst Scott Larprise, and ex-Morgan Stanley Japan auto analyst Noriaki Hirakata.

10 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 3: RECENT IRP LAUNCHES (2016-PRESENT)

Year Analyst E-Employer Preious Role Ne IRP Name Specialisation

Head of Gloal 2016 Mark Pacitii Primary market research Quantitative Strategy

Head of EuropeAsia 2016 Rod Manalo Event-driven research event-driven strategy

Head of Gloal 2016 Des Supple Economicsmacro Market research

Head of Fixed 2016 Jens Nordvig Big datamacro strategy Income research

UK Chief 2016 Phil Rush Economic research Economist Heteronomics

Athaporn Head of Thailand 2016 Thai thematic euity Arayasantipar Research

Head of CEEMA & 201 Cristina Marea Banks research LatAm Banks

Gloal Banks 201 Mike Mayo NA “Free Agent” Banks research Analyst

Source: Press releases, Quinlan & Associates analysis

We forecast more senior analysts from both bulge GREATER WALLET SHARE bracket and tier-2 firms to go it alone or join buy- The growing influence of independent research side in-house investment firms in coming years, houses is being reflected in their financial and as integrated brokers struggle to monetise their market performance, with MiFID II appearing to be a waterfront coverage and budget cuts weigh on net benefit for leading research franchises. analyst compensation.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 11 One of the UK’s leading IRPs, Redburn, saw Top-line revenue growth for many IRPs is occurring its revenues increase by 14.8% y/y from GBP at a time when research revenues at many global 78.9 million in 2015 to GBP 90.6 million in 2016, brokers are coming under pressure. As highlighted according to its most recent financial statements. in our March 2017 report on the rise of online Moreover, BCA Research, Ned Davis Research, research marketplaces (ORMs), IRPs have already and Institutional Investor – the research arm of gained considerable market share since the global Euromoney Plc – reported a combined increase in financial crisis, particularly outside of the US. While net revenues of 9% y/y from GBP 150.8 million in we forecast global research spend to fall by 25-30% 2015 to GBP 164.5 million in 2016. Paul Miskin, over the next 3-4 years, we expect IRPs to capture CEO of Agency Partners, a privately owned IRP roughly a fifth of the total wallet by 2020, with the focusing on aerospace and defence, said revenues most notable gains in Europe (20% market share) at his firm have grown 15-20% quarterly for the past and Asia (17% market share) (see Figure 4). six years.6

TOP-LINE REVENUE GROWTH FOR MANY IRPS IS OCCURRING AT A TIME WHEN RESEARCH REVENUES AT MANY GLOBAL BROKERS ARE COMING UNDER PRESSURE.

6 Financial Times, ‘Boutique research groups set to gain from charging shake-up,’ 1 March 2017, available at: https://www.ft.com/ content/551ed82a-f1ff-11e6-8758-6876151821a6

12 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 4: MARKET SHARE OF IRPs (2009-20)

25 23 200 2016 2020 20 20 20 17 17

15 11 10 9 5 5 3

0 US EUROPE ASIA

Source: Integrity Research Associates, Quinlan & Associates forecasts

INCREASED CONSOLIDATION In May 2016, private investment firm Fin-Ex announced the acquisition of Roubini Global As the independent research industry market Economics’ (RGE) core subscription business, matures and becomes more substantiated in the which would be merged with research firm 4CAST to lead-up to MiFID II, we are witnessing an uptick in create 4CAST-RGE. The combined entity has a total M&A activity as industry players look to establish client base of 600 financial institutions, and provides a more dominant footprint, capture economies of a stronger platform for product development to help scale, and best position their offering in a rapidly drive revenue growth. The merger was designed to evolving competitive environment where research create a global leader in the provision of independent wallet is on the decline. financial market and macro strategy research.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 13 A few months later in August 2016, Trusted Sources In October 2016, Morningstar, an early investor and Lombard Street Research announced they would and 20% equity holder in capital markets research merge to form TSL Research, in the expectation that firm PitchBook Data, announced it would acquire buy-side research budgets will increasingly shift the remaining 80% stake in the firm in a deal worth to IRPs in the wake of MiFID II. Nicholas Mather, USD 180 million. The move was designed to further CEO of TSL, said ‘Financial regulation is reinforcing combine Morningstar’s market intelligence on public two trends whereby asset managers are reducing companies with PitchBook’s coverage of investment overall research costs whilst dedicating a greater and deals for private companies. The acquisition proportion of total budgets to independent firms. also highlights the considerable premium that IRPs Trusted Sources and Lombard Street Research have are placing on differentiating their research through capitalised on this new normal and will together offer the use of proprietary market data (see Figure 5).8 a global set of independent macro, strategy, country, and sector thematic research services.’7

7 FTSE Global Markets, ‘Lombard Street Research merges with Trusted Sources,’ 1 August 2016, available at: http://www. ftseglobalmarkets.com/news/lombard-street-research-merges-with-trusted-sources.html

8 PitchBook Press Release, ‘Morningstar to Acquire PitchBook Data; Agreement Will Combine Leading Providers of Public and Private Company Research,’ 14 October 2016, available at: https://pitchbook.com/media/press-releases/morningstar-to-acquire-pitchbook- data

14 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 5: KEY M&A TRANSACTIONS BY IRPs (2016)

MERGER MERGER ACQUISITION

Merger of Rouini Gloal Economics’ Merger of Trusted Sources USD 180m acuisition y RGE core suscription usiness and Lomard Street Research Morningstar of remaining 80 with 4CAST to create 4CAST-RGE to form TSL Research stake in PitchBook data

Source: Press releases, Quinlan & Associates forecasts

As global sell-side players struggle to monetise their As the competitive environment heats up and global waterfront coverage, and adapt to more transparent research spend comes under pressure, we are also and competitive pricing, we believe IRPs, where likely to witness heightened consolidation among there is a natural fit in content coverage, will more established IRPs looking to capture economies accelerate their inorganic growth ambitions in an of scale and bring down their operating costs. attempt to strengthen product development efforts and broaden research coverage.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 15 SECTION 3 INDEPENDENT RESEARCH: A BETTER MODEL?

THE PROVIDER PERSPECTIVE Recognising these challenges, a number of IRPs are attempting to attract top-ranked sell-side In more recent years, we have seen a growing analysts by leveraging their capacity to offer more number of top researchers from investment banks amenable working hours than the major brokerage emerging at IRPs; both established firms and ones houses, while simultaneously providing flexibility they have set up themselves. on compensation. London-based TS Lombard, for example, promotes the ability for its analysts JOINING AN ESTABLISHED IRP to produce unbiased, independent research that is Our interviews with a number of sell-side analysts free of conflict of interests, flexible working hours, at global investment banks suggest various push and a business model that rewards analysts with factors are driving top analysts at global banks to a 50:50 revenue share arrangement on their work. join established IRPs, including an ongoing decline The firm hired BNP Paribas economist Ken Wattret in bonus pools, diminished levels of job security, and in early 2017. pressures to cover house stocks positively. Together IRPs such as BNP Exane, BNP Paribas’ cash with the need to frequently push out “maintenance equities joint venture in Europe, have benefited from research”, many analysts we interviewed said these the buy-side’s growing focus on sourcing high quality, were constraining their intellectual freedom and thematic, in-depth research. According to the firm’s capacity to produce genuine, value-add research. London head of research, Ben Spruntulis, the firm Moreover, given the ongoing headcount constraints is focusing on the type of work many analysts want at many global banks, a growing number of senior to be doing. As such, the firm receives at least one analysts are facing a rapidly deteriorating work- new CV every day. In the first half of 2016 alone, life balance, with frequent travel, regular late night the firm’s London office hired five senior researchers conference calls, and considerable data crunching from leading investment banks, including Nomura, 9 becoming increasingly common as junior research Citi and UBS. associates become a scarce commodity. Many analysts are also spending a considerable amount of their time undertaking menial administrative tasks rather than producing value-add content.

9 efinancialcareers, ‘How MiFID II inspired Exane to build a top equity research team,’ 5 August 2016, available at: http://news. efinancialcareers.com/hk-en/251878/exane-is-hiring-researchers-this-is-why-you-want-to-work-there/

16 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES SETTING UP AN IRP THE CONSUMER PERSPECTIVE Some analysts have chosen to go a step further in their quest for intellectual and work-life independence PAYMENT MODEL by setting up their own IRPs. As outlined in our March report10, integrated brokers appear to be exploring two revenue models for In addition to some of the firms highlighted in Section their research offering; the first being an “all-in” 2, one unique Online Research Marketplace (ORM) subscription fee for unlimited access to a bank’s in Asia, Smartkarma, provides vetted analysts with a waterfront research services (online access plus platform to develop and sell their own independent value-add services), and the second being a content, with a transparent compensation structure “subscription-plus” model that charges clients an that reflects engagement levels with consumers and annual subscription fee for access to online content interaction with other independent providers on the and additional fees for bespoke services (e.g. platform. This “online ecosystem” for independent analyst meetings) on an as-needed basis. investment insight and analytics has attracted some leading names from the industry, including ex- From our analysis, we have identified three main HSBC consumer analyst Valeria Law, ex-Barclays revenue models that exist among today’s IRPs technology analyst Andrew Lu, and ex-head of (see Figure 6). strategy at BlackRock, Paul Kitney. The flexibility and uniqueness of its model was recently brought to light when in April of this year, Paul Kitney released his respected “Animal Spirits” report from Mount Everest while preparing for his ascent to the summit.

A number of new IRPs highlighted in Section 2 of this report also contribute their content to Smartkarma, including Rod Manalo (Manalo LLP) and Phil Rush (Heteronomics). We see these online ecosystems representing a powerful new business model in the post-MiFID II world and anticipate that a growing number of sell-side analysts will defect to such platforms in search of improved work-life flexibility, greater intellectual freedom, and a compensation structure that is more closely tied to their individual performance.

10 Quinlan & Associates, ‘Research.com: the Rise of Online Research Marketplaces,’ March 2017, available at: http://www. quinlanandassociates.com/insights-research-com/

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 17 FIGURE 6: KEY IRP REVENUE MODELS

1 2 3 Suscription Sponsored Bespoke

Example

Description Periodic payments for A defined payment made y A one-off, commissioned fee access to written research, a corporate to an IRP to paid y a client to an IRP to with limited access to initiate company coverage undertake a specific additional services e.g. for a specific uantum of research exercise e.g. a analyst meetingscalls research coverage sector deep-dive

IRPs 95 3-4 1-2

Source: Quinlan & Associates analysis

1. Subscription Payment From our analysis, we found the subscription- based revenue model to be the industry standard Under this payment method, buy-side firms are for IRPs selling research products, with ~95% of charged an annual fee (usually paid in quarterly independents charging a subscription fee for access instalments) for access to a firm’s written research. to their research. Typically, an annual subscription will also include limited access to analysts via phone or in person, alongside regular access to sector, industry, or macro policy specific articles, or total coverage of a firm’s content via an online proprietary portal (or sent weekly through email).

18 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES 2. Sponsored Research PRICING

Under this arrangement, a corporation (usually a Based on our research with a number of industry small-to-mid-cap firm, or an unlisted company) will professionals, we found a wide-range of prices engage an IRP to initiate coverage of their company. being charged by the IRPs. Research on a client company would usually cover At the low end of the spectrum, we found annual its business model and strategy, with financial subscription fees to start at USD 20,000-25,000 forecasts, equity valuation, and key sensitivities. A p.a. (usually for smaller providers), rising to typical offering would include services such as an USD 250,000 p.a. from some of the more prominent annual initiation-style report, together with monthly industry players. Average fees were generally in the and quarterly reports. range of USD 40,000-60,000 p.a., with some IRPs, Some firms, such as Edison, are particularly active such as Capital Economics and 4CAST, offering a in the sponsored research space and have built a free trial period for investors. lucrative business model around covering small-to- On average, fees being charged by IRPs were mid-cap companies that are often overlooked by considerably lower than those charged by global larger brokerage houses. We estimate less than banks, where we have seen quotes for waterfront 3-4% of IRPs adopt this revenue model. coverage ranging from as low as USD 60,000 for pure-play regional players, to between 3. Bespoke Reports USD 500,000-5,000,000 for global tier-1 firms for Some IRPs charge clients a one-off fee for a piece access to their research platforms (see Figure 7). of specific commissioned research. These fees can However, given the ongoing pushback from the buy- be charged in addition to annual subscription fees, side, we are starting to hear of some global banks where the scope of research may be outside what exploring 5-digit pricing schedules for access to their is included in a typical subscription – for example, online research content, though these specifically the client may wish to commission a deep-dive exclude any other value-add services such as and/or report on the outlook for a specific industry, analyst calls or meetings. theme and/or country. A number of these IRPs also conduct pre-IPO investigative due diligence and broader market-based survey studies. Firms such as Blackpeak Group are particularly active in this space.

From speaking to industry insiders, we found this revenue model to be more niche, given demand was lumpy and focused more on technical research specialists where insights were needed on a more periodic basis (i.e. per transaction). We estimate only 1-2% of the IRP wallet is generated from the provision of bespoke reports.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 19 FIGURE 7: ANNUAL SUBSCRIPTION FEES

MIN AVG MAX

IRP USD 20,000 USD 40,000-60,000 USD 250,000

REGIONAL USD 60,000 USD 150,000-250,000 USD 350,000

GLOBAL USD 300,000 USD 500,000-1,500,000 USD 5,000,000

Source: Quinlan & Associates analysis

We found many of the IRPs segmented their fees For example, a number of firms have carved out across their various product offerings, broken a competitive niche in the macro and investment down by sector, country, and/or toolkits. This is strategy space, such as TS Lombard and Capital considerably more granular than pricing schedules Economics. Others have established a foothold being offered by many of the global brokers. in credit research, including Credit Sights and Independent Credit View AG. Among the equity For bespoke reports, we found that pricing would research houses, firms such as Redburn and generally start at ~USD 2,500 for a high-level Alpha Value have earned a reputation as credible economic newsletter, rising to USD 15,000-20,000 generalists, while other equity-focused IRPs for a more in-depth piece of research. Investigative remain sector focused, including New Street research firms typically charge anywhere between Research (telecoms, healthcare, and internet), USD 20,000-30,000 for a 3-4 week research Arete (technology, telecoms, and alternative energy) engagement. and Drewry (maritime) (see Figure 8). A number of alternative data providers, such as Prattle, are OFFERING also starting to make their mark in the investment While some IRPs, such as BCA and Morningstar, management industry through tools such as offer comprehensive research coverage across machine learning. multiple products, sectors, and geographies (akin to the global brokerages), the vast majority of players are relatively niche in their focus, offering in-depth, specialised coverage. As such, IRPs can be selected for their specific content strengths, as opposed to sell-side brokers with mixed capabilities across their waterfront offering.

20 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 8: RESEARCH COVERAGE

Full Service Macro Investment Fundamental Euity Fundamental Euity Credit Alternative Coverage Strategy Generalist Specialist Research Data

Source: Quinlan & Associates analysis

INDEPENDENCE As highlighted in Section 1 of this report, there appears to be considerable bias in the stock One of the main reasons put forward by the buy-side recommendations given by research analysts at for sourcing research from IRPs is that it is free of many integrated investment banks, with “buy” calls the conflicts of interest faced by research analysts significantly outweighing “sell” calls. For many IRPs, working at full-service investment banks; namely, buy-to-sell ratios appear to be considerably more that research calls are not being used to drive trading balanced – for example, boutique research houses commissions or support a bank’s primary deal flow. Alpha Search and Boening & Scattergood currently have buy-to-sell ratios of 0.99 and 0.60 respectively.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 21 Larger research houses, including Thomson Reuters/ QUALITY Verus and Morningstar, also maintain buy-to-sell Given a more specialised offering and fewer conflicts ratios of less than 1. Moreover, while its analysts of interest, is research provided by IRPs “better” don’t provide explicit buy or sell recommendations, than research sourced from integrated brokers? Smartkarma’s overall bull-to-bear ratio has been ~60:40 since inception. One potential way to examine the quality of a firm’s research is to look at the accuracy of stock Despite these examples, we have identified a recommendations made by its analysts. When number of IRPs with buy-to-sell ratios considerably looking at data from Investars on the top 25 most higher than the investment banks’. Aegis Capital “accurate” research houses over the past 12 Corp, Barrington Research Associates, and months,11 three of the top five research houses Benchmark Capital, for example, all have buy-to- were IRPs, with Argus Research Co and Sidoti & Co sell ratios in excess of 100, and Ameriprise Financial taking the top two spots. Moreover, among the top doesn’t have a single “sell” rating on any of the 133 10 most accurate firms, four were IRPs, five were stocks it covers. tier-2 integrated brokers, while only one (Goldman The question of bias remains particularly unclear for Sachs) was a bulge bracket investment bank (see IRPs who engage in sponsored research coverage; Figure 9). as fees are being paid by the company being covered (and not the investors in that company), we believe the removal of bias – and hence achieving true independence – is extremely difficult to obtain. However, for IRPs who derive their revenues from manager subscriptions, we believe they have a stronger motivation than integrated brokers to keep their recommendations impartial, given their sole source of revenue is so heavily dependent on their reputation and the integrity of their insight.

11 Based on 1-year trailing performance of “buy” calls minus 1-year trailing performance of “sell” calls

22 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 9: PERFORMANCE OF STOCK CALLS (1-YEAR TRAILING)

ANALYST RECOMMENDATION SPREAD PERFORMANCE

RANK FIRM BUY HOLD SELL BUY-SELL 1 Arus Research Co 21.55 16.65 -5.32 26.87 2 Sidoti & Co 26.14 17.42 na 26.14 3 Piper Jaray 18.02 21.50 -6.45 24.47 4 Northland Capital Markets 29.78 23.90 13.34 16.44 5 TD Securities 7.26 7.42 -7.54 14.80 6 Macuarie Group 23.83 22.28 17.97 5.86 Nomura Securities 21.29 18.16 15.77 5.52 8 CFRA Research 19.40 19.72 16.30 3.10 Credit Aricole Chereu 27.81 16.26 24.82 2.99 10 Goldman Sachs 19.20 18.35 16.53 2.67 11 Janney Montomery Scott 16.51 24.02 14.45 2.06 12 CLSA 28.31 25.01 27.59 0.72 13 UBS 21.37 17.18 21.80 -0.43 14 Deutsche Bank 19.48 18.52 20.76 -1.28 15 BMO Capital Markets 17.13 19.76 19.09 -1.96 16 Eane BNP Paribas 23.01 30.17 25.33 -2.32 1 Merrill Lynch 19.55 21.18 21.97 -2.42 18 CIBC Oppenheimer 5.97 6.50 9.52 -3.55 1 JP Moran 19.89 19.01 24.56 -4.67 20 Credit Suisse 18.77 17.55 24.88 -6.11 21 Barclays Bank PLC 15.85 21.59 22.43 -6.58 22 Citi 17.54 21.70 25.36 -7.82 23 Moran Stanley 16.07 17.38 25.71 -9.64 24 AllianceBernstein L.P. 21.57 24.20 35.49 -13.92 25 HSBC 19.02 21.06 36.98 -17.96

Tier-1 Global Bule Bracket Tier-2 Reional Interated IRP

Note: Data as at 7 May 2017

Source: Investars, Quinlan & Associates forecasts

The accuracy of stock calls is, of course, only one The ability to provide access to corporates, identify way to evaluate the strength of a research provider, emerging trends, or provide in-depth insights about given alpha generation is just one of the many a particular industry, are also integral to the role of “inputs” provided by a research analyst to an asset an analyst. manager.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 23 Sanford C. Bernstein & Co (Bernstein), for example, SUMMARY has built its reputation in the industry around its While the case for quality and independence is open monthly research Blackbooks, which provide to some debate, we believe IRPs are able to offer unbiased, in-depth company and industry analysis a number of distinct benefits when compared to and forecasts with a contrarian flair. Unlike its research provided by investment banks, including: peers, Bernstein recruits its senior analysts directly from industry, providing it with a unique competitive 1. In-country, on-the-ground coverage (i.e. research edge in the industries that it covers. Managers we is not centralised out of a central hub like spoke to value the deep level of insight provided by Hong Kong); Bernstein and said that this value is independent of 2. Small and nimble operations whose primary focus stock call accuracy. is on insight generation (as opposed to churning out “maintenance” research updates); and 3. The ability to provide unconstrained opinions that are not tied to a bank’s ECM relationships or secondary trading businesses. In a post-MiFID II world, we see a very compelling business case for the use of IRPs by fund managers and forecast a continued shift in research wallet from incumbent providers (i.e. the global investment banks) to high quality, independent content providers.

WE SEE A VERY COMPELLING BUSINESS CASE FOR THE USE OF IRPS BY FUND MANAGERS AND FORECAST A CONTINUED SHIFT IN RESEARCH WALLET FROM INCUMBENT PROVIDERS (I.E. THE GLOBAL INVESTMENT BANKS) TO HIGH QUALITY, INDEPENDENT CONTENT PROVIDERS.

24 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES SECTION 4 ALTERNATIVE RESEARCH MODELS

OVERVIEW MODEL 1: INTEGRATED OFFERING

Given the numerous challenges facing investment The majority of brokers remain focused on offering banking research departments and the advantages their own proprietary research content through a of using IRPs, we believe sell-side players may wish fully integrated primary and secondary investment to consider exploring alternative models for their banking platform (see Figure 11). research platforms.

In this section of the report, we explore the relative merits of three distinct broker operating models in a post-MiFID II world, including:

1. A fully-integrated brokerage providing its own proprietary research; 2. An execution-only brokerage offering branded research out of a research joint venture; and 3. An execution-only brokerage sourcing content from IRPs (see Figure 10).

WE BELIEVE SELL-SIDE PLAYERS MAY WISH TO CONSIDER EXPLORING ALTERNATIVE MODELS FOR THEIR RESEARCH PLATFORMS

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 25 FIGURE 10: ALTERNATIVE BROKER RESEARCH MODELS

MODEL 1 MODEL 2 MODEL 3 INTEGRATED OFFERING SEPARATED OWNERSHIP OUTSOURCED RESEARCH

Waterront Specialised Controlled Non-Controlled Independents ORMs

Example

Description Proprietary research Proprietary research Research provided out Research provided out Research sourced Research content offering across all key coverage focused on of a separate entity of a separate entity from preferred group of sourced from various regions, products and key regions, product that is whollymajority- that is minority-owned independent research providers through an industries andor industries ownedcontrolled controlled providers aggregation platform P&L   -    Impact Support for    - - - Primary Business

Support for       Trading Business Conflict of   - - -  Interest Operational   -    Manageaility Brand   - - -  Visiility

 Unaourable - Conditional  Faourable

Source: Quinlan & Associates analysis

26 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 11: INTEGRATED OFFERING

INVESTMENT BANK FUND MANAGER DESCRIPTION

1 Fully integrated investment ank offering oth corporate advisory i.e. M&A, ECM and DCM and secondary market capailities including research, execution and corporate access to fund management clients

PRIMARY SECONDARY PortfoPlioM Mgmt

M&A Execution PortfoPlioM Mgmt PM 1 ECM Corp Access PortfoPlioM Mgmt

DCM Research PortfoPlioM Mgmt

Source: Quinlan & Associates analysis

On one end of the spectrum, bulge bracket The ability to produce proprietary research offers investment banks (such as UBS and Morgan natural support to a bank’s primary capital markets Stanley) are looking to offer buy-side clients business, especially its ECM franchise. Much of this waterfront research coverage across all key regions, relates to the fact that bankers can present a “house products, and industries. On the other end of the view” during their pitching/roadshow efforts. This is scale, smaller full-service brokers (such as Kepler also important from the perspective of maintaining a Cheuvreux and Berenberg) provide more targeted broker’s own brand visibility. research coverage focusing on a specific region/ geography. KEY DISADVANTAGES

In light of the recent report by the FCA (see Section KEY ADVANTAGES 1), the merits of providing in-house research to While brokers producing their own proprietary support a bank’s ECM business are likely to come research will be able to generate separately under considerably more scrutiny in years to come, identifiable income streams for their content post- given the potential conflicts of interest associated 2018, we see top-line revenue pressures mounting with connected research produced by analysts as the buy-side becomes increasingly more within investment banks that are part of the IPO’s disciplined around their research consumption book-running syndicate. Moreover, given MiFID habits. We believe that brokers will need to scale II’s directive to divorce research spend from trading back their waterfront coverage offering to focus volumes, the value of research in driving a broker’s on key products, sectors, and geographies where secondary trading revenue has been significantly they have a competitive niche, given the difficulty depleted. Taken together, these will weigh heavily in monetising content from lower ranked analysts/ on the business case for integrated investment teams. banks post-2018.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 27 It is also clear that maintaining investment research We believe pricing models akin to Macquarie capabilities in-house is proving extremely expensive Dimension’s (i.e. a low subscription price for for global brokers. As highlighted in Section 1, much unlimited access to online content, with additional of this is due to allocated cost mechanisms that exist fees for value-add services on an as-needed basis) at global banks, leaving them with far less pricing appear to be the most workable fee structure being firepower than IRPs. As it stands, the combination showcased by the global firms at present, though we of top-line revenue pressure and a sticky cost base still caution any temptation by global banks to “loss is likely to see many investment banking research lead” with their written research (see Section 1). departments experience negative P&L outcomes post-2018. Added to this, the process of managing MODEL 2: SEPARATED OWNERSHIP research in-house is likely to become increasingly To address some of the disadvantages associated complex as banks scramble to address their heavy with operating a fully integrated brokerage platform, compliance obligations under MiFID II. some investment banks may wish to explore the creation of a separate research entity, which may involve the formation of a joint venture (JV) (see Figure 12).

THE COMBINATION OF TOP-LINE REVENUE PRESSURE AND A STICKY COST BASE IS LIKELY TO SEE MANY INVESTMENT BANKING RESEARCH DEPARTMENTS EXPERIENCE NEGATIVE P&L OUTCOMES POST-2018.

28 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES FIGURE 12: SEPARATED OWNERSHIP

INVESTMENT BANK FUND MANAGER DESCRIPTION

1 Investment ank with full primary offering ut without in-house research

2 Research usiness is run out of a separate entity in which it has an euity stake

PRIMARY SECONDARY Portfolio Mgmt 3 Research services provided to fund managers M&A Execution Portfolio Mgmt exclusively out of the separate entity 1 ECM Portfolio Mgmt 4 Research services also provided to the ank to support its primary deal flow DCM Portfolio Mgmt

RESEARCH ENTITY

2 4

Corp Access

Research 3

Source: Quinlan & Associates analysis

One of the most notable examples of a successful According to the firm’s website, the three core pillars research JV is Exane BNP Paribas, a tie-up of its partnership include: between Exane Partners and BNP Paribas that was 1. An operational partnership in European cash established in 2004. The firm performs fundamental, equities where BNP Paribas conferred exclusivity long-term research on more than 600 Pan-European to Exane under the Exane BNP Paribas brand; stocks and boasts over 250 analysts, sales, sales- traders, and traders among its employee base. It 2. A balance sheet partnership which is particularly is also the exclusive distributor for European ECM well suited to the firm’s Derivatives business, transactions originated by BNP Paribas. Exane providing financing and support for Exane’s BNP Paribas ranked 1st overall in equity research rating; and th and sales in Extel’s 44 annual pan-European 3. A capital partnership uniting the strength of BNP survey in June 2017. Paribas with the independence of Exane. Exane Partners holds 50% of the capital and 60% of the voting rights in the entity, while BNP Paribas holds 50% of the capital and 40% of the voting rights.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 29 KEY ADVANTAGES For an investment bank holding a non-controlling stake, careful consideration will need to be given to Operating a bank’s research business out of a the governance structure between the entity and the separately-owned entity has the potential to reduce bank itself. In worst case scenarios, strategic and perceived conflicts of interest if the bank’s research cultural differences between any partners (such as a is branded distinctly under a newly-named operating misalignment in client/product focus or management unit. P&L is also likely to improve, given the platform styles) could lead to a breakdown in the relationship, can function without the burden of substantial especially in the case of a JV. In particular, without central cost allocations from an integrated bank.12 operational control, a minority partner may also For example, for its 2016 fiscal year, Exane BNP fail to exert meaningful strategic influence over the Paribas booked a net profit of €43m on an income of platform. €401m. The firm has operated at a cost-to-income ratio of ~80% for the past two years, considerably The pitfalls of operating minority-controlled JVs can better than the cash equities businesses of many of most clearly be seen with Sino-foreign securities its bulge bracket peers. JVs, in which foreign firms have generally been limited to a maximum stake of 33%. Many of the Investment banks opting to take non-controlling early JVs have been dissolved and the majority of stakes in JVs stand to receive significant cost those remaining have failed to achieve meaningful and headcount benefits; as the entities are not profitability since they were launched.13 Whilst consolidated, all direct costs tied to their research we recognise cultural nuances associated with business, as well as a large share of allocated operating in China may have exacerbated such costs, will be removed from the banks’ P&L. With problems, we nevertheless believe it is important substantial top-line revenue pressure forecast for for investment banks to manage any JV relationship global brokers post-MiFID II, cost reduction should carefully. remain a core strategic priority.

MODEL 3: OUTSOURCED RESEARCH KEY DISADVANTAGES Given some of the strategic and operational Compared to operating an integrated brokerage complexities tied to operating research out of a platform, operating a research business out of a separately-owned entity, as well as the downside separate entity may come with potentially lower P&L implications of operating as a full service brand visibility, though this will largely depend on the brokerage post-2018, investment banks may wish naming protocol of the new entity. to consider shutting down their internal research arms and sourcing their content needs from IRPs – either using a select group of preferred providers or through an online research marketplace (ORM).

12 This potential benefit would also apply to non-controlled JVs branded as distinct entities

13 Quinlan & Associates, ‘Sino-Foreign Securities Joint Venture: Round 2,’ September 2016, available at: http://www.quinlanandassociates. com/insights-sino-foreign-securities-joint-ventures/

IRP

Corp Access 4 Research

INVESTMENT BANK FUND MANAGER DESCRIPTION

1 Investment ank with full primary offering ut execution-only secondary usiness

2 Research sourced from IRPs to support ank’s primary deal flow

PRIMARY SECONDARY Portfolio Mgmt 2 3 IRP research offered to fund managers as part of its secondary offering note: white- M&A Execution Portfolio Mgmt laelling is a potential option 1 ECM Portfolio Mgmt 4 IRPs also provide research directly to their DCM 3 Portfolio Mgmt fund management clients

Source: Quinlan & Associates analysis

A recent example of an investment bank that has KEY ADVANTAGES gone down this path is Société Générale (SocGen) We believe integrated investment banks stand to which, in December 2016, announced a partnership realise substantial P&L benefits from sourcing their with Smartkarma. The tie-up provides SocGen’s investment insights from IRPs. institutional clients with access to Smartkarma’s investment research platform, as part of a package While we anticipate global research spend to of services offered to their clients. Given SocGen decline by up to 30% by 2020, we believe bulge does not offer in-house research in Asia, this tie- bracket investment banks will see their research up provides a broader service offering to SocGen’s income fall by up to 40% as managers rationalise clients without the need to build content internally. their purchase decisions and IRPs capture a greater Smartkarma has also benefited from adding a share of the global research market. With many significant number of new users to its platform. investment banks’ equities businesses operating at cost-to-income ratios of ~90%, the need to reduce costs is of paramount importance.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 31 Sourcing research from IRPs also allows investment By shuttering their own investment research banks to address potential conflicts of interest departments, banks will undoubtedly lose some through the provision of unbiased, independent brand visibility in the market, unless they choose insight to their clients. Despite lacking their own to “white label” content that is provided by their “house view”, banks could also look to market this preferred IRPs. Moreover, there may be a negative impartiality as a way to support their primary market impact on their primary business if the IRP provides deal flow. Most importantly, through focusing on their a negative outlook on companies a bank is looking core, value-add capabilities (such as deal origination to engage in potential transactions with. However, and trade execution), banks can streamline their we believe content objectivity will only benefit the operating models considerably. This operational capital markets industry in the long-run, ensuring streamlining will be particularly evident post-2018, only the best deals come to market. when global banks become burdened with a host of new regulatory and compliance obligations SUMMARY under MiFID II that many of the IRPs have already It is clear that each of the three research models addressed. outlined above comes with its own unique selling points, as well as disadvantages. However, when KEY DISADVANTAGES viewed as a whole, we believe the business case While we anticipate conflicts of interest to diminish for continuing to operate an integrated brokerage under an outsourced research model, this will platform is rapidly deteriorating, while the financial, only be the case for those banks who source their strategic, and operational merits of exploring insights from truly independent IRPs (i.e. firms who alternative research models cannot be ignored. do not engage in sponsored research, where there is likely to be inherent bias).

We had the opportunity to interview the team at THE PLATFORM Smartkarma, an Asian-based online research platform which extends its service offering beyond USER EXPERIENCE the aggregation of research, allowing independent research providers to interact and collaborate Following registration, users can define their amongst themselves, and engage with research investment mandates by selecting countries, sectors, users. and market capitalisation. Further refinements by “Verticals” – such as thematic, event-driven, BACKGROUND technical analysis-driven, or macro research – can be selected. The platform recommends IPs for its Smartkarma was set up in 2014 by a team of buy- users to “follow” based on the investment mandate and sell-side professionals looking at where fintech chosen. Specific companies can also be followed had yet to impact the status quo. In the investment by users. research space, the introduction of PDF reports in the early 1990s was commonly seen as the last On the main dashboard (see Figure 14), the Insights major innovation. Smartkarma saw regulatory tabs show in real-time: (1) insights based on a changes surrounding unbundling as the necessary user’s personalised filter; (2) what is trending based impetus to disrupt the investment research market. on what other users are reading; and (3) the latest insights that have been published. Insights are Currently, Smartkarma has over 140 research simultaneously disseminated across the Smartkarma providers – Smartkarma calls them Insight Providers platform, via social media, and syndicated onto or IPs – covering approximately 1,600 companies Bloomberg at the time of publication. in 15 markets across the region. Certain US and European companies with Asian operations are also The Discussion Stream is a live stream of the various covered by its IPs. Over 500 reports or “insights” are group chats generated off the back of insights. now published through Smartkarma each month. When we viewed the highest trending insights, we noted very comprehensive engagement from fellow Smarkarma also aims to cover areas historically IPs, with chats eliciting content-rich responses of under-covered by the research departments of between 150 to 300 words. Users can also initiate traditional brokers due to the economics of coverage. private message chats with IPs – we expect that Niche focus areas include IPOs & placements, research users will be more likely to engage in this event driven / special situation, and small and mid- manner. cap equities. Being a cloud-based platform, Smartkarma can be accessed via mobile devices. Different watchlists can be customised, with personalised insights delivered as real-time alerts and/or regular scheduled emails.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 33 FIGURE 14: SMARTKARMA – DASHBOARD

Source: Smartkarma, Quinlan & Associates analysis

34 A BRAVE CALL | © COPYRIGHT QUINLAN & ASSOCIATES PRICING AND SUBSCRIBERS Separately, the main dashboard includes a “My Locker” area which users can treat as a working There is a flat subscription fee for each user which space to develop ideas. Users can pin insights here, allows unlimited access to content and the ability to make notes, upload documents and add web links. interact with IPs. We understand that current users Search functionality typical of the rest of the platform include traditional asset managers, hedge funds, is also available in “My Locker”. endowment funds, sovereign wealth funds, and family offices. We expect the company to continue to augment the stable of work efficiency tools that can be used by Smartkarma’s partnership with SocGen at the end both research providers and consumers. of 2016 saw them add a significant number of new institutional users to its platform. COMPLIANCE ASPECTS

ADVANCED CONTENT MANAGEMENT Smartkarma is registered in Singapore and classified as an Internet Content Provider under the Algorithms have been developed to automatically Singapore Media Development Authority’s Class tag publications according to the content, although Licence Scheme. It is not registered or licensed as IPs can also manually tag relevant key words. a “financial adviser” under Singaporean legislation Keyword tags allow easier filtering of content. and regulation. As a result, there are no stock Another concept that Smartkarma has introduced is recommendations or price targets. As we have called “forking”. Publications with sufficient nexus noted earlier, however, its bull-to-bear ratio has can be grouped together either automatically via been approximately 60:40 since inception. algorithms or manually tagged by the publishing Compliance safeguards have been built into IPs. This provides users with an easy reference Smartkarma to “future proof” against future changes for a particular topic, as well as other topics which in regulation. A recent enhancement allows may pivot from it. Insights on an ongoing topic – compliance officers from a user organisation to for example, an infrastructure company building monitor and download activity for their internal a major asset – are grouped together. An insight reporting requirements. about a particular company’s supplier relationships can also pivot to publications about those suppliers. THE PROPOSITION FOR RESEARCH WORK EFFICIENCY TOOLS PROVIDERS

Several work efficiency tools have been developed HOW TO JOIN by Smartkarma. One is a standardised chart creation application that follows Smartkarma’s Currently, IPs are recruited via direct enquiries, branding protocols, allowing IPs to save time on referrals from current IPs, or actively sought out by the visual presentation of their intellectual content. the Smartkarma team. A multi-step vetting process Another tool, called HoldCo Monitor, quickly pulls includes the submission of written research work, up the holding company discount to net asset value a review of experience and submissions, and an (NAV) and NAV composition for companies in the interview. IPs are then provided with a trial period to coverage universe. Other tools support IPO and observe the platform without publishing. M&A analysis. To add depth to the insight contributions, the company has opened up the platform to non- traditional research providers, including academics, lawyers, and data scientists.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 35 REMUNERATION Engagement measures levels of interaction with consumers, including the quality of that interaction. For research providers, the company provides a We understand that it discounts the “noise” from unique remuneration proposition. More than two- simple clicks on a report, but takes into account thirds of monthly subscription revenues are paid aspects such as users proactively reaching out to out to IPs based on a Smartkarma-coined term and IPs, and the IP’s follow-up actions. 75% of QVA is methodology, called Quantified Value Add or QVA. determined by engagement. Determined by more than twenty metrics, QVA is an index of the total value that Smartkarma provides Collaboration measures interaction amongst IPs, to consumers, and is used to determine the sharing including peer reviews of reports prior to publication. of the revenue pool amongst all IPs. The two key It also serves the purpose of supporting and variables measured by QVA are engagement developing newer IPs, especially those making and collaboration. the move to an independent research analyst set- up, or those expanding beyond their traditional domestic audience. 25% of QVA is determined by collaboration (see Figure 15).

ENGAGEMENT MEASURES LEVELS OF INTERACTION WITH CONSUMERS, INCLUDING THE QUALITY OF THAT INTERACTION. WE UNDERSTAND THAT IT DISCOUNTS THE “NOISE” FROM SIMPLE CLICKS ON A REPORT,

ENGAGEMENT • Measures the level and uality of interaction 25 with consumers • Discounts “noise” from simple report clicks • Takes into account proactively reaching out to IPs, as well as IP follow-up actions

COLLABORATION • Measures the level of interaction among IPs 75 • Examines criteria such a peer review and feedack prior to report pulication

Source: Smartkarma, Quinlan & Associates analysis

Monthly payments to IPs are based on a rolling Some research providers, especially the larger three-month QVA, in order to smooth QVA income firms, continue to use the platform as a traditional during breaks from work. This adds to work flexibility, research push platform to distribute their research, especially for independent analysts. Since April whilst other research firms allow their analysts 2016, total payments to IPs have increased over to develop an individual, online, and engaged 140%, reflecting the increase in subscriber base. presence on the platform.

PULL-FACTOR RESEARCH

A discovery scoring tool that has recently been released allows IPs to understand which topics or companies users are most interested in, compared to the research that is currently available. This investment research supply-demand “gap analysis” allows IPs to be more strategic around where they focus their publishing efforts.

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 37 SUMMARY For IPs, Smartkarma is not just a content distribution platform – through the use of content and work For users, Smartkarma is attempting to differentiate management tools, it is also a publishing platform. itself through new and alternative content, the And whilst the platform is heavily reliant on curation of content both through its upfront selection technology, the humanistic aspects incorporated of IPs and smart algorithms to filter content, and into the platform are particularly thought-provoking. dynamic engagement between users and IPs. It These include the collegiate support network for not only offers Asian-focused content, but also IPs where desired behaviour is directly reinforced newer content verticals such as accounting, through remuneration, and QVA income smoothing financial risk, and big data analytics, which are not which provides income stability. typically covered by the larger brokers. We believe Smartkarm’s bull-to-bear ratio of ~60:40 is a telling By designing a platform that places as strong indicator of the independence of the IPs publishing an emphasis on supply as demand, we expect on the platform. Smarkarma to be an attractive proposition to even highly-ranked research analysts looking to move The Smartkarma-SocGen tie-up was a major to a more independent set-up. As the number of breakthrough for the industry and we expect to see IPs increases, we expect that Smartkarma’s main other tie-ups between ORMs and broker firms in the challenge will be in ensuring the quality of IPs and months ahead. their content is maintained.

FOR IPS, SMARTKARMA IS NOT JUST A CONTENT DISTRIBUTION PLATFORM – THROUGH THE USE OF CONTENT AND WORK MANAGEMENT TOOLS, IT IS ALSO A PUBLISHING PLATFORM. AND WHILST THE PLATFORM IS HEAVILY RELIANT ON TECHNOLOGY, THE HUMANISTIC ASPECTS INCORPORATED INTO THE PLATFORM ARE PARTICULARLY THOUGHT-PROVOKING.

As highlighted in Section 4, beyond the strategic and With research revenues forecast to decline by operational benefits that integrated brokers stand to ~40% for some of the largest investment banks, receive from exploring alternative research models, we anticipate some research departments to be we expect MiFID II to have a negative impact on the underwater to the tune of USD 240 million post- P&Ls of many leading investment banks. MiFID II under their current structures (see Figure 16). This does not take into account additional costs Based on our discussions with various industry tied to a bank’s MiFID II compliance obligations. experts, we estimate the largest global banks are spending anywhere between USD 600-800 million per Given the negative outlook for integrated year on their research platforms (USD 300-450 million brokerages, we feel current structures are generally for tier-2 global firms) on a fully-loaded basis. More unsustainable, and believe brokers will need to critically, many of these banks’ cash equities platforms make a brave call around their future business (i.e. the research distribution engines of the equities models post-2018. businesses) are currently operating at cost-to-income ratios in excess of 90%.

WE ANTICIPATE SOME RESEARCH DEPARTMENTS TO BE UNDERWATER TO THE TUNE OF USD 240 MILLION POST-MIFID II UNDER THEIR CURRENT STRUCTURES

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 39 FIGURE 16: P&L IMPACT OF MiFID II ON LEADING GLOBAL BROKERS

Pre-MiFID II Post-MiFID II

500 Significant P&L loss forecast under existing 300 research model

100

-100

-300 Revenue Expenses P&L Revenue Expenses P&L

Source: Quinlan & Associates estimates

Our consultants have worked with a number BUY-SIDE of brokers, buy-side players, and IRPs on their We recognise many buy-side firms are still extremely strategies in response to MiFID II’s research unprepared for MiFID II implementation, especially unbundling regulations. players in Asia-Pacific. Examples of where we can help include: SELL-SIDE The sell-side faces considerable challenges • Assessing the impact of regulations on current realigning their businesses in the wake of the business models, broker interactions, service structural changes affecting the industry. Immediate offerings, and governance models, especially for decisions will be needed to remain competitive in regional businesses the short-term. However, we believe a fundamental • Determining an appropriate research payment rethink of research provision within sell-side firms is option (i.e. P&L vs. RPA) ultimately required. Examples of how we can help include: • Developing a methodology for research budget setting and monitoring (including setting up KPIs) · Evaluating alternative options for investment banks’ research product offering, including • Reviewing and developing an in-house research the financial, strategic, and operational strategy considerations of new models such as JVs and outsourced research INDEPENDENT RESEARCH PROVIDERS As we have indicated in Section 3, changes in • Conducting client-level profitability segmentation the research landscape provide the ideal timing analyses to improve coverage decisions for research analysts to re-evaluate their options, • Benchmarking performance of research offering whether to join an IRP or to set up their own to drive product recalibration decisions IRP. Examples of areas where we can help include:

• Developing workable research pricing schedules • Developing strategic plans for IRPs to capture to maximise firm economics and client demand the new opportunities, including comprehensive reviews of their value propositions and unique selling points (USPs)

• Reviewing growth strategies, including branding, marketing, and scaling of the business

• Determining the most appropriate collaboration and distribution channels

• Introducing new entrants to potential collaborators

• Developing alternative revenue streams, including new markets and products

IS IT TIME FOR INVESTMENT BANKS TO EXPLORE ALTERNATIVE RESEARCH MODELS POST-MIFID II? 41 STRATEGY WITH A DIFFERENCE

Copyright © 2017 Quinlan & Associates. All rights reserved. This report may not be distributed, in whole or in part, without the express written consent of Quinlan & Associates. Quinlan & Associates accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Quinlan & Associates. This report is not financial or investment advice and should not be relied upon for such advice or as a substitute for professional accounting, tax, legal or financial advice. Quinlan & Associates has made every effort to use reliable, up-to-date and comprehensive information and analysis in this report, but all information is provided without warranty of any kind, express or implied. Quinlan & Associates disclaims any responsibility to update the information or conclusions in this report. Quinlan & Associates accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. This report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. Quinlan & Associates engages in and seeks to do business with some of the companies mentioned in its reports. ABOUT US Quinlan & Associates is an independent strategy consulting firm specialising in the financial services industry. We are the first firm to offer end-to-end strategy consulting services. From strategy formulation to execution, to ongoing reporting and communications, we translate cutting-edge advice into commercially executable solutions. With our team of top-tier financial services and strategy consulting professionals and our global network of alliance partners, we give you the most up-to-date industry insights from around the world, putting you an essential step ahead of your competitors. Quinlan & Associates. Strategy with a Difference.

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