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We’ve talked a little before about how I don’t understand Wall Street research. Let’s start slow: why publish research? There are I think three, or three-ish, possibilities:
1. To inform your investing clients (asset managers and such) about your best views on how they should manage their money, so that they can manage their money well and thus one day have more of it,
2a. To induce your investing clients to do trades that generate trading revenues for you,
2b. To induce your investing clients to do trades that optimize your book (i.e. slapping a Buy on whatever you need to sell and vice versa), or
3. To induce banking clients (corporate issuers) to pick you as an underwriter.
So, #1, ha ha ha. Choosing between #2 and #3 is harder and if you wanted to be serious about it you might ask questions like how much revenue does trading bring in versus underwriting (more!), how good is that revenue (market making for pennies using your capital: probably not as good as risk-free 7% IPO gross spreads), and how much does research influence trading (meh?) vs. how much does it influence underwriting (meh?).
This weekend, though, we got kind of a strange data point via this FT article about the JOBS Act and the research settlement. In brief, as we’ve discussed, the JOBS Act lets banks basically do whatever they want for research on “emerging growth” companies, including in particular publish research pre-IPO and have bankers and analysts and the company all in the same room pitching business and generally scheming. But there’s a catch, which is that the ghost of Eliot Spitzer, in the form of the global research settlement, still restricts that activity, so all the banks subject to the settlement (the bulge-bracket ones) are disadvantaged vis-à-vis their smaller cousins. But, the FT points out, the big banks have a trick up their sleeves, which is to make all the small banks sign an agreement preventing them from publishing research ahead of the big banks, as a condition of joining the syndicate for any deal:
[S]ome big banks are said to be pressing the Securities Industry and Financial Markets Association, the biggest trade body, to level the playing field between themselves and smaller competitors. That could potentially include creating a new “master agreement” for underwriters, said one person involved in the discussions. Altering the agreement would make it difficult for brokerages not bound by the global settlement to use the act’s relaxation of the rules.
Big banks often act as “lead” underwriter for IPOs, with smaller brokerages as distribution agents. Underwriting agreements define how soon research may be published after an IPO. Typically it is 40 days, in accordance with the settlement.
Sean Davy, associate general counsel at Sifma, said: “Sifma is not . . . considering changes to our standard agreements that in any way restrict the publication of research.” …
But industry insiders have said that big banks could still try to shut out smaller competitors by altering the underwriting provisions that may accompany the master document. These can be customised with each deal.
“I don’t believe the regional banks will actively pursue doing all the things the big banks can’t because of the global settlement,” said David Meyers, a lawyer at Troutman Sanders.
This is a pleasing story for lots of reasons. Oh look the power of private ordering, you might say: trade organizations, standardized master agreements, and cartel power trump puny government action. (Hi, ISDA!). You could also, if you were so inclined, mutter vaguely about the antitrust implications of making every bank sign a master agreement agreeing not to compete on research.
But never mind that. I can’t make out the motivations here. It’s worth remembering that a few weeks ago a bunch of people at big banks told Reuters basically “we cannot trust ourselves to do research for pre-IPO companies! We will puff these terrible fake companies and then they will tank and people will sue the shit out of us! Stop us before we hurt ourselves!” So that was kind of weird. But they’d have no choice because:
“Imagine what’s going to happen when deal economics is getting decided by how good an underwriter’s pre-deal research is,” said a senior lawyer at a Wall Street bank who asked not to be named. … “Do the underwriters write it and concede to the demands of the issuers, or do they just say no because of the preservation of the volatility in the aftermarket and the liability risk?”
Doesn’t … I mean, doesn’t the FT sort of have the solution here? Here is what I would do if I ran tech ECM at a big bank:
1. I would pitch an IPO by wearing T-shirts and saying “we are awesome at calling people up and being all ‘ooh buy this stock ooh.’”
2. My client would say “Well what about research?”
3. I would say “Ah, yes. Like all of our bulge-bracket competitors – that is, everyone whose seal of approval is useful in doing an IPO – we cannot publish pre-IPO research. It’s the law. Or, the sort-of law. Eliot Spitzer says, anyway.”
4. “But I know someone who can!” (I would continue, pausing only to enumerate)
5. “Have you met my buddy Dave at Dave’s Capital in Chattanooga? Great guy. Publishes lots of research. Bring Dave in as a co-manager with 1% economics.”*
Right? Isn’t that the right way to go here? Like, thing one, you don’t get sued: Dave gets sued! Dave’s research is not a prospectus on the deal for which every bank is jointly liable; Dave’s research is just Dave’s research.** Dave is, let’s say, less well capitalized than JPMorgan. The banking system can thus efficiently provide all the research puffery that its clients want, without endangering the balance sheets of the big banks.
Thing two: all the bulge bracket banks are in this boat together. The current pitch to IPO candidates is basically “our excellent research analyst covers your sector and will write on you 40 days after your IPO.” This creates an arms race among bulge bracket banks, who all need to have excellent (bullish!) research analysts in all the sectors where there will be lots of IPOs. This requires hiring bullish analysts, paying them, figuring out where there will be lots of IPOs, etc. It’s all very inefficient. But if the playing field changes so that small banks can write before the IPO and big banks can’t write until 40 days after pricing, then it’s harder for an issuer to care. “You’re telling me that your awesome in-house research guy, who is bullish on my competitors, will write research which will be excellent and may or many not recommend buying my stock, but in any case he’ll write it 40 days after pricing? But you can also get Dave, who is awesome and at a smaller firm, to write research that I know is bullish, because I can read it, and it will come out before the deal? That seems better.”
Relatedly, if this plan works, your own bank’s research is less important. You have outsourced research, and your job becomes more about what is in your control. Bankers hate being evaluated on research because they can’t do anything about it. If a company calls its banker and says “your research analyst sucks, he just put a Sell on me,” the banker is limited to saying basically “sorry about that.” The banker is the last person to do anything about it. Now, if I want to tell a Goldman research analyst that her Sell recommendation is a crock of shit, I can just go email her. (She is unlikely to care.) If I wanted to tell her that when I worked in capital markets at Goldman, I couldn’t – my email wouldn’t go through. Also I’d be fired and maybe prosecuted for trying. Explaining that to an issuer CEO – who just sees “Goldman has a Sell on me, and you are at Goldman” – is challenging.
If I were the head of ECM at a big bank, I’d be lobbying desperately to leave the research settlement alone, and to interpret its interaction with the JOBS Act as conservatively as possible. I’d be modifying my master AAU to encourage non-settlement banks to publish early and often on “emerging growth” companies. And I’d be happily referring potential IPO clients to tiny but plausibly intelligent independent research firms for tiny co-manager roles in their IPOs. I’d probably try to get my own bank’s analysts fired and shipped off to those firms, too, except that under the research settlement it kind of looks bad when bankers try to get research analysts fired.
* Does Dave have a sales force to sell the IPO? Did you think that was required to co-manage an IPO? No. It’s not. The less Dave can do independently of the bulge bracket firms, the better.
** Maybe. I kind of just made that up. There’s not a lot of precedent; maybe everyone ends up jointly liable. But I doubt it.