The Napsterization of Sell-Side Research

Cross-posted on the Gridstone Blog.

Candace Browning, Head of Research at Merrill Lynch posted an open letter last week that talked about the “Napsterization” of sell-side research, justifying why Merrill Lynch would have to take control of the distribution of their research.

As messages go, “Napsterization of Research” is as sticky as they come. Drawing an analogy with digital music (and film) is apt, but there are key differences as well. Understanding those differences is important to be able to see where the sell-side research puck is headed.

Both music and research are information products. For both, however, there is more to the experience than can be digitized. In music the “augmentation” (like concerts) is minor. But in research there are many aspects of the value that the firm provides – one-on-one consultations, management meetings etc. – that cannot be digitized. The threat of being napsterized into oblivion is therefore considerably less in the case of research than in music.

However, the cost of piracy or unauthorized use is higher in research. Piracy in music results in a loss of revenue from consumers who would have bought legal music in the absence of readily available illegal music. In research, unauthorized use results in not just loss of revenue of the abovementioned kind, it also reduces the value of the product in the hands of legal users. Widely distributed insight is already priced into the market and is therefore not actionable.

The customers for music are individual consumers. Research clients are investors and asset managers of various sizes. This difference is key to how unauthorized use is tackled. Its largest customer holds no power over a music label. For a sell-side firm, on the other hand, a large mutual fund or an actively trading hedge fund could be paying a significant percentage of total fees. So while the RIAA can sue individuals for pirating music to make an example out of them, Wall Street must walk on egg shells while they try to take back control of their IP.

In this context, I foresee a greater use of technology to discourage sharing and unauthorized use. Watermarking will be used more extensively. Use of alternative media types that are less reproducible, like podcasts behind authenticated websites is another interesting possibility. The tricky part is to find ways to discourage unauthorized use while not making it harder for authorized paying clients. But it is not completely hopeless. If the digital music industry led by Apple has been able to pull it off with complex, user-unfriendly DRMs (Digital Rights Management), there is no reason sell-side can’t.

Pricing is perhaps where the differences are the greatest. Music pricing, for the most part, is clean and simple. $10-15 per album and $0.99 per song on iTunes. Films have a little more sophistication in their pricing. They use what is called “windowing” – theatrical release, followed by DVD and pay-per-view, followed by cable. Value extraction is higher per viewer in the earlier windows and lower in the later windows.

Sell-side attempts to “value price” research. I say attempts to be because if there is one thing that is begging to be fixed in research, it is pricing. The days when commissions on trades were considered a good measure of the value of research are dead and gone. But independent of how research is priced, there is no question that the value of research in the hands of an investor drops off sharply with time. It actually drops off much, much faster than in films. So even while research pricing evolves, there is still every reason to have and impose strict windowing policies on the distribution of research. Average commissions attributable to research may be falling in the industry, but why must you lower the value of research to your best clients by releasing it to non-clients too early?

For people who have gotten over the Wall Street excesses of the late nineties, it is clear that a healthy, growing sell-side research is necessary for the efficient functioning of the investment management industry. Disciplined windowing and controlling unauthorized use of research are much needed measures in restoring sell-side to health. Merrill’s moves are welcome and necessary.