Equity research under pressure #research #bankculture

William Vincent, Senior Consultant, william.vincent@skadilimited.com

UBS has been caught up in a political row in Australia after it produced a research report on the privatisation of a New South Wales electricity utility, a deal in which it is acting for the seller. What happened is that UBS put a report entitled “Bad for the budget, good for the State”, then changed the title to, simply, “Good for the State”. The opposition Labor (sic) party is claiming that this was the result of direct interference from the ruling Liberals.

To which a rational first response is “so what?” After all, Australia is a long way away, and Australian politicians are renowned for fighting like starved rats in a barrel, so why should anyone bother about this? In fact, while the details are not terribly important, this case, coming on top of several others, illustrates equity research is still vulnerable as it tries to square the various circles of adding value to its users, not offending the investment bankers and their clients, satisfying ever-more intrusive regulators, all the time while facing a crippling squeeze on revenues.

Two instances over the past year or so indicate the scale of the problem. First, last summer UBS (again) came under fire, this time in the UK. A UBS analyst had produced a report on Saga, which UBS had helped to float a few months earlier, with an Underperform recommendation and a target price some 4% lower than the sale price. The result was a chorus of criticism, notably from the UK Shareholders’ Association, which was quoted in the Financial Times as saying, “It’s all wrong for them to value the company at a high level and then drop it,” while an unnamed but — according to the FT — influential fund manager described the incident as “very, very strange.”

So, this argument goes, it’s wrong for an analyst to set a price target (which, incidentally, has proved to be accurate) independently of the bankers, rather than try to ramp up a price simply because his house had a role in the flotation? Clearly, no-one has told the regulators, who have spent much of the past fifteen years setting and enforcing rules that give analysts no choice but to act in a way that the UK Shareholders’ Association believe is “all wrong”. In short, UBS’ analysts were attacked for doing exactly the right thing – a classic case of damned if you do, damned if you don’t.

Second, there was the case in the USA last November when Citibank was fined a cool $15m for inadequately supervising equity analysts. The specific issue was that an analyst told people at a dinner that he’d short a stock on which he had an official Hold rating. It is possible to think of reasons why analysts might feel there is little wrong with this position, for example a share that is expected to perform in line with the market over a twelve month timeframe might well be over-bought in the short-term, nonetheless the regulator took tough action.

These cases, and others, illustrate how difficult it can be for research to operate today. What should banks now do – send a compliance person to every analyst dinner, lunch or post-work beer with a client? The only answer is for research to have absolutely clear, transparent and detailed policies for every regulatory contingency. Banks must be able to convince the regulators that every analyst is aware of the rules, receives regular training in them, and understands the consequences of not following them. Research management and the analysts under them must understand that compliance is not optional, and that the penalties for even what seem like minor breaches will be severe. Needless to say, this will not go down well with the notoriously egotistical and touchy research community, but the price of being caught in financial and reputational terms is so high that no alternative exists.

The problem is that heads of research aren’t necessarily experts on the regulations, and in any case are likely to be caught up in the day to day cat-herding exercise that is managing analysts. The compliance and other professionals who do understand the regulations are not analysts, and thus don’t necessarily know the pressures inherent in the job, and they run the risk of being seen as “the enemy” by the people at the coalface, with all that that implies.

Meanwhile, Frost Consulting has estimated that total spending on equity research fell to about $4.8 billion in 2013 from $8.2 billion in 2008, with a further cut, to around $3.4 billion, expected by 2017. London is likely to be hit especially hard, because new rules will effectively prevent payment by the buy side for research that is not “substantive.”

Many banks will almost certainly have to axe much, if not most, of their current output, and with it the people responsible for it. The whole ethos of research will have to change, from churning out yet another quarterly results analysis or big, bland sector review to doing radical stuff, like producing readable, original, tightly argued research that produces recommendations that actually make money.

All in all, therefore, research is facing a period of fundamental change. Those that get it right have the opportunity to clean up in a market where much of the competition will be squeezed out. Those that do not will be the squeezed.

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