Archive | Financial System RSS feed for this section

Future Consolidation Ahead?

29 Nov

Over the past few months, I have been informing you about the trend we are starting to see in the independent investment research marketplace. My past posts have called for the independent investment research marketplace to consolidate for a few reasons:

1. Discretionary spending on independent investment research is down due to the awful effects of the recent crisis. – causing revenue sustainability and growth challenges for the smaller research providers.

2. The number of hedge and mutual fund professionals is down from the height of the market in 2007 – further challenging revenue sustainability and revenue growth.

3. Independent investment researchers will continue to be threatened by issuer generated lawsuits – to offset these challenges, firms will merge to create a stronger balance sheet.

4. The recent challenges of the credit rating agencies will provide an opportunity for independent investment research providers to enter this marketplace. Considering these propositions, this memo is to once again reinforce our original hypothesis and to provide a glimpse into the past few weeks’ events. _________________________________________________________________________________

This week much coverage has been given to the impending indictments of insider trading across the financial services industry. As one may expect, the typical cadre of hedge funds and analysts are being mentioned among those possibly indicted. However, recognized names in the independent investment research and expert network business have been rumored upon, as well. This presents a unique difficulty for these businesses. Institutional and retail trading, brokerage firms, understandably sensitive to any controversy, will most likely sever ties to any research or expert network providers embroiled in the impending investigation, despite the very strong possibility that many of these firms will be cleared of all charges – in the long run. Unfortunately the long run is just too far in the distance for many of the smaller independent investment research firms.

Impacted by the drop in discretionary investment research spending, the drop in fund professionals and the elimination of federal funding, many of these firms will have a severe challenge of making it through to next year, despite the fact that their research may be industry or market leading.

In addition to the most recent downbeat press, there are signs of vitality in the investment research marketplace as well. Most recently Meredith Whitney, the previous ¬Oppenheimer & Co. banking analyst who predicted the credit crisis, announced that she plans to alter her independent firm into a nationally recognized statistical rating organization that will rate debt and will compete with Standard & Poor’s, Moody’s and Fitch.

With the yet unknown regulations that will impact the credit research marketplace, it is still too early to tell if the move to become a NRSRO agency is a potential avenue for many of the smaller investment research firms. What can be taken away from this is that the investment research market will change, some firms will go away no doubt, some will merge and some will be acquired – the open question is who will win and who will lose

 

Independent Investment Research — What’s To Come

28 Sep

My overall hypothesis is that the independent investment research marketplace is finding its way amidst the previous market turmoil, recent and unwarranted issuer retaliations, the end of the Global Settlement monies and the declining number of investment management professionals.

Independent investment research has a market size estimated at about $2 billion and growing, and represents approximately 250 companies in the United States. Yet I have been noticing a consolidation in the marketplace: companies between $8- $20 million in revenue have faced serious challenges achieving their next level of growth. The decrease in the number of traders and fund managers, coupled with the decrease in discretionary spend of retail investors seeking alpha, may have temporarily thwarted the upward momentum of both leading and average firms. Although the end of the Global Settlement has not impacted many of the research firms, it has created a hole for some of the larger providers.

To offset some of these challenges, investment research firms are looking to become multi-faceted by enlisting qualitative, quantitative, and expert network services, integrated within multi-asset class offerings. This is a direct attempt to increase competition with the larger research providers, such as Morningstar, S&P, MSCI, Risk Metrics, Moody’s, Thomson Reuters, IHS and Gerson Lehman.

In addition, I have noticed some firms are taking advantage of the recent challenges facing the credit rating agencies by entering this marketplace, albeit cautiously. Lastly, I have noticed that some firms have realized that a larger balance sheet can help sustain them in a down market and when dealing with adverse situations, such as “issuer retaliation” a common concern throughout most of the investment research marketplace.

It is my opinion that with the recent credit rating agency concerns, the recent sell-side research issues, and the conflicted activities of independent auditors that over the next few years, independence within the marketplace will return to prominence.

However, despite my bullishness on the industry, in the near term I see continued consolidation with companies seeking greater sales and distribution systems, larger balance sheets, and diversified offerings leading the way. Companies that are at the apex of the growth curve, those that are at the crossroads of raising more capital for infrastructure and hiring a larger sales force will be most favorable for an exit by a larger strategic provider.

Compared to the second half of 2009, the first half of 2010 has shown 40% and 20% increases in Price to Revenue and Price to EBITDA multiples, respectively. I believe these attractive movements in multiples will only accelerate consolidation in this industry.

The strategic acquirers that have been active in this marketplace are those you might expect, such as Morningstar and MSCI Barra but media conglomerates have also been expressing interest in this market. I have seen some of these firms purchasing their way into the investment research business. It is not far-fetched to see social media companies such as LinkedIn purchase Expert Network Providers and or dabble with equity and or fixed income research. For example, SourceMedia has recently entered the independent investment research business with the hiring of Jim Moore, former CEO of Highline Financial. The continued interest on behalf of media companies to diversify their portfolios into research will most likely gain traction as such businesses are not associated with ad revenues or steep correlations with marketing spending.

In addition to media companies, market data providers and analytics companies without news organizations also find great value in independent investment research providers. Most recently, FactSet’s acquisition of MarketMetrics, Thomson Reuters acquisition of Asset 4, and Point Carbon and Morningstar’s acquisitions of Old Broad Street, Aegis Equities Research and Realpoint LLC support this point. Other financial information providers, such as MSCI Barra, will continue to find interest in data analytics and quantitative research firms, as evidenced by their recent purchase of Risk Metrics.

Overall, I am bullish on the independent investment research marketplace long term, yet cautious over the next few years. Only time will tell, but it seems that with the consolidation in the industry, the higher quality independent investment research providers with deep domain knowledge, strong intellectual property, and strong margins will be acquired and those with less than stellar margins and limited access to sales distribution may find it challenging to compete.

There is no easy path to job growth

20 Sep

Sorry for the extended delay in writing, life recently took the best of me.   In between work, lectures and family events it has been challenging to address some of the things on my mind.  I am currently in the midst of writing a series of articles on job growth, structural unemployment and the need for a private-public initiative to fix the structural challenges facing our country.

In many respects my thoughts are in favor of free-market ideals, yet only when those who we are competing against are doing the same.  In many respects my thoughts have a mercantilist stance as well, considering moving away from our current stance as overseer of world events to a participant in trade, a country who minds their own business and focuses on growing GDP, increasing innovation, decreasing domestic poverty and increasing domestic education.

A quick entree into the upcoming articles, you can see where I am headed with the following quotes in the Star Ledger yesterday.  

http://www.nj.com/business/index.ssf/2010/09/theres_no_simple_solution_to_j.html

Cheers,Unemployment lines of the 1930's

Chris

From Research to Credit Ratings – The Case for Independence

20 Aug

Over the past twelve years, the markets within the United States have been plagued with research analysts, auditors and now credit rating agencies who were influenced to communicate information that was less than truthful.

Regulatory changes were implemented due to each of these situations, and while they addressed some of the more pernicious practices, they have not fundamentally changed the misalignments that still persist between investors, corporations, and stakeholders.

  1. 1. The research analysts were financially aligned with the company they were researching rather than with the stakeholders who were relying on the research reports.
  1. 2. The auditors were financially aligned with the company they were auditing rather than with the stakeholders who rely on the validity of the financial statements.
  1. 3. The credit rating agencies were financially aligned with the investment bank underwriting the securities rather than with the stakeholders who rely on the validity of the ratings.

At the core of the problem is a lack of fiduciary responsibility; those who manufacture, analyze or rate corporate information do so for the client and not the stakeholder relying on the information.  It seems that in order to reestablish trust in the marketplace and to once again reinforce the free-market system, the government must address this real concern.

First, any financial misalignments between those relying on and those creating or supplying financial or corporate information must be eliminated, requiring the mandated divestiture of investment banks’ research departments.

Secondly, it must be ensured that auditors and credit rating agencies are not paid by corporations or investment banks.

Lastly, we must re-establish competition in the market.  Today, there are only four major auditing firms, ten credit rating agencies (with the largest three servicing the majority of the marketplace) and only a handful of reputable firms creating independent research.  Consideration must be paid to the idea of breaking up the four major auditing practices into a dozen or so companies that will foster competition.  Transparent SEC guidelines that enable competent analysts can gain Nationally Recognized Statistical Rating Organization status will also increase competition.  By creating more competition in the marketplace, these service providers will continue to seek out new and innovative processes to help create better quality audits, research, and ratings.

Below are some recent articles that may be of interest.  We will continue to follow the changes in the market for credit ratings, audits and research.  Next week I will be posting a larger analysis of the misalignments between these actors.

http://online.wsj.com/article/NA_WSJ_PUB:SB10001424052748704268004575417811362825370.htm

http://www.nytimes.com/2010/06/01/business/01sorkin.html

http://technorati.com/business/article/credit-ratings-hit-euro-and-greek/

http://www.dailyfinance.com/story/credit/credit-ratings-have-outlived-their-usefulness/19510068/

http://reason.com/blog/2010/08/11/credit-rating-agencies-cant-li

http://www.project-syndicate.org/commentary/bebchuk12/English

“Who’s keeping Score?”

14 Aug

Opinion By: Luigi D’Onorio DeMeo

Have you been to a tee-ball game lately? Did you hear the score? You may be surprised to learn that the score is not kept and there are no league standings, such as what team is in first, second, third or dead last. Despite the idea that there are no standings and no recognized winners or losers, at the end of the season all the teams celebrate with a pizza party and most likely every child will receive the same size reward, regardless of their team and or personal performance. Another example that is similar to, yet different in many respects is the all too often young child in the toy aisle stomping up and down for a toy until the mother or father finally shouts, “Fine, you can have it!”

Although these are only two observations, arguably they underscore a larger movement that is predicated on indulging young children and shielding them from the realization that sometimes you lose and sometimes you cannot get what you want.  It seems that over time, as the nation has become wealthier, this type of pampering has led to generational changes in the United States with the younger generation being taught that it is OK to seek reward when you are not successful and it is OK to buy, even when you do not have the means to afford it. Perhaps it is this type of education that has made us accept the concept of bailing out a company when they should have failed, supporting a homeowner when they borrowed more than should, or paying for unemployment when individuals do not save anything and the list goes on.

It appears as though today, Darwin and his suggestions about nature and survival of the fittest, notions driving the capitalist system have been replaced with more motherly, nurturing approaches. The fundamental problem seems to rest with the parents who guard their children against loss – unfortunately taking away their natural instinct to compete. Capitalism only works when corporations compete fairly with one another with one corporation winning and the other losing. Similar to a zero-sum gain, this capital system cannot sustain itself if we are afraid to facilitate competition amongst our youth. Harsh as this may sound, the youth of the United States need to experience the challenges of life and the joys of success – only than will responsibility regain its position as virtue.

I would contend that children that grew up during the strong economy of the 1990’s and 2000’s tend to be more spoiled and less responsible than those who did not. For example, it seems that the Americans that grew up between 1920 and 1940 became prudent adults and leaders who helped build this great nation. From JFK to Ronald Reagan, Paul Volker to Warren Buffet they all grew up through the Great Depression. These people all share something in common; they seem to believe in the efficiency and competition of the free markets.

On the other hand, the generations that grew up during the Great Moderation, between 1980 and 2000 and who were raised with a more kind nurturing capitalist system have now come into power. People of this generation include George W. Bush, Bill Clinton, Barack Obama, and Tim Geithner. It is no coincidence that these are the individuals that could not let an entity fail. They created backstops for weak companies and disrupted the stronger ones. It is this generation that has attempted to create affordable housing for everyone, bank and auto bailouts, and tee-ball games with no scores.

Fortunately or unfortunately, depending on how you observe the situation, it seems at though the tides will change, as we live through the next ten or so years of dismal growth and high unemployment. As my generation thinks through and painfully solves the problems of our past excesses, perhaps we will learn that we need to keep score with our youth, we need to teach responsibility at a young age because we have learned that it hurts too much and costs us dearly to learn about competition and responsibility when we are entering our productive years.

Luigi D’Onorio DeMeo is a recent graduate of Seton Hall University and a frequent writer at ReinventingTheMarket.com.  Luigi can be reached at — luigidemeo@gmail.com

The FINANCIAL REFORM BILL – Times of Uncertainty

16 Jul

One is not hard pressed to appreciate the energy and execution ability of President Obama.  Since he took office, he has passed the Healthcare Reform Bill, the Economic Stimulus Package and the most recent Financial Reform Bill.  Despite his ability to get this legislation through the House and Senate and despite his appeared real conviction for these bills’s value, he has suffered dramatically in public opinion and support.  In many ways I appreciate his willingness to stand up and lead, even in spite of his most likely short lived presidency.

Regardless of his willingness to lead and take decisive action in hard times, it appears to me and most of the United States’ population that something is amiss with his policies. The most likely candidate for his continuous decline in public support may have something to do with uncertainty.  It seems as though the Healthcare Reform Bill and even more the Financial Reform Bill are fraught with ambiguity and lack of insight into the economic impact these bills may have on the business and financial community.

To help explain this uncertainty, let’s briefly analyze the Financial Reform Bill (FRB) that was approved by the Senate yesterday.  The bill touches all financial regulatory bodies and creates new financial regulators and offices that add to the already complex nature of financial regulation.  According to SIFMA, the FRB contains 456 actions that need to be implemented.  These actions may include conducting studies to analyze systemic risk across the economy or creating new reports to be shared across many of the financial regulatory agencies.  The takeaways from these actions are that they will be conducted over the next 3 years with many studies and actions taking place over the next 12 months.

Inherent within this bill is the fact that uncertainty of the real economic impact to the financial community will not be known in totality until 36 months from the time the bill is signed into law.  Sure, there will be periodic updates and learning’s that will help put some clarity around the impact but the true costs will not be known for some time.  Yesterday at the SIFMA Summit of Regulatory Reform some of the financial forecasts put forward were that investment banks would suffer a 4-8% decrease in return on equity, whereas some retail banks may do worse. In addition, many were calling for smaller retail and commercial banks to begin a consolidation cycle because the costs to maintain and report on the new reform may be burdensome.  Others were stating that the consumer will be hurt because the regulatory costs will be transferred to them with the chances of eliminating ‘free-checking’ accounts and potentially increasing ATM fees and loan fees.  Rather than provide increased competition in the financial community it appears at the surface that this bill creates a barrier to entry for the larger financial institutions.

In addition to the 456 actions the bill requires the creation of new organizations, such as the Financial Stability Oversight Council which is chartered with reporting on systemic risk, derivatives and will have authority on liquidating failing financial institutions.  Another noted organization is the Office of Financial Research which will be part of the Treasury and will be chartered with aggregating financial data across the economy.  This office, although not described well in the bill sounds a bit like the Office of the Director of National Intelligence in the sense that they aggregate intelligence data and encourage collaboration across the intelligence community.

The main speaker at the SIFMA conference yesterday was Deputy Secretary of the Treasury, Neil Wolin.  When prompted with questions on the ‘how’, ‘when’ and ‘costs’ of the bill, Neil seemed to politely dodge the question.  The outcome of Neil’s discussion was that we will need to wait and see how the studies go and the recommendations that will be made by each of the regulatory bodies before we know the ‘how’, ‘when’ and ‘costs’.

Unfortunately there are takeaways from the bill that need to be highlighted.  First, the bill is overly aggressive which will only increase the chances of poor implementation and lack of intelligent policy.   For a frame of reference, major corporations only take on about 6 or less emphasized activities in a given year.  Second, the bill leaves substantial ambiguity and lack of a clear path that is needed to encourage banks to lend, businesses to borrow and hire and financial markets to rally.  Third, the bill aids the larger financial institutions, eliminating competition and potentially creating the next ‘To Big To Fail” institution.

At the core of this bill I think is the unfortunate yet true spirit of a zealous administration shrouded with populist intentions. In a time when we need clear regulatory guidance, a welcomed business and financial climate and a sense of leadership that galvanizes the American population, President Obama and his administration delivered a bill that is extremely vague creating an economy of uncertainty which will only continue to push out lending, borrowing and hiring – once again creating the appeared division between Main Street and Wall Street.

Follow

Get every new post delivered to your Inbox.