The Economics of Equity Research
Revisiting the banking/research scandals of the 1990s
I have written before about Marc Rubinstein’s excellent financial services newsletter, Net Interest, and I have on several occasions featured particular posts of his along with a bit of my own commentary. I am doing this again today, with a Net Interest post which discusses the economics of equity research and the major changes taking place recently in that business. I encourage you all to read Marc’s analysis, which you can find here.
I have little to add to Marc’s discussion, other than to note that the economics of equity research have been under pressure for a long time, certainly back into the 1980s when I began work as an investment banker at Salomon Brothers in Chicago. But from my perspective, what has really changed since then is the relationship between equity research and investment banking, which collapsed in scandal with the dotcom crash in 2000-01. When I started in the business in 1984, the big investment banking firms were just beginning to discover the benefits (to the banks) of aligning the efforts of equity research and investment banking. And like many good things on Wall Street, this sensible alliance of research and banking got taken to ludicrous extremes and ultimately caused the symbiotic equity research and investment banking model to come crashing down with the collapse in internet stocks, complaints from outraged investors and retail brokers, reactions from embarrassed regulators and a major investigation by a politically motivated state attorney general. This is a fascinating story that many of my readers will not know, but you should. So please continue reading to learn more.
For some investment banking firms in the 1980s and 1990s, particularly those who specialized in bringing to market small high-growth companies in defined industry segments (tech, health care, new media….), the close alignment of banking and research was a core part of their business model and key to their commercial success. This was certainly true at Alex Brown, the Baltimore-based securities firm acquired in 1997 by Bankers Trust, which was itself acquired a year later by Deutsche Bank (where I worked as an investment banker). And it made sense. There was little reason for a firm like Alex Brown to pitch for the investment banking business of a young growth company if the Alex Brown equity research team was not supportive and the firm could not as a result recommend the shares for purchase by its customers. But if the equity research team really liked the company’s prospects, and was perhaps already recommending the stock, why not also try to become the company’s banker and use the firm’s integrated banking and research model to compete for the company’s lucrative underwriting and advisory business? Especially since investment banking fees dwarfed brokerage commissions at most large securities firms. Properly managed, this was a sound and sensible business model. And it worked very well for firms like Alex Brown, at least while it lasted.
But how exactly did this alignment of equity research and banking work, and why is this no longer the model today? When I started in the business, equity research was a fully bundled service, as described in the Marc Rubinstein piece. Institutional investors paid for the full range of equity research services--investment recommendations, detailed research reports with company models, updates on new developments, introductions to company management, etc-- largely in the form of trading commissions (so-called “soft dollars”). If a particular money management firm liked the research services provided by Morgan Stanley, it paid for these services by routing the firm’s equity trades and brokerage commissions through Morgan Stanley. And if a portfolio manager especially liked the research services provided by the Morgan Stanley internet analyst, he helped get her paid (and incentivized to continue calling him with good investment ideas) by making this clear to his Morgan Stanley sales person and voting for the analyst in the annual Institutional Investor analyst rankings poll.
And if a high-flying young internet company was thinking about going public, it might well choose Morgan Stanley to act as lead underwriter on its IPO in order to garner the support of the firm’s top-ranked equity research analyst. In this environment, top equity research analysts effectively got paid by both the firm’s investor customers (through trading commissions) and by its investment banking clients (through underwriting and other investment banking fees). But over time it became eminently clear that the top analysts at the top firms were being paid primarily out of investment banking fees, not trading commissions, and the compensation, activities and loyalties of these analysts quickly changed to reflect this reality. This was a very symbiotic relationship between research and banking, but one fraught with potential and actual conflicts of interest, which came dramatically to life in the 1990s with the advent of the internet, dotcom IPOs and the TMT bubble.
The relationship between equity research and investment banking took different forms at different firms. For some firms it was a core part of their business model, as noted above with respect to Alex Brown. For other firms it was much less prevalent, as at Deutsche Bank prior to its acquisition of Alex Brown (or more precisely before DB hired tech banker Frank Quattrone and his banking and research team from Morgan Stanley in 1996). And for some firms the alignment of research and banking occurred more in certain industry segments (eg TMT) than in others (Industrials). And while some firms generally handled the potential conflicts of interest between banking and research responsibly, others did not. In this regard, let’s consider the actions of just three firms and their star analysts during the go-go days of internet stocks and the TMT bubble: Morgan Stanley (Mary Meeker), Merrill Lynch (Henry Blodget) and Salomon Smith Barney (Jack Grubman).
Morgan Stanley built its internet investment banking business in large part on the back of its star research analyst Mary Meeker. Morgan Stanley underwrote the IPO of Netscape in 1995, a transaction which some refer to as “ground zero” of the internet era. In conjunction with the Netscape IPO, Meeker and her equity research team issued the first edition of their voluminous Internet Report, which went on to become the so-called “bible” of the internet space. Over time Meeker and her team expanded their internet research coverage to include e-commerce, digital advertising, search, mobile and other emerging new industry segments, and Morgan Stanley went on to dominate the internet IPO and investment banking business. And Meeker herself morphed from being Morgan Stanley’s lead internet analyst to becoming effectively the firms top internet rainmaker.
As you might expect, this close alignment of banking and research presented some very real potential conflicts of interest for the banking firms and their customers (investors) and clients (issuers). For example, Morgan Stanley was hired to lead the IPO of Priceline.com (and many other companies) based in large part on the commitment of research coverage from Mary Meeker and her team. Given the industry standards of the time, the senior management of Priceline would almost certainly have expected Morgan Stanley to commit to provide continued (and favorable) research coverage of the company following the IPO. While many institutional investors in Priceline might not have been surprised or concerned by this apparent conflict of interest, other investors (including retail) might have been more gullible and none too happy when they discovered what was really going on. And when Priceline’s business collapsed and the stock price fell over 90% , with only one firm (Morgan Stanley) retaining its “buy” recommendation, disgruntled investors and suspicious securities regulators began belatedly to ask some very tough questions. (For more on the Priceline story, see the link below at the end of this post.)
These conflict concerns were often well founded, and in the internet space many of them came home to roost during the dotcom collapse in 2000-2001. In her analyst role, Mary Meeker found herself under intense scrutiny as stock prices across the sector collapsed--including those of her top picks--but she retained her well-deserved reputation as “Queen of the Net” notwithstanding the Priceline and other embarrassments. By this time, of course, Meeker’s actual (but not official) role at Morgan Stanley had morphed from lead internet analyst to top rainmaker and dealmaker. And so many people--including big Morgan Stanley customers nursing large portfolio losses as well as regulators-- began to question the independence and judgment of Mary Meeker and her team. (For an in-depth look at the career of Mary Meeker during this time period, see the Fortune article, “Where Mary Meeker Went Wrong”, link below.)
Mary Meeker survived the dotcom collapse with her reputation heavily damaged but still intact. Other internet analysts were not so fortunate, however, perhaps in part because they were not as talented or well supported by their firms as Ms Meeker. An extreme example was Merrill Lynch’s lead internet analyst, Henry Blodget, who shamelessly promoted to Merrill customers (including its large retail base) a number of low quality companies which had banking relationships with Merrill Lynch. Blodget made millions of dollars in compensation over a several year period (much less than Meeker), but he left the firm following the dotcom collapse and was eventually banned from the securities industry for life following investigations by the NY State Attorney General Eliot Spitzer. (For more on the Blodget/Spitzer story, and the broader reverberations of the Spitzer investigation across Wall Street, see the link below.)
But the poster boy for analyst conflicts of interest was undoubtedly Salomon Smith Barney’s star telecoms analyst, Jack Grubman, shown in the photo above. Mr. Grubman made a name for himself, along with $100mm or more in total compensation, promoting the securities of upstart telecom companies, most notably Global Crossing and Worldcom. Both of these companies went bust after raising billions of dollars from investors on the back of Grubman “buy” recommendations, and the CEO of Worldcom (a former high school basketball coach who bragged about being personally close to Grubman) eventually went to prison for securities fraud. Grubman himself did not go to prison, but he was banned for life from the securities industry and fined $15mm, the pain of which was substantially lessened by the $13mm severance payment he received from Salomon on his forced departure from the firm. (For more on the Grubman story, see the link below.)
Prompted by the Spitzer investigation of Blodget and Merrill Lynch, the SEC and other regulators belatedly swung into action and in the early 2000s charged ten different investment banks including Morgan Stanley, Merrill and Salomon, and two individual analysts, Blodget and Grubman (but not Meeker), with violations of the federal securities laws. In settlement of the civil action, the SEC imposed fines and related costs on the ten firms totaling $1.4bn and it banned both Grubman and Blodget from the securities industry for life. The SEC also imposed on the banks stringent new regulations reforming the ways in which investment bankers and research analysts interacted, how analysts were compensated and how securities firms promoted their own research coverage as part of investment banking pitches and to their brokerage and asset management customers and clients. To many of us in the investment banking business at the time, some of the new SEC regulations seemed a bit heavy handed, but this sort of regulatory overreach is not unusual and I think it is fair to say that the SEC was belatedly addressing a real problem which had been ignored (indeed promoted) by the investment banks for far too long. (For more the SEC settlement, see the SEC Fact Sheet, link below).
There is in my mind little doubt that the securities industry is healthier today without Grubman, Blodget and their ilk, although there was some value in the research-banking alliance which we have lost as a result of the SEC settlement. And while the investment banking business is perhaps less “colorful” today than it was in the go-go days of the 1990s, I think it is fair to say that we are better off with a bit less color in this part of our financial infrastructure.
To learn more about this fascinating period in our recent financial history, I encourage you to read these stories:
Only One Analyst is Clinging to Priceline.com, Deseret News, October 7, 2000
Where Mary Meeker Went Wrong, Fortune, May 14, 2001
The Investigation: How Eliot Spitzer Humbled Wall Street, New Yorker, March 30, 2003
Grubman May Agree Fine of $15mm, LA Times, December 21, 2002
SEC Fact Sheet on Global Analyst Research Settlement, Securities and Exchange Commission, April 28, 2003