The ascent of primary research

The availability of quality research on companies not only helps investors generate alpha, but is also a public good that drives financial market efficiency. The industry has faced upheaval in recent years as regulators have attempted to reduce conflicts of interest and improve fee transparency for investors. In turn, how investors pay for research has fundamentally changed since 2018 – with some unintended consequences.

So, what went wrong and how has the research landscape changed? First, a brief history lesson.

The arrival of Europe’s second Markets in Financial Instruments Directive (MiFID II) in 2018 upended the industry by requiring equity managers to separate research costs from execution services. The move was intended to level the playing field and improve pricing transparency, but instead, it had a deflationary impact on demand for research.

Some of the largest banks increased their market share by absorbing costs within their own P&L and charging peppercorn prices. By contrast, many smaller- and mid-sized research players could not survive. Output is now more concentrated than ever among banks with the deepest pockets (some having acquired smaller players), equity analyst headcount has dwindled, and coverage of smaller companies has suffered.

But fast-forward five years and options are being explored to reverse MiFID II’s ban on bundling research fees with trading commissions. It is part of the UK Government’s Investment Research Review which, among other objectives, is exploring whether MiFID II has contributed to the UK’s lower levels of research vs other jurisdictions. It is hard to imagine that this will be disproved. According to the European Association of Independent Research Providers, the revenue of most standalone research boutiques fell after MiFID II, and now represents less than 10% of research output.

There is another dynamic to note. With US broker-dealers prohibited from accepting hard dollars for investment research, the Securities and Exchange Commission introduced a temporary waiver enabling them to continue transacting with UK and European managers in the post-MiFID II world. After multiple extensions, the waiver expired in July 2023, causing fresh complications for UK and European managers looking to buy US research.

What happens next remains to be seen, but one thing is certain: against this backdrop of fewer independent players, falling research budgets (by a third outside of the US), and less choice for investors, one category of the independent research market, the primary research category, has experienced unprecedented growth.
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A more sophisticated investor

For over a decade, there has been a heightened focus on only deploying budgets on “must-have” research – but particularly since MiFID II landed. Increasing investor sophistication and savviness has turbocharged demand for truly differentiated and unbiased research and as a result the primary space is continuing to gain momentum alongside declines in the traditional research market.

Even though research spending on aggregate has been hit by macro headwinds in 2023, Integrity Research argues the opportunity for innovative products is growing, with many buy-side firms spending more on “unique third-party research and data products” – including expert networks.

This trend is evident across the entire asset class spectrum. Whether a private equity investor is looking for fundamental company information or a credit investor is identifying company-specific issues, investors have realised that the most actionable insights often come directly from those with first-hand experiences working at a company or within an industry, and who have gained rich experience from past situations and crises.  

Interestingly, this mindset mirrors the age-old Scuttlebut Method of investing, coined by Phil Fisher and outlined in his book, Commons Stocks and Uncommon Profits (originally published in 1957). The Scuttlebutt Method involves talking to clients, vendors, competitors and past and present employees to extract insights that can be hard, if not impossible, to glean from elsewhere. This is exactly what primary research is all about: pinpointing and speaking to relevant people and then analysing their insights alongside other sources of information.

So while independent research is being squeezed overall, the industry is still evolving and innovating at pace. With its roots in the expert network space, primary research now includes a broad range of research content such as interviews with industry experts, and, increasingly, alternative data.
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How could MiFID II’s reversal impact primary research?

MiFID II may have fallen short of its goals in the research arena, but it has accelerated the growth of a research category whose purpose is to enable investors to make decisions faster and with greater conviction.

If the MiFID II U-turn goes ahead, this trajectory should continue, says former hedge fund manager, Marc Rubinstein. Rubinstein says the research sector has benefited from the requirement that managers understand their research budget – and it is too late now to unscramble the eggs. “Systems that have been implemented to track, measure and value research are unlikely to be thrown out.”

There has also been a shift in investors’ mindset. As we know, before MiFID II there was virtually no research pricing transparency and therefore no real understanding of its worth. But in the relatively short time since 2018, the situation has evolved and there is now a much greater emphasis on innovation and differentiation. Investors have also raised their expectations. They are looking for research that truly adds value to their investment processes – and that can be easily integrated into their workflows. Above all, they are looking for research that is relevant and rich with insight that is hard to find elsewhere. The Scuttlebut mentality, it seems, is gaining momentum once again. 

We may see the return of research bundling, but the buy side has matured and now leverages large in-house teams for investment analysis. Research has become part of the due diligence checklist investors across all asset classes are doubling down on. Gone are the days of “quantity over quality” in investment research, and the primary space is leading this shift.

Joshua Maxey, CFA, is Co-Founder of Third Bridge