Boris Groysberg is Professor of Business Administration at Harvard Business School. He is author of the award-winning book Chasing Stars: The Myth of Talent and the Portability of Performance.
Paul Healy is Professor of Business Administration at Harvard Business School. He is co-author of one of the leading financial analysis textbooks, Business Analysis and Valuation, 5th Edition.

Wall Street Research

Past, Present, and Future

By Boris Groysberg, Paul M. Healy

Stanford University Press

Copyright © 2013 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
ISBN: 978-0-8047-8531-0

Contents

Preface…………………………………………………………..ixAcknowledgments……………………………………………………xiii1 The Rise and Fall of Equity Research at Prudential…………………..12 What Do Analysts Do, and How Are They Managed?………………………203 Sell-Side Research: The History of an Information Good……………….444 Investment Banking Model Challenges………………………………..595 Challenges to Trading Commission Model……………………………..746 The Performance of Sell-Side Analysts Revisited……………………..887 The Future of Sell-Side Research in the United States………………..1138 Sell-Side Research in Emerging Markets……………………………..1389 Conclusions……………………………………………………..155Notes…………………………………………………………….165Index…………………………………………………………….175

CHAPTER 1

The Rise and Fall of Equity Research at Prudential

In the span of twenty-six years, the insurance giant Prudential enteredand then exited the stock brokerage industry. Prudential’s story illustratesmany of the changes and challenges facing the equity research industryduring this period. Like many competitors, Prudential entered the industryas part of a “financial supermarket” strategy. Lured by attractive fees,Prudential subsequently built an investment banking business leveragedthrough equity research. The firm was also among the first to recognizethe conflicts of interest between equity research and banking, and voluntarilyclosed its investment banking business prior to regulatory changescreated to mitigate such conflicts. The resulting business model focusedon providing investors with trustworthy investment advice and trade execution.However, this model was tested by sharp declines in trading commissionsbrought about by electronic trading. As a result, despite having ahighly ranked equity research department, Prudential exited the industryin June 2007.

Insurance History

Prudential Insurance Company was founded by John Dryden in 1875to provide life insurance to working-class families. The company wasnamed after Prudential Assurance Company of Great Britain, a pioneerin industrial insurance on the other side of the Atlantic. The companyquickly developed a reputation for financial stability, inspiring the well-recognized symbol “The Rock.”

During the 1970s, Donald MacNaughton, Prudential’s chief executiveofficer (CEO), encouraged employees to think of Prudential’s business asselling, not just providing, insurance. This approach led Prudential to expandinto auto and homeowners’ insurance. MacNaughton believed thatPrudential’s continued prosperity could be assured only by leveraging thefirm’s selling capabilities and finding new ways to serve policyholders.Insurance was certainly one component of a customer’s financial needs,but there were many others. MacNaughton and his successors worriedthat unless Prudential could broaden its product offerings, other financialservices firms could capture a portion of their customer base by offeringa broad array of financial services through a single distribution network.

The Acquisition of the Bache Group Inc.

In early 1981, the Bache Group was looking for help. For two years, managementhad been trying to fend off a hostile takeover attempt by FirstCity Financial, a Canadian financial services company owned by theBelzberg family. The family had acquired more than 20 percent of thecompany despite defensive maneuvers by Bache management, and mostinsiders considered the takeover virtually inevitable. However, Bache’sCEO, Harry Jacobs, had one last plan—in February 1981 he launched asearch for another potential acquirer.

Garnett Keith, a senior vice president, was the first person at Prudentialto be contacted about acquiring Bache. Keith reported, “I received aphone call from Bob Baylis at First Boston, and he asked me if Prudentialwould like to acquire Bache. And I said well, not likely, but let me talk tothe chairman. So I went and talked to Bob Beck, and he thought about itand was quite enthusiastic.”

At the time, Bache was primarily a retail brokerage firm serving individualcustomers, although not a very prestigious one. An analyst recruitedto the firm recalled his first weeks on the job:

Bache was headquartered at 100 Gold Street, which was one of the seediest,most disgusting buildings in Manhattan. The furniture looked awful,and the orange carpeting was worn down to its last few threads. It wasnot a place to which you’d want to bring anyone you were trying toimpress. Bache had a poor reputation among institutional investors, andit had no investment banking that anyone could see. It did have a largeretail sales force, but it often seemed in bad spirits, was not terribly successful,and was not well respected. During my first few months at BacheI recall moments when I found myself staring at my rotary-dial telephoneand feeling as if I was back in the nineteenth century.

Despite Bache’s marginal position in the industry, Beck saw the acquisitionas a way to jump-start Prudential’s “financial supermarket” strategy.The goal was to turn Prudential into a one-stop shop for all of a customer’sfinancial service needs. Beck understood that the quality of Bache’sproducts (especially its equity research) would have to be improved, buthe also envisioned a day when insurance agents would sell mutual fundsand brokers would sell life insurance. Keith explained why Beck was soconfident that Prudential could effectively harness these synergies:

Bob Beck was a consummate marketing executive. He had run Prudential’sagency organization and was very confident in his ability to managepeople selling products on commission. What he saw in Bache wasanother commission-driven sales organization that additional productscould be put through. At the time, Bache clearly had mediocre productsand therefore was not able to attract and hold top talent. Beck felt thatPrudential could upgrade Bache’s product and then could attract and holda better quality of financial advisors, which is what really drives business.

Others, like Fred Fraenkel, a former research director at the firm, weremore skeptical and harbored doubts as to whether Prudential understoodthe complexities of the stock brokerage industry. He explained:

Prudential was a really large mutual insurance company that had tensof millions of lives insured. It was based in Newark and run by insurancecompany executives whose motto was “perpetual and invulnerable.”That had little to do with returns or profitability or cost or policyholders.”You give me money, you’re going to die, I’m going to pay your policyface amount.” What assures that? That we’re perpetual and invulnerable.So they had a view of the world that didn’t really have anything to dowith what went on in the rest of the financial services continuum.

In March 1981, Prudential Insurance Company of America offered$385 million to acquire Bache Group Inc. The deal was consummatedthe following year. Although Bache had a small investment banking operation,there were no plans to grow that business. Keith explained why:

The investment side of the Prudential organization was quite concernedthat if we owned something that had even a fledgling investment bankingoperation, it was going to foul up our relationships with the bulge-bracket(most prestigious) investment banks that were necessary to keepour cash flow invested. Through the whole acquisition process, less wasmore. Less investment banking made it more attractive to Prudential.The last thing we wanted was investment banking activity over at Bachethat could potentially ruin a much more important cash investment processat Prudential, the parent. Investment banking was a concern, not anattraction.

New Management at Bache

Shortly after the acquisition, Prudential began looking for someone tolead the new company, renamed Prudential-Bache Securities, or Pru-Bachefor short. In 1983, George Ball was hired. At the time, Ball wassecond-in-command at E. F. Hutton, a highly successful retail brokeragefirm. Fraenkel described him as an exceptional motivator:

He was the son of the superintendent of schools of Milburn, New Jersey,a speed reader, a very high-IQ person, a very dynamic person, who hadspent his career in a meteoric rise through E. F. Hutton on the retail side ofthe firm. The thing he was unbelievably good at was personnel management.E. F. Hutton was like Bache, it had several thousand brokers, and heknew every broker’s name, and he knew every broker’s wife’s name, andhe knew every kid of every broker and what school they were at. Georgewas a memory-system person; he had “mental compartments” where hecould literally memorize thousands of items and recall them instantly.He would ask people personal questions, and everyone felt they were hisbest friend. He was probably one of the best cheerleader-managers thatI’ve ever been around.

Ball’s first priority was to develop the institutional side of the business—tobuild a research department and a sales and trading organization thatcould service large institutional investors such as mutual and pension funds.He believed these important capabilities could then be leveraged to developother businesses. To lead the effort, he looked to his former colleagues.Mike Shea, former president of Prudential’s equity group, remembered:

The first big move was the joining of Greg Smith, Fred Fraenkel, and EdYardeni from E. F. Hutton. They came in as the strategy trio. And theirmission was to begin the formation of a true institutional business. A lotof institutional salespeople followed from E. F. Hutton and a couple ofother places to Pru in the early ’80s because they wanted to be involvedin the business with them. So that was really the very beginning; that wasthe genesis.

The “strategy trio” had some success in accomplishing their goals.Pru-Bache began to service institutional clients and started to leveragetheir new capabilities to better service retail clients as well. Soon the focusturned to investment banking.

Project ’89: The Genesis of Investment Bankingat Pru-Bache

In the years immediately following the merger, little was done to improveBache’s small investment banking business because of the potentialimpact on the Prudential Insurance Company’s Wall Street relationships.Keith recalled that the decision to expand Pru-Bache’s business was undertakento “internalize some of the investment banking fees that werebeing paid to the bulge-bracket firms.” Prior to May 1, 1975, tradingcommissions had been regulated, generating fees that covered the costs oftrade execution and equity research. However, the May Day deregulationwas followed by a steady decline in commissions, reducing the resourcesavailable for research.

In 1987 Ball officially launched Project ’89, investing close to $200 millionover the following two years to attract top new investment bankingprofessionals. The plan was to build one of the best investment bankingoperations by 1989. Keith, who was present at the executive committeemeetings where the project was approved, commented:

George (Ball) convinced Bob Beck that he should be allowed to builda better investment banking organization. And what he sold Bob Beckwas to be the “best of the rest”—that he knew he’d get his head kickedin if he took on Goldman Sachs, Morgan Stanley, and First Boston, buthe needed to be at least as good as PaineWebber. So the franchise and thefunding George got from the Prudential board with Bob Beck’s blessingwas to upgrade Bache’s investment banking activity to equal the “best ofthe rest.”

Prior to Project ’89, Pru-Bache’s investment banking business rankedwell behind those of the bulge firms. Furthermore, its current investmentbanking professionals were not terribly impressive. Therefore, from theoutset it was decided that a serious effort to develop investment bankingwould require new blood. As Investment Dealer’s Digest put it, ultimately”Project ’89 was about hiring, and about spending top dollar to do so.”Pru-Bache hired aggressively in all of its divisions: Thirty senior investmentbankers joined the firm in the first five months of the project. Theseprofessionals were brought in to develop the firm’s relationships with Fortune500 companies in hopes that associations with big companies wouldtranslate into large fees and increased visibility.

Pru-Bache recruited most of their new investment bank and researchanalysts from elite firms, in the hopes of competing against them. Thecompensation packages offered during Project ’89 became legendary. Notonly were the salaries and bonuses higher than those paid by many bulgefirms, but they were usually guaranteed—not tied to individual or firmperformance. A research analyst at a bulge-bracket firm approached byPru-Bache during Project ’89 commented:

Honestly, they didn’t have a lot to offer me. Pru-Bache was a firm witha terrible reputation. It had an investment bank that was in the buildingstage but had no real presence and no track record. So what they had tooffer was, essentially, money. From my perspective, this simply wasn’t abig enough incentive to move. At that time, I was an Institutional Investor–rankedanalyst. The research director at my firm did not want to lose me.When he heard about Prudential’s offer, he matched it and I stayed put.

At first, Project ’89 appeared to yield positive results (Exhibit 1.1).Prudential-Bache represented Rupert Murdoch in his bid for the Herald &Weekly in Australia and completed the Reliance Electric Company managementbuyout—at the time, one of the largest leveraged buyout divestituresever done. Its equity underwriting market share rose by over 10 percent,and its ranking shot up from eleventh in 1987 to fourth in 1988. Prudential-Bache’sresearch department also began to move up in the Institutional Investorrankings (institutional clients’ rankings of research departments). By 1988, itwas ranked number five with nearly thirty-five ranked analysts (Exhibit 1.2).

The ’87 Crash and the Demise of Project ’89

On October 19, 1987, the stock market plummeted, losing more than20 percent of its value. The crash had a serious impact on all banks, butit hit the fledgling Pru-Bache especially hard. Investment banking dealsdisappeared, and retail commissions dried up due to falling investor confidence.The following year, Prudential Insurance cut funding for Project’89. Pru-Bache stopped recruiting and let go more than 25 percent ofits banking professionals. In 1988, there was a bright spot when the firmcompleted the Diamandis management buyout of the CBS magazine division.Unfortunately, the market correction of 1989 followed soon after.Pru-Bache posted losses of $50 million in 1989 and $250 million in 1990.In early 1991, George Ball resigned.

There was some controversy over just what caused the project’s failure.Clearly the stock market crashes were part of the reason—revenues driedup while Pru-Bache’s compensation commitments were fixed. However,some maintained that Prudential Insurance Company effectively killed theproject by reneging on its financial commitment before all the necessarypersonnel were in place. In fact, many pointed to instances in which Prudentialfailed to support Pru-Bache. Although the insurance company dida great deal of investing, it directed very little of its business to Pru-Bache,preferring instead to deal with the bulge firms. Prudential also limited thetypes of deals that Pru-Bache could pursue. For example, the firm was notallowed to participate in hostile takeovers, defined by whether “the targetcompany said ‘no’ at any time during negotiations.” This was problematicgiven that, according to one banker, “target companies routinely said’no’ the first time out as a standard negotiating tactic.” Concerning Pru-Bache’srelationship with the parent company, Ball commented:

Prudential was very helpful in terms of providing the appearance of morethan adequate capital for any transaction. It was not helpful in terms ofcross marketing or relationship sharing. There were a number of restrictionsplaced upon the investment bank that made it almost impossible forany of the expected synergies to be achieved. In point of fact, I think thatpeople at Prudential went out of their way to drive business outside ofthe Prudential family, rather than saying that “if you’ve got equal competenceand there are no apparent conflicts, let at least part of the businessbe done inside.” Some people at Prudential Insurance Company wouldrelatively subtly, but nonetheless overtly, give companies a signal that theymight be better off using Goldman Sachs or Morgan Stanley than PrudentialSecurities.
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