Sell-side analysts from investment banks have long been suspected of issuing overly optimistic stock research in exchange for investment banking business, especially during the Internet bubble period in the late 1990s. Amongst a series of reforms from 2002 to 2003 to address the conflicts of interest in equity research, the Global Research Analyst Settlement (Global Settlement) prohibits the use of investment banking revenue to fund equity research and compensate equity analysts. Our recent paper documents a serious brain drain of top investment bank analysts and the resulting drop in the quality of information investors received as an unintended consequence of Global Settlement and related regulations. [i]
The Global Settlement was an agreement between U.S. financial regulators, including the Securities and Exchange Commission and the top ten investment banking houses, aimed at separating investment banks’ securities research activities from investment banking. In particular, banks’ senior management must set the budget of the research department without input from investment bankers and without tying the budget to investment banking revenue. Investment bankers cannot take part in evaluating analysts’ job performance or determining their compensation. Research analysts are prohibited from participating in investment banking activities or receiving compensation related to investment banking. As the restriction in the above reforms has led to a significant reduction in the bonuses and total compensation of sell-side analysts, we conjecture that the decrease in compensation may cause a brain drain in investment banks and the sell-side research profession if high ability analysts exit sell-side research to pursue other lucrative opportunities.
In our study, we treat star analysts as a representative group of the best performers in the profession and examine whether they are more likely to depart from the sell-side investment research industry as a result of the reforms. Star analysts are voted by institutional investors based on a number of features such as industry knowledge, earnings reports, and stock recommendations (Bagnoli et al. 2008), and are shown to be superior to their non-star peers.[ii] Besides broader industry knowledge, star analysts provide more accurate and timely earnings forecasts and their forecasts suffer less from conflict of interests due to their concerns for their personal reputations (Bonner et al. 2007; Fang and Yusuda 2009)[iii] and their status and coverage affect the market share of equity offerings of investment banks (Clarke et al. 2007).[iv]
Star analysts have been substantially affected by the Global Settlement as they are mostly involved with their firms’ investment banking activities and their compensation, especially bonuses, was largely tied to investment banking revenue (Groysberg et al. 2011).[v] With a significant cutoff in their compensation, it is likely that star analysts would exit sell-side equity research to pursue other lucrative opportunities and their departure would suggest a brain drain in the sell-side investment research profession.
Over the period from 1995 through 2007, we find that the average percentage of investment bank star analysts leaving the sell-side increases from 5.1% per year before the regulations to 11.8% per year afterward. Investment bank star analysts are more likely than their non-star counterparts to leave sell-side research in the post-reform period, holding constant the analysts’ forecast accuracy, optimism, experience, and affiliation.[vi] These findings suggest that it has become more difficult for investment banks and the sell-side research industry to retain star analysts since the reforms. To further investigate the loss of investment banking bonuses as an explanation for the departure of star analysts, we test whether the reforms have a more pronounced effect on star analysts specialized in industries with a high level of investment banking activities. We observe that the likelihood and propensity of star analysts to exit sell-side research is positively associated with investment banking revenue in the core industry of the star analysts.
We further track the career choices of the departed star analysts. We document that after the reforms, there is a significant jump in the percentage of investment bank star analysts moving to buy-side hedge funds, private equity, or venture capital firms. In particular, 31.1% of the departed star analysts moved to the buy side after the reforms, compared with 24.1% in the pre-reform period. We repeat the same set of empirical analyses on a sample of star analysts from non-investment banks, including independent research firms, brokerage firms, and syndicate banks.[vii] As non-investment banks have no or very little investment banking business, they are less affected by the reforms. We do not find an increase in the likelihood of non-investment bank star analysts exiting the sell-side or moving to the buy-side after the reforms. These findings provide triangulating evidence that the loss of investment banking-related bonuses is a reason for the departure of investment bank star analysts.[viii]
The departure of star analysts is potentially harmful for the investors who use the analysts’ research (Pizzani 2009).[ix] We compare the informativeness of the earnings revisions and stock recommendations made by the departed star analysts with those made by other analysts following the same companies or the analysts from the same brokerage firms replacing the departed star analysts.[x] We show that the departed star analysts provide more informative research than both benchmarking groups. Specifically, the market reacts more positively (negatively) to the upward (downward) forecast revisions and recommendations changes made by the departed star analysts than those issued by replacing analysts. Consistent with departing star analysts having more industry knowledge, we also discover that departing star analysts are more likely to issue industry recommendations and the market reacts more positively (negatively) to the upward (downward) industry recommendation changes made by departed star analysts than those issued by other analysts. These findings suggest that star analysts make significant contribution to the informational efficiency of the capital markets and their departure, as a consequence of the reforms, may impede the information being fully incorporated into stock prices.
We add to the overall understanding of the economic consequences of the Global Settlement and other regulations in the equity research industry. Prior research has mostly shown that these regulations have effectively achieved their objectives, such as making analysts’ stock recommendations less upwardly biased (e.g., Barber et al. 2006; Kadan et al. 2009; Guan et al. 2012) and more consistent with valuation based on analysts’ earnings forecasts (Barniv et al. 2009; Bradshaw 2009; Chen and Chen 2009), and reducing security mispricing (Lee et al. 2014) etc.[xi] We identify an unintended consequence of the Global Settlement and other regulations, i.e., they are associated with a brain drain in investment banks and the sell-side equity research industry, which provides important implications for a fair and comprehensive assessment of the efficacy of these reforms.
Our study also contributes to the stream of literature investigating the career concerns of financial analysts (e.g., Hong and Kubik 2003; Wu and Zang 2009).[xii] We show that compensation is a factor that leads to the voluntary departure of the best analysts from the sell-side investment research profession. By 2008, annual pay for top analysts had fallen to approximately 25% of its peak in 2000. We provide systematic evidence supporting the notion that the reforms affected the career choices of star analysts by reducing the earnings potential of sell-side analysts. More broadly, our study adds to the labor economics literature by demonstrating how regulations and compensation shocks affect human capital flows.
[i] “Brain drain”, a term of British origin, often refers to the departure of skilled professionals who leave their native lands to seek more promising opportunities elsewhere. We use this term to describe star analysts leaving equity research for other industries. We focus on the Institutional Investor (II) ranking to identify star analysts. The II magazine has published the All-America Research Team ranking since 1972. Many prior studies have examined II star analysts. We follow this stream of the literature to examine the career choices of star analysts who are considered to be superior in certain dimensions. We believe that the loss of star analysts who possess superior skills represents a brain drain to the equity research industry.
[ii] Bagnoli, M., S.G. Watts, and Y. Zhang, 2008. Reg-FD and the competitiveness of all-star analysts. Journal of Accounting and Public Policy 27: 295-316.
[iii] Bonner, S., A. Hugon, and B. Walther, 2007. Investor reaction to celebrity analysts: The case of earnings forecast revisions. Journal of Accounting Research 45: 481-513. Fang, L., and A. Yasuda, 2009. The effectiveness of reputation as a disciplinary mechanism in sell-side research. Review of Financial Studies 22: 3735-3777.
[iv] Clarke, J., A. Khorana, A. Patel, and P. Rau, 2007. The impact of all-star analyst job changes on their coverage choices and investment banking deal flow. Journal of Financial Economics 84: 713-737.
[v] Groysberg, B., P. Healy, and D. Maber, 2011. What drives sell-side analyst compensation at high-status investment banks? Journal of Accounting Research 49: 969-1000.
[vi] This result is robust to controlling for the confounding effects of the decrease in the investment banking revenue of banks and the change in investors’ sentiment.
[vii] Syndicate bank analysts are only involved in distribution and, hence, face little investment banking incentives. The results are unchanged if syndicate bank analysts are excluded.
[viii] The departure of star analysts represents a brain drain in the sell-side equity research industry. These departures can be voluntary or mandatory. On the one hand, a decrease in compensation encourages high ability analysts exit sell-side to pursue other opportunities. On the other hand, investment bank research departments can potentially terminate highly paid star analysts to cut costs. In the latter case, the number of companies followed per analyst should increase and the number of companies covered by brokers should decrease. Using our main sample and a constant sample of brokers, we find that the evidence is not consistent with the budget cutting story. The number of companies followed per analyst (the number of firms covered per broker) decreased (increased) after the regulations were enacted. In addition, the analysts whose employers do not replace them with a new analyst within a year of their departure may not have left their employer voluntarily.
[ix] Pizzani, L., 2009. Settling down. CFA Magazine, March-April, 41-44.
[x] The informativeness of earnings revisions and stock recommendations is measured by the short-term market responses to these revisions or recommendations.
[xi] Barber, B.M., R. Lehavy, M. McNichols, and B. Trueman, 2006. Buys, holds, and sells: The distribution of investment banks’ stock ratings and the implications for the profitability of analysts’ recommendations. Journal of Accounting and Economics 41: 87-117. Kadan, O., L. Madureira, R. Wang, and T. Zach, 2009. Conflicts of interest and stock recommendations: The effects of the global settlement and related regulations. Review of Financial Studies 22: 4189-4271. Guan, Y., H. Lu, and M.H.F, Wong, 2012. Conflict-of-interest reforms and investment bank analysts’ research biases. Journal of Accounting, Auditing, and Finance 27: 443-470. Barniv, R., O-K. Hope, M.J. Myring, and W. B. Thomas, 2009. Do analysts practice what they preach and should investors listen? Effects of recent regulations. Accounting Review 84: 1015-1039. Bradshaw, M.T., 2009. Analyst information processing, financial regulation, and academic research. Accounting Review 84: 1073-1083. Chen, C-Y. and P.F. Chen, 2009. NASD Rule 2711 and changes in analysts’ independence in making stock recommendations. Accounting Review 84: 1041-1072. Lee, E., N. Strong, and Z. Zhu, 2014. Did regulation fair disclosure, SOX and other analyst regulations reduce security mispricing? Journal of Accounting Research 52: 733-774.
[xii] Hong, H., and J. Kubik, 2003. Analyzing the analysts: Career concerns and biased earnings forecasts. The Journal of Finance 58: 313–52. Wu, J., and A. Zang. 2009. What determine financial analysts’ career outcomes during mergers? Journal of Accounting and Economics 47: 59-86.