Analyzing Wall Street’s Research

Frank P. Quattrone thinks Wall Street research has “proven to be a disaster, in my humble opinion.”

You remember Mr. Quattrone, don’t you? He’s the mustachioed Silicon Valley banker who brought some of the biggest technology initial public offerings to market — Cisco Systems, Amazon, Netscape, just to name a few. His career was famously derailed by a four-year-long public battle against obstruction of justice charges at the height of the previous market bubble. The charges were ultimately dropped, and he’s now back in business.

He was speaking a couple of weeks ago at the AlwaysOn conference for start-ups at Stanford, a buzzy affair for Palo Alto entrepreneurs looking for money and Sand Hill Road venture capitalists looking to spend it. The panel was titled, “The Doctor Is In: An Hour of Free Advice From Frank Quattrone.”

Frank Quattrone
Frank Quattrone

Mr. Quattrone, dressed in his West Coast uniform — a blue blazer over a polo shirt and a pair of khakis — was almost finished with his presentation when, in response to a question from the audience, he shared his views about the state of Wall Street research, a topic that was once all the rage but now often goes overlooked.

“I do think the industry should petition to remove the Spitzer initiatives because ultimately they hurt the competitiveness of our country by denying small companies the access to research analysts,” he said, throwing a proverbial grenade into the auditorium.

Mr. Quattrone was referring, of course, to the former New York attorney general Eliot Spitzer’s landmark settlement in 2002, which forced the separation of investment banking from research. The settlement followed an investigation into whether some Wall Street analysts were providing misleading ratings of the companies they covered to bolster their firms’ investment banking business. Henry Blodget of Merrill Lynch and Jack Grubman of Citigroup were barred from the securities industry and others took their licks. (As an aside, Mr. Spitzer was not behind Mr. Quattrone’s prosecution.)

As a result, banks are no longer allowed to pay their analysts from any revenue derived from investment banking, only from trading operations. Beyond that, an investment banker can’t even call a research analyst at the same firm without a lawyer chaperoning the conversation.

At the time, the new rules had a certain undeniable appeal. Because research analysts so depended on investment banking work for their own bonuses — working on initial public offerings and mergers — they faced unquestionable conflicts.

Mr. Spitzer’s efforts may have been noble, but five years later it is clear that the effort to eliminate those conflicts created its own set of unintended consequences.

If Mr. Quattrone had his way, he would turn the clock back entirely. “I am not denying that there is the potential for conflict — always has been, always will be. I’m just questioning the best means of managing the conflict,” he told me after his presentation. “If the principles of what constitutes ethical and unethical behavior are spelled out clearly, such as disclosing the firms’ investment banking relationships and ownership interests in the covered security, as well as not publishing favorable reports on companies in which you do not believe — and violators are punished — the conflicts will be managed.”

It’s widely known on Wall Street that because research can no longer count on investment banking revenue, research is expected to pay its own way. Many of the big banks have responded, to put it bluntly, by running their research departments more cheaply, or not running them at all. Prudential Financial, which had a pretty good research arm, decided to shut it down entirely last summer.

Many of the most talented analysts — and therefore the most expensive — have left the business. And the smart up-and-coming ones who saw the handwriting on the wall ran to the “buy side,” jumping into hedge funds, venture capital firms and private equity. Some ambitious analysts have tried to go the independent route, but nearly all of them will tell you it has been tough going.

That has created a two-part dilemma. The first is that the quality of research on Wall Street these days, notwithstanding some great recent calls from the likes of Meredith Whitney of Oppenheimer and Richard Bove, an independent analyst, has deteriorated even further and is coming under greater pressure as more banks begin to outsource research functions.

It may be true that analysts now put a lot more sell ratings on stocks than they used to, clearly a result of Mr. Spitzer’s settlement. But sell ratings are only a small part of the story. Analysts were never supposed to be just stock pickers. Ask any big institutional investor about what makes good research analysts and the answer is rarely the buy, sell or hold ratings. It is the information they can provide, the details they model and understanding the nuance of the executives. Those aspects of research don’t always end up in reports, but that’s what separates the good analysts from the not-so-good.

Quattrone's newspaper analogy

The second problem — which is an even bigger one — is that it is hard to find good research on small companies. All the focus has moved to large companies where the big money is sloshing around. And that makes being a small public company a very difficult task, since nobody’s paying any attention to them.

“The only way that sell-side analysts now can make money inside of a big firm like that is to become an ‘Institutional Investor All-American’ research analyst,” Mr. Quattrone told me, “which means they have to cover the Microsofts and Googles. Why would they spend any of their time working with these small companies?” Mr. Quattrone posits that the lack of research has been one reason the initial public offering market for technology companies has had a tough time.

Mr. Quattrone compared Wall Street research with journalism. “Publications have journalists and editorial staff — kind of like research analysts — whom the public expects to be unbiased reporters of fact and opinion who report the truth and provide their honest opinion on important matters,” he said. “They also have a circulation department and an advertising department — kind of like institutional salespeople and bankers — who generate revenue. There is an inherent omnipresent potential conflict of interest between the journalists and the revenue generating departments because the latter produce the revenue that pay the former.”

Of course, in journalism — especially at this paper and others — it is forbidden for anyone in the advertising department to tell a journalist how to write his articles. (Other publications are not so fastidious, he said, writing sensational articles to pump up sales or producing a positive piece to suit an advertiser.)

But to take Mr. Quattrone’s metaphor one step further, that’s what investment bankers were doing before the settlement — steering analysts to write things that would help land banking deals, often betraying investors and the public in the process.

Mr. Quattrone is right that the pendulum has probably swung too far, and in the cool light of day, it might be time to lift some of the restrictions. Analysts should be allowed to talk to their own investment bankers on occasion. Most analysts I talked to for this column said that they missed talking to bankers calling for advice ahead of a meeting, which they said made their research better and helped the banker. They argued that would perhaps make the whole franchise more valuable and give firms the impetus to spend more on research.

Give Mr. Quattrone credit for raising an important issue and making an articulate case for change. The solution, of course, is more complicated.