Corporate finance bankers press research analysts to be "banker-friendly." Salespeople yearn for new stock ideas they can use to solicit trades from clients. Investors demand that research analysts write unbiased research, while companies wish for the best rating possible. Although within the department, research is often less political than corporate finance, those in research face more external pressure than any other area in investment banking. Because the demands placed on an analyst can be severe and multifarious, we will cover in this section the various pressures hurled on the research analyst. We will examine the relationship between research analysts and corporate finance department, outside investors, salespeople and traders, and the companies they cover.
Corporate Finance
The reason for disagreement between bankers in corporate finance and research analysts essentially boils down to their incentive systems. Bankers are paid for deals completed and deal size. Nothing in their pay-scale takes into account the post-offering performance of the stock. In comparison, a research analyst covering the same stock will generally be paid based on a formula that measures the performance of the stocks he covers, as well as the trading activity in those stocks.
A common analogy used to describe this difference in incentives is that when a company goes public, the banker dates the company, but the research analyst marries the company. Poor stock performance down the road in no way directly impacts the banker, except perhaps in industry reputation. The real scapegoat in the marketplace for a lousy IPO stock is generally the research analyst (if he maintains a buy rating). And the analyst's pay and reputation will be adversely affected when and if the stock tanks.
When does this translate into pressure on the research analyst? Generally when a banker wishes to underwrite an IPO, but the analyst is not convinced that the company and/or management are sound. This pressure from corporate finance cannot be understated, however, as a manager role in a public offerings usually means millions of dollars in revenue for the firm. An analysts' rejection to cover the company or endorse the deal can squelch any transaction in the making.
Sometimes, companies considering a follow-on offering in a few months will hint that favorable research coverage will win the business. Again, the banker will pressure the analyst to publish favorable research before the company begins selecting the managers. Note that once a company begins the process of the follow-on offering (defined by the first working group meeting or the decision by company management to officially pursue a deal), a "quiet period" ensues, forbidding the managers involved in the secondary offering from publishing any rating changes on the stock.
Between corporate finance and research, firms build a "Chinese Wall" separating research analyst: from both bankers and S&T. Why? Often, bankers are privy to "inside information" at a company because of ongoing or potential M&A business, or because they know that a public company is in registration to file a follow-on offering; either transaction is considered "material non-public information" and research analysts privy to such information cannot change ratings or mention it as doing so would effectively enable clients to benefit from inside information at the expense of existing shareholders.
When it comes to certain information, a Chinese Wall also separates salespeople and traders from research analysts. The reason should be obvious. Analyst reports often move stock prices, sometimes dramatically. Thus, a salesperson with access to research information prior to it being published would give clients an unfair advantage over other investors. Research analysts even disguise the name of the company on a report until immediately before it is published. This way, if the report falls into the wrong hands, the information remains somewhat confidential.
Salespeople within the Firm
Nothing leads a research analyst quicker to the professional grave than when she touts stocks (to the salesforce) without doing the necessary background checks on the company. Too often, young research analysts finish out of business school buy into a company's story without really kicking the tires, and publish favorable reports without digging deep enough. Recommending a stock that tanks hurts salespeople, as their clients can become irate at the poor advice given.
Let us further understand why a salesperson can love or hate an analyst. Suppose a research analyst initiated coverage of a company with a strong buy (buy-1) rating. Or that a fixed income analyst put out a new report that was bullish on a certain sector. The research piece immediately ends up on the desks of the relevant salespeople, who proceed to call their clients (investors) pitching a trade. Many clients will actually purchase the security based on the analyst's recommendation, and the salesperson takes home a commission on the trade. However, if the stock drops or the bond declines in value, the relationship between the salesperson and the client can be jeopardized. The salesperson would think twice about extolling the virtues of the next buy-1 research report from that analyst, especially if the cause of the stock falling were something the analyst should have known. To avoid salespeople pitching stocks just to generate trades, many firms pay salespeople based on the performance of the stock or bond, so that a poor stock trade makes less money for the salespeople.
In addition, salespeople lose respect for research analysts who become too "banker-friendly." This refers to analysts who compromise research quality to generate corporate finance business, and willingly publish ratings simply to help out the bankers gain manager roles. On the flip side, salespeople value analysts willing to sacrifice some income for their reputation.
As noted by one sales-trader, a good analyst "reads between the lines of things a company says" and "does industry digging" to ferret out all risk factors and potential landmines. That includes talking to the company's vendors, customers, and even the company's competitors, to understand the stock.
Companies
For obvious reasons, a company wants the best possible rating on its stock. To get such a rating, CFOs and CEOs not versed in the workings of the market may attempt to highlight the positive developments, downplay the risk factors, and influence earnings estimates. Smart companies learn quickly, however, that the backlash from the markets from over-inflated estimates kills credibility with both research analysts and investors alike. Thus, most companies actually understate their expected future earnings. That being said, it is not unheard of for a company to almost threaten to terminate corporate finance relationships without a strong stock rating from the analyst.
Once a research analyst places a "sell" rating (either a 4 or 5) on a company's stock, the relationship between the company's management and the bankers and research analysts changes forever. In fact, company management may refuse to return calls, give guidance on estimates, or even extend professional courtesy to an I-bank that has issued a sell rating. Thus, it is a rare case indeed when a researcher chooses to issue a sell on a stock.
Outside Investors
An investor whether a large institutional investor or a small retail investor wants research that accurately reflects a stock's prospects. Investors understand when a research analyst makes a bad call once in a while, but they must believe that the research analyst's primary goal is to publish unbiased analyses and opinions. After all, analysts are the experts and their primary market is the institutional and retail investor. However, the best institutional investors view Wall Street research with tremendous skepticism, recognizing the inherent conflicts of interests.
