INDEPENDENTS' DAY?
With the equity research profession in serious disarray, bold efforts are under way to reshape the industry - with wide-reaching implications for CFOs.
By Chris Leahy

Like all CFOs, Canice Chung has his gripes about equity analysts. As finance chief of Singapore-listed Elec & Eltek International, and its sister company, Hong-Kong-listed Elec & Eltek International Holdings, Chung finds the high turnover of researchers frustrating. He resents having to spend precious management hours educating newcomers in the basics of manufacturing printed circuit boards and liquid crystal displays - the mainstays of his business.

Another reason to moan: the obsession of Hong Kong's big brokerage houses with property firms and banks at the expense of the local electronics market. "The industrial sector in Hong Kong is regarded as third tier," he sniffs, "it's a forgotten sector."

He isn't alone in criticizing equity researchers. Among the more serious complaints leveled elsewhere are allegations of conflicts of interest, where analysts at some investment banks stand accused of posting fraudulent recommendations on duff companies in order to win lucrative financing deals. While Chung says he hasn't witnessed any cases of this sort, the evidence, particularly in the US, is unequivocal. Nothing highlights the issue more than the much-trumpeted "Global Settlement" struck in America in April. Under the terms of the deal, local regulators led by Eliot Spitzer, New York's attorney general, forced 10 of the largest banks in the US to cough up US$1.4 billion to pay for their past research misdeeds (see "What price atonement?" below).

Final Analysis

Add it all up, and it's clear that equity analysts are increasingly finding themselves stuck in the firing line. Indeed, many parties believe that the research industry is fundamentally flawed and are calling for a wholesale restructuring. Among the most important issues are how to make research truly independent and how to pay for it. And then there's the question of how unloved firms can attract greater research coverage. The answers are far from clear, but certain initiatives currently being considered could point the way forward.

Without question, the most important development to date has been America's Global Settlement. Heralded as a remedy to the flagrant conflicts of interest that riddled investment banks and their analyst teams during the excesses of the last stockmarket bubble, the settlement sets out new rules for the conduct of research analysts. In particular, banks must physically separate analysts from investment bankers, and ensure that analysts' pay is de-linked from corporate finance commissions. What's more, analysts have been forbidden from taking part in roadshows and investment banking pitches, and must show that they are free from influence when it comes to choosing which firms to cover and which to ignore.

While such rules only apply in the US at present, in many cases, they look set to find their way to Asia. Take Goldman Sachs, one of the 10 signatories to the settlement. "We intend to apply the rules globally," says Lucas Van Praag, the bank's global head of corporate communications: "If there are local listing rules or market practices that supersede them, we'll review our application of the rules in the light of those local factors."

For their part, local regulators in Asia say they're unlikely to make the stipulations of the Global Settlement mandatory - at least for now. Alan Linning, executive director of the Securities and Futures Commission of Hong Kong, says he's "waiting for the dust to settle a bit" before making any serious changes. "We can afford to take a more evolutionary approach and be less evangelical," he explains. "We're not na•ve enough to think that similar issues [to those in the US] haven't happened here, but what's relevant is that we haven't received the same litany of complaints as the US."

The reaction in Singapore is almost identical. "We haven't seen the same market failures here that are driving change in America," notes Alan Shaw, head of risk management and regulation at Singapore Exchange. Still, both Shaw and Linning concede that they are currently reviewing regulations, and plan to draw on recent US experiences in the process.

Partial to Impartiality

But even if the US research recommendations do find their way to Asia, do they go far enough? Many in the market suggest that they don't. In particular, some claim that research will never be truly independent as long as it remains within the confines of an investment bank or a brokerage. The potential conflicts of interest will always be too great, and consequently investors will suffer. At such institutions, equity analysis is generally seen as a cost rather than a profit centre, and is used as a tool to drum up business in other parts of the firm, principally to drive orders through sales and execution.

As one prominent broker succinctly puts it: "He who pays the piper calls the tune." Responding to such concerns, a number of efforts are under way to provide genuinely independent research. One important player looking to fill this space is Standard & Poor's (S&P). Better known as a credit rating agency, S&P has in fact carried out equity analysis in the US since the 1980s. Today, it's looking to expand its research product internationally, and recently signed a big deal in the UK with Nordea, a European financial services firm, to provide the bank with branded equities research. Building on that success, S&P is making a big play for Asia too, hoping to become an important source of independent research in the region. Unlike its credit rating business, where the client pays to be assessed, S&P charges banks and fund managers to subscribe to its equity reports.

Lorraine Tan, research director at S&P's Asian headquarters in Singapore, reckons that size is key to being a successful independent. "You've go to be a global player with a recognized brand to serve the bulge bracket brokers," she says.

And if S&P's equity research business catches on, it could be good news for CFOs in Asia, especially those who work for smaller companies. As Tan points out: "There have been a lot of cutbacks in Asia. It's less viable for the bulge brackets to allocate resources to cover mid-cap companies: that's where we'd like to play a role."

For Nancy Tan, such announcements are music to her ears. As CFO of Pacific Internet, an Asian internet service provider based in Singapore but listed on the Nasdaq stock exchange in the US, Tan has found it tricky attracting research interest. When the firm floated in 1999, dotcom mania was at its peak and Pacific Internet effortlessly drew the attentions of a handful of analysts. Yet by the end of 2001, all of them had fallen away.

"The bursting of the technology bubble didn't help," says Tan. Factor in a market capitalization of just US$100 million, and a free float of less than half that, and it's no surprise that analysts have steered clear. "We're off the radar screens of many brokers," she sighs, "the trading volume in our shares is too low."

Broken Broking

And therein lies the root of most of the problems with equity research, the fact that it's paid for by broking commissions. Traditionally, brokers have provided equity research coverage as part of an overall broking service to institutional clients without ascribing a specific value to the research product. The two businesses - broking and research - have grown up under the same roof, despite having fundamentally different economics.

Equities execution is volume-driven: brokers earn their keep by taking commissions on the trades they make for their clients. Up until now, brokers have used research merely as a way to generate investment ideas, and thereby orders. And yet, research lends itself much more to a subscription model, in the same way that media firms charge for content.

The big question is whether or not institutional investors will pay for something they have always received for free, for if research is to be truly independent, it will have to rely on subscription charges rather than broking fees. Fabrice Jacob, of Hong Kong-based fund manager MYM Capital, puts it bluntly: "No one is prepared to pay for research, no one has ever paid for research."

And even if they do pay, notes Edmund Bradley, global head of research at Credit Lyonnaise Securities Asia (CLSA) in Hong Kong, it's unlikely that they'll pay enough. "The start-up costs [of launching a stand-alone research firm] are too high," he calculates. "To hire the, say, 30 analysts you need to cover Asia, it's going to cost you something like US$20 million a year. You can't generate enough revenue flow [without broking commission] to cover your costs."

It's a point not lost on Kevin Scully. Back in 1999, he launched an independent research firm in Singapore called NRA Capital that works on a subscription basis. His team of analysts operates identically to a brokerage, only it doesn't actually place trades. "We pitch investment ideas to our client base, and if a fund manager likes the idea, we sell hours on the phone with our analysts," explains Scully. A basic subscription costs US$12,000 per annum and includes eight hours of analyst time.

But while NRA Capital has managed to survive so far, it's had to turn to corporate advisory work to make ends meet. Scully admits that this route raises accusations of the very same conflicts of interest that have dogged the bulge bracket brokerages, but he's unapologetic. "My conflict is that I can't survive on research alone," he concedes, at least not until the market for research products begins to mature. In the meantime, he says, "we've started business as a listing manager. We're doing it because we're trying to survive. We're just the arranger; we earn a flat fee and don't take commissions. That limits the conflict."

At investment bank UBS, Michael Oertli, the firm's head of research in Asia, is another who doubts that independent research firms will cover their costs. Nonetheless, he adds, "niche players may well survive, but it won't be a trend."

Still, concerns over whether or not investors will pay for research haven't stopped the likes of Standard & Poor's and many others from having a go at providing independent analysis. And for Tan at Pacific Internet, such efforts are already bringing her benefits. Earlier this year, her firm managed to pick up coverage from a firm called Forun Technologies. As a US-based independent research house, Forun draws revenue by selling reports to interested parties rather than taking commission on stock broking. For that reason, Forun reckons it can make money covering Pacific Internet no matter how small the firm's free float. Trading volume no longer matters. And with interest in China's burgeoning internet sector taking off, Forun's decision to cover Pacific Internet could prove to be a wise move.

Independents Shall Inherit the Earth

But in the end, much of the debate may prove to be academic, for some commentators claim that the days of free research are limited anyway. Not least that's because brokers may find that they can't afford simply to give it away.

Simon Ogus, who runs an independent economics research consultancy in Hong Kong called DSG Asia, reckons fund managers have been leaning on brokers to cut commissions for years. "[Electronic trading platforms] like Instinet and Island have effectively pushed commissions down from 50 basis points to seven or eight basis points," he says. "Yet fund managers still expect houses to provide full coverage with 50 analysts across the region, all the boxes ticked."

At MYM Capital, Jacob also sees brokers coming under pressure. He sees fund managers using analysis from the big banks, but then making their trades with cheaper alternatives. "Sure, investors give the banks a little bit of business in return for research, but the bulk now goes to the discount traders," he notes.

What's more, regulators are starting to get in on the act too. Consider moves afoot by the UK's Financial Services Authority (FSA). In a recent report, the FSA looked into mandatorily unbundling research from broking and making firms charge for each separately. The issue is still being debated, but pressure from an unlikely source - big pension schemes - could help force change on the market.

"Some of the large pension funds in the UK want to see separate prices for sales, sales trading and research," admits CLSA's Bradley. "But they're all part of the same process. As long as you can manage the conflicts of interest, which we think we can, it's much better to have one price."

Should CFOs Pay?

In Singapore, a different sort of regulatory initiative could force change onto the market. The local monetary authority, together with Singapore Exchange (SGX), is exploring the possibility of having companies pay for their own research. Believed to be part of the recently announced S$7.5 million (US$4.3 million) joint initiative to raise investor awareness in Singapore's securities and derivatives markets, the scheme will create a pool of funds from SGX-listed companies who choose to participate, that will be used to pay research houses to produce regular analysis on those firms. In order to avoid the obvious conflicts associated with company-paid research, SGX will arbitrarily allocate up to three research houses to cover each opted-in company.

Charles Sng, vice president for corporate relations at SGX confirmed that the funding of independent research is one project being considered as part of the joint initiative, although both SGX and the monetary authority declined to provide further details.

For their part, CFOs think such a scheme would be positive. At Elec & Eltek International, Chung, who doubles as CEO, says he would support such a plan if research was commissioned in such a way as to guarantee that it was truly independent. At Pacific Internet, Tan believes it would help small and mid-cap companies to boost their profile with investors, but again, she stresses the need for "a good governance structure in allocating the research work so that it's genuinely independent".

No doubt, the debate over how to make equity research independent, and how to pay for it, will rage for some time. Some even believe the issue will never be truly resolved.

CLSA's Bradley, for one, believes greed will have the last laugh: "The fact is that investment banking still drives the business of the bulge brackets. Even if you unbundled broking and research, it's neither here nor there from [the banks'] point of view. When the market picks up, and the large M&A deals roll in and the IPOs return, there'll be another feeding frenzy and everything will be forgotten. Another trillion dollars will be written off, the banks will make multi-billion dollars in fees, pay huge fines and get another slap on the wrist."

Chris Leahy is a contributing editor of CFO Asia