Competition is heating up in the equity research industry for a product that until recently has been regarded by its fund manager consumers as ostensibly free. Next year’s introduction of commission unbundling regulations, as part of MiFID II’s implementation, is forcing the industry to value research in a way that fundamentally disrupts the economic relationship between investment banks, or brokers, and their fund manager clients.
The regulatory move coincides with increasing cost pressures, leading to reduced buy-side research budgets, and is pitting investment banks against new entrant research providers in a battle for a global market that is said to be as large as $20bn in value. Now that fund managers need to directly pay for research, they are starting to shop around.
And this clash is akin to the one between incumbents and new entrants described by celebrated Harvard Business School Professor Clayton Christensen in his 1997 book “The Innovator’s Dilemma.”
A Deflationary Shift
While the industry is focusing on the mountain of work needed to become compliant with the new regulations, and is working out how to deal with a world of constrained costs and price competition, the underlying forces that are driving these shifts can be viewed as economic and not only regulatory.
The changes, at their core, are deflationary. MiFID II’s ultimate aim is to reduce fees and costs for the end consumer of fund products, the public, and this is having knock-on effects throughout the equity industry supply chain. And as with most deflationary trends, technological change is a significant factor in the cost down process.
MiFID II may be the catalyst, but the agents of change are the smaller equity research new entrants, and Christensen’s theories neatly encapsulate their emerging position within the research industry.
Christensen argues that large companies are good at improving existing technologies but are unable to deal with disruptive ones. He asserts that it is new entrants who can deliver product in a “cheaper, simpler, smaller and, frequently, more convenient to use” model and the read-through to the shifts in the equity research business are evident.
Incumbent brokers are structured to generate a high-cost product, aiming to cover all the needs of all their clients. But, regulation and cost pressures are changing how fund managers consume research – cheaper, more data and fact-driven primary research is increasingly valued over expensive secondary research, which focuses on opinions.
The focus by incumbent players on this expensive secondary research gives space for the emergence of smaller, more nimble, new entrants. Sensitive to the changing demands of their fund manager clients, the new entrants are able to use technological innovation to gather and distribute their primary research in a more cost-effective manner.
Cheaper, Simpler, Smaller and More Convenient
New entrant research firms are cheaper. They run compact research teams and do not have the legacy and high allocated costs that incumbents suffer from. They are simpler, avoiding the large bulge-bracket management structures where the only way of dealing with change is to add more features – and complications – to try and improve existing methods.
Smaller and more agile, they are better placed to take advantage of new technology shifts and apply them without being constrained by legacy structures. And their product is often more convenient to use – new entrants do not feel the need to be “all things to all people” and can specialise, helping their clients form a clearer view of what areas they excel in and provide direct access to the people who are doing the research.
Incumbents Hesitate, New Entrants Move in
Christensen concedes that new entrants at first use “innovations that result in worse product performance, at least in the near term” and “do not initially satisfy the demands of the high-end of the market.” But while incumbents are too invested in their current models to anticipate shifts and hesitate to execute change, new entrants can take advantage of their low cost base to gain market share and then, crucially, climb up the value chain.
Be it Toyota’s low-end entry into the US market in the 1970s, eventually laying waste to GM’s legacy dominance, or Steve Jobs’ singular focus on the PC during the heyday of the mainframe computer, there are numerous historical examples of this. Equity research provision looks like the next example of an industry where smaller, specialised firms take advantage of lower cost structures to provide a new – and initially raw – product that satisfies changing consumption trends.
Certainly, incumbent investment banks will remain powerful forces within the equity research business. They maintain a number of advantages, including market knowledge, information flow, a stock of high-quality analysts and strong corporate relationships that they can bring into play for their clients.
But MiFID II has acted as a catalyst for change. The genie is out of the bottle and new entrants can take advantage of this change to focus on the value ends of equity research that investment banks, handicapped by cost pressures, are vacating. As they develop, new entrants will gain market share – and when the market shifts to them, so eventually will the information flow, high-quality analysts and corporate clients.