I will forever remember Thursday April 29 2004 as a seminal moment. First, just after lunch Google filed its S1. Largest IPO in recent history, larger than Netscape which ushered in the first .com valuation bubble. At the same time, as word spread of Google's filing, more and more people started to chatter about the company's insistences upon gaining leverage over the ways things are traditionally done on Wall Street.
A few hours later, after watching the Nasdaq wrestle, alomost succumb, but ultimately battle back from its March lows, I hustled off to Pier 59 at Chelsea Piers where there was a 6p poker tournament hosted by one of our broker dealer partners. Replete with 27 beautiful hostesses on loan from the Ford agency, a full and active bar, and more than 20 poker tables feeding into a tournament of no-limit Texas hold-em, the party fulfilled the full set of ambitions and desires of the traditional sales trading function. We are here to service you and make you feel like a king. Please trade with us as a gesture of thanks for how much and how often we put ourselves out for you (sports tickets, reservations to new restaurants, etc) not to mention how we will be there for you to execute complex trades and participate in valuable "flow" from the desk.
As the sunset shimmered off of the Hudson onto the veranda, and beautiful women handed out pigs in a blanket and shish kebabs, I thought to myself: "God bless the sales trader!" If he is going to become a dinosaur, he is going to do so in style. Booze, Gambling and Sex remain as compelling now as ever: the perfect premiums to layer on to the front end of a broker dealer to generate commissions. Forget about research, or even access to underpriced hot issues. Investors have little problem accepting such fringe benefits, not unlike advertisers getting nice perks from their media sales counterparts.
So there you had Google coming out rightfully declaring that any incremental value generated by investors belongs to Google, at the same time as the broker dealer mechanism was busy trying to steer basic equity trading business through its desk. I believe that Google's decision to set its offering price through a retail auction mechanism has the potential of destroying a traditional profit center of wall street. Most hedge funds and mutual funds of a certain size think nothing of paying each bulge bracket firm millions of dollars each year in commission fees. As we have reviewed previously, traditional equity research, access to management and trade execution have become commodities in the wake of Spitzer, Reg FD and Technology respectively. The last bastion of hope for wall street has remained capital commitment and access to hot issues. I will leave aside the former concern and focus on the relationship between institutional investors and hot issues.
Wall Street has cut back their coverage of equities in order to rationalize their cost structures (no more investment banking to pay for the analysts) at the same time that investors have begun to self-regulate their position vis a vis the safe harbor qualification for their trading commissions. Increasingly, commission dollars are becoming more accountable. This is similar to the recent evolution of online advertising from destination web sites and branded banners to pay for click pricing. If new technologies enable increased accountability, such markets will indeed become more accountable. This is what is happening in the brokerage industry, as the powerful meme of transparency has become a consistent menace to bundled commissions and opaque pricing.
Google's IPO is above all a capital performance. Its offering memo describes a set of rules that at once promise zero short term accountability on behalf of management while at the same time promise unparalleled tick-by-tick efficiency in terms of equity pricing.
On Friday, Tina and I got together with some friends for dinner. One of the husbands works for CSFB and I congratulated him on the coup of being named the lead on the Google IPO. Whereas I expected a little gloating, instead he bit his tongue and complained about the greed of Google and how little money CSFB was going to make (including its not insignificant banking fees). I think the point he was trying to make was that by going the way of the auction, that Google was trying to take every single penny off the table that they can. Seeing his genuine anger, I didn't have the heart to remind him that this was a good thin overall, namely that companies were going to start to benefit fully from the intersection of buyers and sellers of their stock, not the marketmakers per se.
Instead what I saw was the end of a certain kind of investment banking innocence. No, the outsized commissions are not your divine right. No, you can't control the allocation of underpriced shares to your best clients. Yes, you will be paid, but it will be in fees like those paid to lawyers, consultants or accountants. Profiting from outsized bid-ask spreads will need to be replaced by a different type of value. I am not sure Wall Street has figured out what it will do if Google's auction model proves to become the rule rather than the exception.
It is interesting to note that the lone vocal holdout of the Google offering has been Goldman Sachs, who was rumored to express concern about the company's auction format. This from a firm that perhaps more than any other benefits from proprietary trading desks. Perhaps this is the next stage of conflict, between the democratization of hot issues and the entrenched commitment of the bulge bracket to commit more and more capital behind their trades.
I will leave the notion of capital commitment for a future post, as I collect more research. In the meantime, my partner Tony Berkman who is Director of Research at Majestic was asked to respond to some of the recent media hype about Soft Dollars potentially going away, and specifically MFS's somewhat misguided attack on the practice. Tony is one of the smartest guys I know, and here is how he responded:
"MFS' decision to 'get off soft dollars' raises some important and interesting issues. It was a very different tact from Fidelity which had advanced a proposal to simply make soft dollar research expenses more transparent. Clearly, the Fidelity proposal would have less of an impact on Majestic's business than MFS' decision, however we should examine the impact of both scenarios particularly given the possibility that the SEC takes the draconian measure of mandating all mutual funds abandon soft dollars as proposed by the ICI (in an embarrassingly laughable press release which did all but announce: "the large wall-street firms sell our funds therefore we will recommend something most beneficial to them"). This would require a repeal or amendment of the "safe harbor" rule, and is generally not expected but should not be dismissed. The truth is, the SEC did a surprise study of soft dollars in 1998 and "found no soft dollar abuses by mutual funds."
What strikes me about the Globe article, and why I think that ultimately any reform will be in the form of increased transparency versus elimination of soft-dollars for independent research (and not brokerage research), is that the article completely misses some extremely important and pertinent points.
First of all, where does the author come up with $10-15 Million for "proprietary data from the brokerage firms."? And what exactly is meant by this proprietary data? I'll tell you what it is: "IT"S THE SAME LOUSY RESEARCH PRODUCED BY THE BROKERS!!!" So they haven't really "gotten off of soft dollars" - just stopped paying soft to companies that don't sell their mutual funds. The real issue is that these brokerage firms were over-charging for crap... the amount paid to third parties is already transparent and accountable. Why not just force the brokerages to break out execution from everything else. Why not expose the emperor? What confuses me is that they are shifting the one part of the equation that was already completely transparent. They will still be egregiously overpaying for the schlock. This strikes me as little more than lip-service and grandstanding to help alleviate their bad-image from the market-timing scandal (incidentally, the impact of the market-timing on shareholders has been estimated at 3-4% annually in some of the international funds, hardly pennies as the article would lead one to believe), and the media seems to be buying into it hook-line-and-sinker. The question must be asked, "would Pozen take the same brokerage-friendly, anti-independent stance if the brokerage weren't selling shares of his funds?" I doubt it.
Still, Pozen quotes, "We're going to pay cash out of our own pocket. We want to pay for research that is valuable and not just pay 5 cents per share for research that we don't think is valuable." indicating a willingness to pay for valuable independent research and if Majestic is the best, we should get our fair-share even from wrong-minded funds such as MFS. Assuming the amount they paid for independent research and market data was in the range they are now allocating, we have not lost an opportunity, but potentially can not grow the opportunity as much as we would like unless they increase their allocation. One would think that differentiated research should ultimately be worth more than 1% of their mgmt. fees, but it is very big of them to "pay cash to the tune of $10 million to $15 million per year for research and market data [and]... take a hit." This tells me that MFS doesn't values independent research very highly and probably would not be one of our best clients to begin with (but probably would be good for 200K or so if they respond to our research the way most firms do).
My point is that ultimately, the money managers will find a way (whether by hard or soft) to pay for the research that helps them the most. A couple of our best clients already pay us by hard dollars which is fine and which we applaud. What would be unacceptable would be a situation whereby the brokerage firms are still allowed to bundle, while the independents were banned from soft. Because of the inherent unfairness of this possibility, as well as the corruption already exposed within the brokerage's research shops, I find this scenario increasingly unlikely."