Fixing Corrupt Investment Research: It's Not That Hard
Major reform is urgently needed on how investment banking equity research is conducted and communicated. The system is broken and badly in need of a fix.
The root cause of the disintegration of the equity research process was the elimination of fixed commissions from trading in 1975. Soon thereafter, equity research started becoming increasingly shallow. This decay process accelerated as the 1990s bull market grew and research became increasingly associated with investment banking fees.
With the benefit of hindsight, it appears that the skin-deep research that became the norm was a prime factor in creating illusions of great companies for countless investors. As the market collapsed, shocking discoveries – ranging from misleading reporting to outright fraud, missed by one "star" analyst after another – led to the loss of trillions of dollars of wealth. Worse still, this awful research began to create a deep distrust of the entire capitalist free-market system.
The lost money is history. Nothing can be done to recapture the wealth destroyed by fraud in businesses like WorldCom, Enron and Global Crossing. However, restoring trust in the equity markets is vital to the long-term well-being of our economy.
Even if genuine reform begins immediately, it might take a generation to remedy the situation. Unfortunately, it is not clear whether many of the people who are currently heavily involved in creating a new structure for equity research really understand the cause of the problem.
Furthermore, many of the changes being debated could worsen, not improve, the process.
In my opinion, righting this equity research mess is simpler than most think. Here's what it will take:
- A thorough overhaul of the way research is done by the firms
- A change in how money managers spend their customers' commission dollars, and
- Wholesale changes in how corporations conduct themselves in relation to research.
If all three combine and work hard and honestly to effect change, research could regenerate itself in a shorter time than many observers now think. All three need to "Walk Their Talk." Simply talking could make today's credibility problem even worse.
The Voice of Experience
I have headed an investment bank for nearly three decades. Our firm specializes in a single industry – energy – which has been perhaps the most volatile and difficult to analyze of any market sector during the great bull market.
My firm spent its first 19 years strictly in the deal (or corporate finance) side of investment banking. When we finally entered the institutional research, sales and trading arena a decade ago, we were warned that this move might make our corporate clients nervous as they would no longer be able to trust us with their most confidential data.
When we started, many of the buy-side institutions we talked to warned us that our research would be viewed with the highest skepticism, since we were already so dominant in oil service corporate finance deals.
Fortunately, we did not listen to the skeptics' warnings. Our firm has successfully conducted energy research in a manner that has never remotely challenged our integrity or hurt our corporate finance business. Moreover, our institutional clients have willingly paid us for delivering high-quality energy investment advice.
We have proved that honest research is not a myth – it can also be a profitable part of the investment banking business. We are not alone in managing to accomplish this – it is a huge misstep to lump all research firms into one "bad basket."
In less than a decade, we proved to our institutional clients that honest, straightforward research can be written, and that it served to enhance the overall quality of our investment banking advice.
The Simmons & Company model demonstrates that it is still possible to do high-quality research profitably. While our research is limited to the energy business and is produced strictly for institutional investors, this has nothing to do with our ability to do high-quality research.
In the 10 years since we have been furnishing published research on energy firms, we have never been accused of slanting our research to generate deal fees. Instead, we have continued to maintain a high market share in the corporate merger and acquisition business and have co-managed almost $7 billion of energy underwritings, while also garnering highest praise in the highly regarded Greenwich Survey as "The Most Trusted Source" of institutional research in the energy field.
A False Premise
The current research debacle has led many to assume that all research is badly flawed. Many of the ideas for research reform are based on this false premise. If this view prevails, the handful of firms whose research has been outstanding and honest could be driven out of business.
If this happens, then clearly the "baby was thrown out with the bathwater." Institutional and private investors alike would be much worse off.
Many currently propose the total separation of research from investment banking as the panacea for all the bad practices. This single separation concept, if enforced across the board, might destroy the handful of great firms that continue to do research the old-fashioned way.
A total separation of research from investment banking would also leave the process of raising new capital to firms that possess little detailed knowledge of the companies they are asked to underwrite. From the simple standpoint of sound capital raising, this makes no sense.
There has also been mention in the press that dishonest and flawed practices would be eliminated if firms merely vow to no longer tie research advice and its compensation to securing deals.
Sadly, this is too simplistic and is the equivalent of asking famed bank robber Willy Sutton to guarantee he will no longer rob banks.
Other reformers suggest that the equity markets need to get equity research from some truly independent groups such as Standard & Poor's or Moody's. These firms now advise on the quality of debt.
This suggestion ignores the fact that firms such as these sometimes failed to detect the lack of underlying value in the bonds they were supposed to rate. To think they could then become expert equity analysts would only dilute the time they need to spend overhauling their skills at properly rating debt.
The Three Legs of Reform
Equity research can be reformed in a manner that truly works. The process is actually quite simple. It involves a three-legged stool of equity research reform. The first leg of the stool involves the firms providing the research. They need a total overhaul in their ethics and work standards.
Some form of "signing off" on all published research by the leaders of the firm needs to occur (similar to the new standards of CEO and CFO signoffs on financial statements).
An investment banking firm that pays a research analyst to write research aimed at merely generating deal income needs to be fined as a firm and the individual severely penalized or banned from the business (just as we now regulate insider information).
These are simple processes to establish. Complying with the new practices takes only ethics and discipline.
Rather than preventing any analyst from ever owning stock in the companies they promote, I would also encourage the analyst to invest in his or her recommendations, after an appropriate cooling-off period, with obvious clear disclosures of what each analyst owns.
Had some of the Wall Street superstars been forced to invest in some of "the highly recommended pieces of crap" they followed, I suspect they might have tempered their public praise! But these changes are merely the first leg of this reform stool.
The second leg involves changes in the way the money-management industry conducts itself. The purchasers of such investment advice also have a huge stake in effecting true equity research reform.
The vast majority of trading volumes on all our exchanges today are not retail investors, but large institutional money managers investing on behalf of small investors who now primarily participate in the stock market through investing directly in mutual funds or through their benefit plans.
These institutional money managers control virtually all the commissions now being paid to the investment banking industry for both research and executing trades. While commissions have fallen drastically since May Day 1975, institutional trading volumes have skyrocketed.
The total commission pool grew from approximately $1.5 billion in 1974 (when commissions per share ranged between $0.30 and $0.35) to between $35 and $40 billion in 2001, although the commission rate fell to around $0.05 per share.
The most important step to eliminating corruption in research is to have these money-management firms make better use of this $35 to $40 billion pool of commission dollars by visibly rewarding firms for doing great research and paying nothing for flawed research.
Today, the allocation of commission income varies by firm, but only a small fraction of the $0.05 per share trading commissions gets paid for pure research. The balance goes to executing trades, although this aspect of the business is also flawed.
Too often, firms that produce shoddy to poor research get paid as much or more than those firms that do first-rate work. The great bull market was responsible for this.
The institutions wanted positions in the "hot" IPOs and the investment banks leading the offerings threatened to exclude them if they didn't receive the bulk of the offering commission.
Since these commission dollars are actually not even the institution's own funds, but commissions indirectly paid by those whose money they manage, it is important to get the highest and best use of these "clients funds."
Today, too many of these funds are effectively allocated for "old times' sake," a euphemism for tickets to sporting events, etc.
Money-management firms should rise to the challenge and make it clear that poor research is not rewarded, financially or otherwise, regardless of the quality of the institutional salesmen's entertaining styles.
This will ensure that excellent research gets rewarded commensurate with the value it provides and a new generation of research stars would soon emerge and blow away the current genre of research superstars, many of whom were merely "hustlers" or "barkers" for investment banking deals.
End the Popularity Contest
Another subtle but important part of this change is to overhaul the process of selecting the high-visibility "Institutional Investor All-American Research Teams."
This process is now a sham and has become nothing more than a popularity process where many of the voters do not even own stock in the sectors on which they vote.
Today, most publicly traded companies in the energy industry, as an example, have a highly concentrated number of institutional owners that own 85-95 percent of their stock. It is unusual to have an energy company owned by more than 250 to 300 institutions.
Yet the "Institutional Investor All-Americans" are selected by votes from a population of about 2,500 institutions. This is why many analysts choose to stop spending any time doing real research when the "Institutional Investor Polling Season" is on.
During this "All-American Campaign," too many analysts embark on a relentless crusade to remind 2,500 potential voters (most of whom own no stocks in a particular group) how "good" the analyst's investment advice had been in this sector. An institution with little or no ownership in a market sector should have no vote.
Too much attention is now paid to this shallow rating system. It accidentally encouraged the "rock-star" environment and helped to foster some of the worst abuses in the whole research process.
Institutional Investor needs to take a page out of the very thorough survey and analysis done by Greenwich Associates. If the magazine's editors cannot spend this detailed time, then perhaps it is time for them to abandon the whole voting process. It has become a "Miss America" beauty pageant, and too many blind people are allowed to cast a vote!
The third leg of this reform stool involves changes in behavior by the publicly held companies who want to be followed by equity analysts. This group also has a lot at stake in returning credibility and trust to our stock markets.
Stop Punishing Analysts
The corporate executives of all public companies have a key role to play in the overhaul. Too often, corporate executives end up punishing analysts for saying anything negative about their stock.
Shareholders of these firms are now paying a high price for this bad practice by having their stocks plummet and access to new capital cut off.
Corporate CEOs and CFOs need to become more aware of the harm they do the entire capital system by trying to muzzle research that does not flatter their stock.
Eliminating a research analyst who was anything but positive from the information loop has become a common practice. It now has to stop. The practice is no different than the pressure exercised by investment banking on research and should be treated and punished similarly.
If a company found guilty of inflicting punishment on an honest equity analyst was banned from having any research published on its stock for even a quarter or two, then this bad practice would stop virtually overnight.
Corporate executives and boards should welcome tough, high-quality analysis on their companies and the industries in which they participate. This information, while sometimes painful to read, is often many times more valuable than all the consulting advice companies pay dearly to get.
And for a company, honest equity research and the advice and guidance it creates is free.
Reforming equity research would not take long if all three key players do their part. It will take a change in attitude, changes in the way business is now being conducted and a genuine commitment to the importance of recreating the type of in-depth analysis that was once commonplace at the great research firms of the early 1970s.
We need to go back to the basics. The dictionary defines research as "careful search or enquiry after, for or into" or "course of critical investigation." All three parties in the research cycle lost sight of this.
On behalf of all my colleagues at Simmons & Company International, I would like to thank the 400 to 500 institutions who pay us well for the research we do on the energy industry.
We have grown this part of our business by over 30 percent per annum each year, even during these troubled times – and the business is a stand-alone profit center within our firm.
So to say there is no money in doing great research is simply and factually incorrect. The system needs to be reformed, not reinvented.
There is still a role the for highest integrity, which can and should include firms that provide both investment banking and equity research. The success of Simmons & Company International has proved this to be true.
Matthew R. Simmons is chairman and CEO of Simmons & Company International, a specialized energy investment banking firm. The firm has guided its broad client base to complete over 450 investment banking projects at a combined dollar value of approximately $56 billion.
Mr. Simmons was raised in Kaysville, Utah. He graduated cum laude from the University of Utah and received an M.B.A. with distinction from Harvard Business School. He served on the faculty of Harvard Business School as a research associate for two years and was a doctoral candidate.
Mr. Simmons founded Simmons & Company International in 1974. Over the past 28 years, the firm has played a leading role in assisting its energy client companies in executing a wide range of financial transactions, from mergers and acquisitions to private and public funding.
Today the firm has approximately 135 employees and enjoys a leading role as one of the largest energy investment banking groups in the world. Its offices are in Houston, Texas and Aberdeen, Scotland.
Mr. Simmons is a trustee of the Museum of Fine Arts, Houston, and the Farnsworth Art Museum in Rockland, Maine. He serves on the board of directors of Kerr-McGee Corporation (Oklahoma City), the Atlantic Council of the United States (Washington, D.C.), the Initiative for a Competitive Inner City (Boston), Houston Technology Center (Houston) and the Center for Houston's Future (Houston). He is also on the University of Texas M. D. Anderson Cancer Center Foundation Board of Visitors (Houston) and is a charter member of the University of Houston National Advisory Council. In addition, he is past chairman of the National Ocean Industry Association. He serves on the board of directors of the Associates of Harvard Business School and is a past president of the Harvard Business School Alumni Association and a former member of the Visiting Committee of Harvard Business School. He is a member of the Council on Foreign Relations and the Advisory Council of the National Trust for Historic Preservation.
Mr. Simmons' papers and presentations are regularly published in a variety of journals and publications, including World Oil, Oil and Gas Journal, Petroleum Engineers, Offshore and Oil & Gas Investors. He is married and has five daughters. His hobbies include watercolors, cooking, travel and reading.