How does Equity Research Get Paid?
Equity research does not sell its research directly to institutional clients. The way equity research gets paid is through commissions. Institutional clients will trade with the investment bank if that investment bank has a strong equity research function who produce good research reports. Trading generates commission revenues since the investment bank keeps a small portion of each trade as commission. At the end of the year, the total commission amount generated by the bank is calculated and a certain portion of it is determined to make up the bonuses to be paid to sales, trading and equity research. The division of this bonus pool between sales, trading and equity research varies from bank to bank. As you can see, Equity Research does not get paid directly for the research it produces. Instead, the research is a tool for institutional clients to make informed investment decisions and these clients will reward the investment bank that provided this research by executing trades with that investment bank.
Structure of an Investment Bank
- Equity Research
The Equity Research function of an investment bank consists of dozens of analysts, each of whom specializes in a certain subsector. These subsectors may include companies in consumer discretionary, consumer staples, industrials, banks, financial services, chemicals and fertilizers, oil and gas, energy infrastructure, software technology, hardware technology, telecommunications, mining, and REITs.
Each analyst usually covers anywhere from 15 to 25 stocks or more in a specific subsector and is responsible for being the expert in these stocks. One analyst may have one, two, three or four associates working for him, depending on how many stocks and how big are the companies he covers. He initiates coverage on stocks, which involves building detailed financial models that try to predict financial results and he comes up with an opinion on each of the stocks he covers, which is summed up in his rating for each stock (buy, hold or sell). He calculates the price at which he expects the stock to be trading one year from now, called the “target price”.
He develops relationships with the companies he covers – in other words with the corporate clients of the investment bank. These relationships are important as they help the analyst to understand company management, company strategy and to help answer any questions the analyst may have. The analyst follows the news on the stocks he covers very closely and updates his financial models, recommendations and target prices accordingly.
The analyst communicates his research findings and recommendations to institutional clients to help them make investment decisions. His communication methods include research comments on individual stocks or the sector as a whole and marketing meetings in which he would meet with institutional clients face to face and “market” his ideas. The analyst would also market the corporate clients, which involves attending meetings that are set up by Equity Sales between the corporate clients and institutional clients. An analyst with good and established relationship with corporate management of the companies he covers will be able to provide institutional clients with prompt and frequent meetings with corporate clients.
- Equity Sales
Equity sales function is responsible for developing relationships with institutional clients and understanding their investment mandate. Equity sales uses these relationships to “sell” or promote investment ideas put forward by the equity research analysts. Equity sales communicates research ideas to institutional clients and tries to elicit trading orders from these clients. In addition, whenever a corporate client performs equity financing on a bought deal basis (where the investment bank buys the secondary common equity from the corporate client and then tries to resell it to institutional clients), equity sales personnel are the main force behind reselling the equity issue to institutional clients. Finally, equity sales sets up meetings between institutional and corporate clients of the bank (called “corporate marketing”), sets up meetings between an analyst and institutional clients (called “analyst marketing”) and coordinates industry conferences, in which a number of corporate clients present about their companies over a one or two-day period to institutional clients.
- Equity Trading
This function involves traders that execute buy and sell orders from institutional clients and manage their books. While this sounds very simple, this function involves serious skill. Imagine a situation where an asset management firm holds a very large position in one stock and wants to liquidate this position. If it simply “dumps” its position onto the market, the price of the stock will decline as there will be an oversupply of the stock, and the asset management firm may end up selling its position in the stock at a loss. Equity traders in this situation will help institutional clients to liquidate their positions in a discreet manner, which may involve selling the position over time and during times of best liquidity in order to avoid depressing the price of the stock.
Client wants a return of 5% over the next 5 years – the structurers would come in and help create them a product that would try and achieve this investment objective
- Investment Banking
The investment banking function involves providing advice to corporate clients, such as obtaining financing on the best terms possible and M&A transactions and divestitures. As we mentioned above, corporate clients use investment banking services to figure out the cheapest way to raise common equity, debt or preferred equity. Corporate clients may also be considering strategic options, such as buying another company or divesting of certain assets. The investment banking function is responsible for advising corporate clients in all of these matters and structuring these transactions.
- Corporate Banking
Just like any individual, a company requires a line of credit that it would use for various purposes, like paying labour or raw materials or legal fees. In addition, some corporate clients may need to hedge their exposure to various currencies or commodities, such as the price of oil or natural gas. The corporate banking function of an investment bank is responsible for addressing these needs, from providing credit to corporate clients to structuring derivatives aimed at hedging corporate clients’ exposure to currency fluctuations or commodity prices.