Reinventing equity research as a profit-making business

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Equities market closed bearish as profit taking continues

Although the traditional business of providing equity research faces challenges, it is still an attractive opportunity for players that can adapt to deliver what the buy side values.

The traditional business of providing equity research to asset managers has been under pressure in recent years, as managers, challenged to deliver alpha to their clients, seek new forms of research and asset owners turn increasingly to passive strategies. Now, new regulation—specifically, the advent of MiFID II in Europe in 2018—is about to escalate these pressures.

The trigger for accelerated change in the equity research business is the January 2018 go-live of European MiFID II regulations, which call for the explicit unbundling of charges for execution services and investment research by banks and broker-dealers. While the new MiFID regulations may strictly apply only to European asset managers, the impact is likely to be broader, as asset managers extend the MiFID II model of separate payments beyond Europe to their global operations. The result could be a sharp decline in the demand for equity research: the consensus view of banks we surveyed calls for an industry-wide drop in equity-research revenues of 30 percent or more over the next three years, although other scenarios could well play out (exhibit).

Several scenarios could play out for research commission pools.

For the first time, bank and broker-dealer equity research will operate as a free-standing profit center, forcing a transformation of the business. The buy side will pay broker-dealers for actionable research that adds investment value, but the demand will fall far short of the mountains of research that banks currently supply “for free.” For asset managers, as research becomes an itemized cost, profits could be sharply reduced—by as much as 15 to 20 percent for firms in Europe. The resulting change to research operations could be enormous.

To succeed in this transformed environment and meet asset managers’ more exacting standards, banks and broker-dealers will need to focus on the changing nature of the types of research the buy side finds useful and overhaul their offerings. Long-only active managers and hedge funds focused on equities are demanding less in the way of traditional products (that is, single-stock research reports) and more in services, such as access to analysts and corporate management. Moreover, investors are seeking new forms of information and analytics, through big data and artificial intelligence (AI), which can complement conventional fundamental research in portfolio decision making.

Beyond producing quality, differentiated research, banks will also need to adopt new operating models for their equity research businesses. This calls for focusing on four strategic priorities:

  1. Establishing a research footprint that capitalizes on strengths of coverage in sectors and regions, and extending reach through joint ventures.
  2. Understanding the scarcity and perishability of ideas, and what value clients place on research in different forms—reports, analyst and corporate-management access, conferences, and other forms of information and analytics.
  3. Translating client preferences and demands into informed pricing structures. Explicit prices must be assigned to research, whether item-by-item for individual products and services or through packages or broad subscriptions.
  4. Adopting new technologies to generate novel investment ideas and lower costs. The sell side can leverage AI to interpret high-frequency market data in real time, patterns in both supply and demand chains, and social media. They can reduce costs by automating basic financial analysis and maintenance research. For client coverage, analytical tools can discern clients’ preferred means of research delivery and service.

Five business models may evolve for the provision of equity research and execution services in the future:

  1. A few global banks will lead the industry with both global execution services and high-quality, broad-based research coverage.
  2. Another cadre of two to three firms, likely market makers that are not banks, will be global leaders in execution but offer no research or only a limited, specialized array.
  3. A second group of universal banks will attempt to maintain their current broad research efforts, combined with global execution at a smaller scale than the leaders. In view of dwindling research revenues and the competition for low-cost execution, however, this model is not likely sustainable, although some firms could make up the shortfall in client revenue internally from banking and wealth-management units. Accordingly, many firms currently large in both research and execution will have to make significant cuts in one direction or the other.
  4. The majority of banks will rationalize their research and execution capabilities by focusing on their “home-field advantage” in local sectors and regional markets. Demand from local and global clients will likely support one to three such banks per region.
  5. Independent research firms offering little or no execution should see significant growth in the new landscape, as they reverse the past trend among many research boutiques of offering execution as a means for the buy side to pay for research.

These strategic shifts are likely to take time, however, given several barriers to exit. Research is an entrenched part of capital-markets operations and provides value to banks’ investment-banking, wealth-management, and equities units, as well the intangible benefits of burnishing the corporate brand. Some firms will want to keep a hand in research as an option to scaling back up. Evolution will come fastest to European banks, followed quickly by the United States, while the Asian market may be slower to change.

 

SOURCE: http://www.mckinsey.com/industries/financial-services/our-insights/reinventing-equity-research-as-a-profit-making-business?cid=other-eml-alt-mip-mck-oth-1709&hlkid=a5d9732c1f814e738c11a5e744e4b3e6&hctky=10103831&hdpid=92936536-8625-4b1b-b89e-7f6961759f5b