Equity analysts have only one way to get paid

The value of equity research flows to the fund manager while the value of trade execution flows to their client, the model embeds conflicts that have long invited scrutiny.

It was in London, in 1995, when Jim Barksdale, chief executive officer of Netscape, famously remarked that there are only two ways to make money: bundling and unbundling. The internet pioneer’s point might have been focused on software but it resonates across numerous other industries — with the apparent exception of equity research.

Investors at Barksdale’s roadshow at the Savoy Hotel would have returned to office desks overflowing with investment research, dispatched daily from brokerage firms. Such research never came with an explicit price tag – it was simply bundled into the cost of trading. In the US, that’s still broadly the way the market works.

But since 2018, the European Union has required money managers to pay for trading and research separately under its second Markets in Financial Instruments Directive (MiFID II) — an experiment that hasn’t worked.

The rules “might have impaired the overall availability of research,” a European Commission memorandum admitted late last year. Rather than creating the conditions to make money, unbundling turned research into a money loser, and capacity left the industry.

While a waiver was issued by the Securities and Exchange Commission to allow both US and European models to operate concurrently, this week it expired. Netscape (bought by America Online in 1998) is long gone, but European asset managers are left in limbo as to how to procure investment research on US stocks.

Fortunately, they may not have long to wait. European legislators are now looking to reverse their ban on bundled research.

In 2021, the EU walked some of the way back, allowing research of small-cap stocks (below €1 billion in market value) to be rebundled into trading. Now, they want to go further. “Rules need to be further adjusted to offer the investment firms more flexibility in the way they wish to organise the payments of execution services and research,” notes a European Council negotiating brief.

For brokers that have already left the industry, the U-turn comes too late. Redburn, a UK-based firm, was founded 20 years ago “on a passionate belief in the importance of in-depth, uncompromised, fundamental research, and serving clients, particularly when augmented by high quality agency execution.” MiFID II upended its business model. It “had a considerable impact on industry practice,” the company wrote in its 2019 annual report. “Especially relevant to the Company was a significant reduction in the aggregate equity research market wallet.”

From peak revenue of £96.4 million ($122 million) in its last financial year before the implementation of the new rules, Redburn’s revenue fell by a third to £63.5 million in the calendar year 2021. Before waiting to see what 2022 had in store, the company agreed to sell out to Rothschild & Co.

Bernstein Research is another firm to have suffered. Although its business is centered on the US, it has seen revenue decline in six of the past seven years. Late last year, its parent AllianceBernstein Holding LP bundled it into a cash equities joint venture with Societe Generale SA.

That unbundling would create so much upheaval should not have come as a surprise. As economists know, bundling works best when two conditions are met: high variance in demand and zero marginal cost. The first makes the product difficult to price on a standalone basis; the second ensures it’s never sold at less than cost. If a product costs $100 to produce but the market only values it at $50, profit can be maximised simply by discontinuing it; if it costs $0 to produce, then some value can be captured including it as part of a bundle. Equity research, like many information goods, fulfills both these conditions.

Yet because the value of equity research flows to the fund manager while the value of trade execution flows to their client, the model embeds conflicts that have long invited scrutiny. The added conflict of research morphing into a marketing front for advisory and underwriting functions in the early 2000s convinced New York Attorney General Eliot Spitzer to lobby for investment banks to fully spin off their research units. But the proposal was abandoned not least because of the poor economic prospects for independent analysts in such a spun-off firm, and softer separations were imposed instead. Later, in 2007, the chair of the Securities and Exchange Commission floated the idea of unbundling and, again, it failed to gain traction. As the Europeans are learning: the bundled model just works.

That’s not to say some unbundled research can’t make money, as the plethora of finance Substacks (mine included!) demonstrates. But we are still small beer in the context of the overall research industry.

Research bundling has now survived multiple challenges throughout its history: from shrinking brokerage commissions to regulatory intervention to European bureaucracy. Barksdale may be right that in most industries there are two ways to make money; in equity research there is only one.