Independents day

Since the high-profile investigation into Wall Street’s provision of equity analysis, the viability of independent research has been a topic of increasingly animated debate. Philip Moore looks at the economic realities of asking investors to pay for their credit research

Long before September 11, Kevin Adams wasn’t buying any new issues from airline companies regardless of how eloquent their lead banks were. To the senior portfolio manager of UK fixed income at Credit Suisse Asset Management (CSAM), it was blindingly obvious that this was no macroeconomic environment in which to be adding exposure to the airline sector. Nevertheless, there was no lack of investment bankers – and investment bank-funded research analysts – trying to persuade Adams that airline bonds were compelling investments.

That is the sort of story you hear when you talk to virtually any of the larger or more established fund managers. At State Street Global Advisers (SSGA) in London, head of global bonds Mark Talbot probably speaks for most larger investment managers when he says that the concerns over independent research prompted by New York State attorney general Eliot Spitzer are “every bit as valid” in the credit market as they are in the equity world. “We’ve always been very aware that when investment banks have relationships with companies, it is impossible for them to be objective in their research of a new issue and to advise investors to go short,” he says. “We’ve always understood that this is the way the business works.”

In fact as long ago as 1994 Gimme Credit was set up to provide corporate bond fund managers with research that was not conflicted by internal investment banking pressures. Gimme Credit has been providing fund managers with well-respected research ever since, and would not have survived for the best part of a decade had its fundamental recommendations been conspicuously inferior to those given by its sell-side counterparts. But it has only been since the Spitzer investigations into equity analysts that the notion of research by independent firms and paid for by the investors themselves has been the subject of widespread media coverage.

Being more aware of conflicts of interest among sell-side analysts at investment banks is one thing. Responding by calling upon the services of entirely independent research houses is quite another, which begs a very obvious question: are investors prepared to cough up for an alternative? Both Adams and Talbot say that although this might be an appropriate solution for smaller investment managers, neither CSAM nor SSGA have considered subscribing to independent research services. Nor are they likely to. Instead, both would much rather spend the money on hiring their own in-house analysts.

Therein, in Europe at least, lies one of the dilemmas facing those independent providers of fundamental credit research hoping to sell their product to a critical mass of investors. It is not that anybody doubts the theoretical value of independent analysis in the credit market, nor that it has a potentially broad audience, rather is it worth the additional investment in these lean times?

Doing the maths
Research that is – and is seen to be – entirely uninfluenced by internal conflict will be valuable to smaller fund management firms and hedge funds unable to recruit and retain large teams of in-house analysts. The price of a subscription to typical independent research is in the $10,000 to $20,000 range. The absolute minimum going price for a junior analyst is probably closer to $40,000.

Nor need that value be restricted to the institutional investors at which it is principally targeted. Research chiefs at sell-side houses concede that the material produced by independent houses such as CreditSights – set up in late 2000 – and Gimme Credit is a useful and relatively inexpensive source of valuable data for their own trading desks.

And at CreditSights itself, president and head of business development Paul Ciasullo is aware that a number of corporate treasury executives are increasingly accessing his company’s research. “The frequent borrowers in particular are very interested in what we have to say about them,” he says, adding that there is no reason why the same should not apply to corporate strategists outside treasury departments.

In the auto sector, for example, Ciasullo describes CreditSights’ analysis as “extraordinarily opinionated” and that executives in the industry could certainly learn from “what a good credit research team thinks about their business plans going forward.”

Fair enough. But as Ciasullo concedes, many of the readers accessing CreditSights’ research are probably doing so without paying for the privilege. And the principal misgiving about the franchise of the independents is the degree to which (if at all) their credit research can generate enough profit to pay for itself.

When he parted company with Bear Stearns, where he was head of credit research, Philip Crate studied the economics of independent research very carefully. But whichever way he looked at it, the numbers refused to stack up. He believes that there is clearly room for independent credit research in the US, where the secondary market has reached a sufficiently mature and liquid level to generate demand for impartial insights. But he describes the European secondary market as one that is still “finding its feet”, and one in which the concept of paying for research is still an “alien” one.

Others also express mystification at how an outfit like CreditSights can expect to pay its way. If the 28 analysts now employed by CreditSights are being paid in the region of $160,000 per year – a very low sum by industry standards – even that would equate to almost $4.5 million per year in salaries alone. With the company charging an annual fee of $12,000, it needs more than 370 fully paid-up subscribers (as opposed to those subscribing to a cheaper abridged service) just to cover the costs of its analysts.

Ciasullo says that CreditSights already has close to 500 subscribers, which presumably means that the analysts’ salaries can be taken care of. But what about other overheads, such as the costs of the IT support that is the lifeblood of the business, rental costs, travel expenses? Whichever way you cut it, there cannot be much left over in the form of clear profit.

Ciasullo insists that the proof of CreditSights’ financial viability is there for all to see in its three-year track record. “We started the firm three years ago with six analysts, and we’ve made profits and ploughed them back into making the product better,” he says. “We wouldn’t have been able to grow as big as we are if investors weren’t paying us.” Nor, he insists, is there any need for CreditSights to increase its annual subscription charge of $12,000.

Gimme Credit has a different model, based upon fewer analysts providing less blanket coverage. But its managing director, Arthur Rosenzweig, says that his firm has been consistently profitable and now has eight analysts distributing research to 350 clients, each of whom pays an annual fee of $18,000 for the service.

“We’ve been profitable by following certain business practices,” says Rosenzweig. “Number one, we’ve always believed that hiring the best analysts is a sine qua non. Number two, we’ve focused exclusively on institutional rather than retail investors. And number three, we’ve found that if we deliver concisely written, one-page reports with a clear investment conclusion then clients will read our analysis rather than the much longer reports they get from investment banks.”

Gimme Credit’s most recent expansion appears to support Rosenzweig’s argument that the business model is a successful and sustainable one. At the beginning of June, it announced that it was pooling resources with Creditex to form Credit Derivatives Research LLC, aimed at providing independent research on the $3 trillion credit default swaps (CDS) market.

Quality control
A concern is that analysts at non-bank research firms, in their enthusiasm to ensure they are noticed, may err towards over-sensationalism in their coverage of credits – or, as one observer puts it, the independents may behave like The Sun, whereas their counterparts at the sell-side banks will be more like, well, The Independent.

That is one way of looking at some of the more outspoken views expressed by analysts at CreditSights, such as the damning verdict delivered by one on Fiat in a presentation last month, namely that the Italian carmaker has no fundamental justification for existing. A kinder way of interpreting the same statement is that it is an articulation of a truth that scores of analysts at banks would express were they not effectively muzzled by colleagues with other ambitions. Chinese walls or no Chinese walls, saying that a company has no justification for existing is hardly the best way of setting about winning an M&A, loan or private placement mandate.

Unsurprisingly, the independent players utterly refute the suggestion that in terms of quality they are playing in some kind of second division. Ciasullo says that there are very substantial differences between the day-to-day responsibilities of credit analysts at sell-side houses and their counterparts at independent firms.

“The principal difference is that our analysts don’t serve as many masters,” says Ciasullo, quite rightly pointing out that an analyst at a typical investment bank will have to juggle his or her time to satisfy in-house trading and syndicate desks, corporate finance departments and so on. Analysts at a firm like CreditSights, by contrast, can channel 100% of their time and effort into credit research, which – irrespective of the pecuniary implications – may be a more attractive career option for dedicated credit analysts.

Another key difference between the two disciplines, says Ciasullo, is that CreditSights’ analysts focus exclusively on credit fundamentals, rather than on offering short-term trading ideas. So comparing the ‘recommendations’ published by investment banks with those of the independents is like comparing apples with oranges. It also means, adds Ciasullo, that the research published by a company like CreditSights lives or dies by its transparency and accuracy. He points out that investors accessing the CreditSights product can scrutinise some 7,000 research articles published over the last few years and draw their own conclusions about their accuracy and merit.

Even if the independent outfits are able, for whatever reason, to attract analysts with proven industry knowledge and capability, twinned with a loyal following of investors, there are other concerns about their long-term ability to compete with their opposite numbers at the sell-side banks. First, is there any guarantee that they will be given the same access to senior management that they enjoyed while acting as ambassadors for much larger banks with plenty to offer companies as a quid pro quo? This is not to suggest that the independent analysts may be privy to less information than their counterparts from the investment banks, merely that independents are less likely to be given as much senior management time as the sell-side houses.

Second is the degree to which independent research houses can ever expect to have the number of analysts they will inevitably need if they are to provide investors with a comprehensive service and therefore compete effectively with the sell side. Crate is doubtful on this score. His concern is that independent outfits will inevitably spread their limited resources too thinly, focusing perhaps on ‘flavour of the month’ credits and sectors such as telecoms or crossover names. That, he says, is fine as long as an issuer like France Télécom is trading at a 500bp spread and attracting the attention of armies of research-hungry hedge funds. But what happens when spreads normalise and those same investors turn their attention to less headline-grabbing companies such as pulp and paper, or cement?

Theoretically, as the subscriber base of the independents expands, so too should their capacity to add to their human resources and analytical coverage. The snag there is that there may come a point at which an increase in the subscriber base has the effect of eroding the value of the independent researchers’ product. What, after all, is the value of an idea simultaneously transmitted to 2,000 or 3,000 institutions?
The independent houses appear to agree that there would be a theoretical point at which their research might begin to lose its relevance if the institutional marketplace became saturated with the same product. But they argue that for the time being they have come nowhere close to that point.

Ultimately the birth of the independents may finally help address the fundamental question of what investors really want from research. Whereas most investors are unlikely to scrutinise free research too thoroughly, they will undoubtedly have a more stringent attitude towards paid-for research. Any independent providers offering a substandard service will soon hear about it from value-conscious investors, and will be forced to adapt to investor demand or die.