Posts Tagged ‘Equities’

Measuring Client Profitability in Institutional Equities

BPCThe Institutional Equities business is a unique animal relative to its Capital Markets peers, with the big distinction that no one individual is responsible for revenue generation for any given account. Clients pay en effective lump sum, through trading, that goes to compensate the broker for a myriad of services. Between research sales, sales trading, program traders, electronic sales, research analysts, strategists, economists, and corporate CEOs that the brokers facilitate meetings with, the contact points can be large and hard to keep track of, making it a particularly challenging business to manage profitably.

Targeting Profitability

Success in the Equities world isn’t just defined by the amount of revenue coming in the door. Strategically, brokers need to ensure that the business coming through is profitable. There are a number of implications to this statement: [more…]

– Control of a broker’s profitability is driven by a delicate balance between targeting revenue opportunity and optimally managing expensive resources. Managing how resources are distributed to clients is the most effective way to increase profitability. Costs can be managed down through expense management initiatives to some degree, but these can only go so far given that the majority of expenses are compensation related which are market-driven. This is assuming, of course, that the firm is on a growth strategy.

– Management needs to develop capabilities to measure and track profitability at the client level so that they can have an ongoing tally of the impact their resources are having on overall profitability.

– As revealing as an understanding of an account’s profitability is, it’s critical to understand the future potential revenue for each account. In addition, managers need to develop a view on what resources are required to capture that potential revenue for any given account, and develop plans to migrate resources for lowest revenue potential to highest revenue potential accounts.

– Firms need to be willing to concentrate their resources towards the highest return accounts, meaning that they need to entertain culling accounts. The idea of cutting off revenue generating accounts is not intuitive for many managers, so this has to be handled in a methodical and intelligent way. More on this is a future post.

Profitability Analysis

Developing a detailed profitability analysis of accounts is a critical step in the process to maximize profitability. First, managers need a clear understanding of revenues across all Equities business lines, specifically an agreement what contra-revenue items (CSA, commission splits, third-party broker fees, trading loses) to subtract from gross revenues to reach a net revenue number that reflects true retention. These vary from sub-product to sub-product, where the dynamics of block cash equities differ from programs which differ from equity derivatives. Differing methodologies reach different conclusions, so it’s important for managers from all business lines agree on approach.

The second step, allocation of resource costs, can range from simple approaches that allocate using simple rules to highly complex allocation methodologies that attempt to be scientific about measurement of time spent and derivation of detailed unit costs. The degree of complexity  should be dictated by the complexity of the organization and the amount of information that being captured, or are willing to invest to capture. Regardless, each resource type should be thought through individually to make sure it makes sense. Salespeople and research analysts could be done through periodic time-spent survey, through a time billing system similar to law firms, or activity capture through an integrated CRM system. Sales traders and program traders can be done through number of trade orders and time-spent survey. Middle Office can be done using number of trade order, or even better, number of trade orders weighted by client processing automation to allocate more costs to more manual accounts.

The results of the analysis should be a full income statement detailing a net income for each account. Because of the sometimes complex nature of this kind of analysis, we often find managers who want to circumvent the process, asking for instance, if we can create profitability analysis for just the top 25 or 30 accounts. While it is possible to estimate costs for a subset of accounts in order to create an income statement, we strongly advise against this because the goal of the exercise isn’t to create an income statement; the goal is to have an analysis that will allow managers to effectively manage resources by moving them from low profit/low potential accounts to high profit/ high potential accounts.

Analysis on the Analysis

The income statement is not the end of the analysis. In fact, we feel that this is just the beginning. The value of really comes from the ability to make sense of the new profitability data and create actions that change how the business is engaging with clients. A second layer of analysis using the profitability results should give deep insights into the structure and dynamics of the account base. Managers can categorize accounts based on type of revenue and intensity of resource consumption. For instance, grouping accounts that predominantly trade on block and consume a ton of research versus accounts that have send a ton of smaller orders and only consume research opportunistically. What’s important is to better understand the drivers of profitability (or lack thereof) and then create strategies around those drivers to maximize profits by targeting resources to the right accounts.

Future Potential

It’s tricky, and in some cases risky, to assume that you can easily increase profitability by taking resources away from unprofitable accounts and move them to profitable ones. Pulling resources from large, yet unprofitable accounts may risk large chunks of stable revenues and may in the end decrease profitability. Similarly, an increase in intensity on profitable accounts may not result in an increase in revenue and will effectively make these accounts less profitable. An important element in the overall analysis is estimating the future potential revenue of the account, and trying to understand what effort and what resources will be needed to capture that revenue potential. In many cases this is not a straight-forward analysis. Size of wallet, market share, right resource matching, depth of relationship – these are all considerations in identifying and quantifying opportunities. In some cases you want to make the account less profitable by dedicating resources in order to gain a foothold with a new product, which is something that many Equity houses are doing to capture chunky prime services business.

Working Smarter

We’ve seen a general reluctance by many firms to tackle the problem of understanding account profitability because they feel it’s going to be a significant investment in time and money, with results that are not immediately tangible (or at least not as tangible as hiring a salesperson who can easily bring in two million dollars or more if incremental commission just from their existing relationships). Our message to them is that there is most likely a lot of low-hanging fruit within their account base and this is the best approach to realize those returns. In addition, once the strategy and analysis are in place, which no doubt will requires some investment, the maintenance going forward will be inconsequential to even the most conservative gains.

Tags: , , , , , , , ,
Posted in Analytics, Capital Markets, Strategy | No Comments »