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

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.