A New York portfolio manager had a question: Will customers for video game software delay purchases and instead wait to buy versions written for Microsoft Corp.'s (MSFT) Xbox 360, set to launch late this year? Investors sure thought so -- shares of video game makers were slipping. But the manager, who asked not to be named, had a hunch the market was overreacting. So he contacted Gerson Lehrman Group Inc. The 7-year-old New York research firm didn't draw up a detailed analysis of which way game makers' shares were headed. Instead, it tapped its nearly 150,000-strong network of experts to provide direct access to a manager in Microsoft's Gaming Div. and a former regional manager at retailer GameStop Corp. (GME)
The portfolio manager wasn't looking for inside dope on Microsoft, just a discussion of trends in the gaming industry. He gleaned two important tidbits: First, the pending Xbox launch was unlikely to slow sales dramatically because Sony (SNE) PlayStation games would still be hot. Plus, sales of new Xbox games were likely to rocket after the launch. Armed with this information and his own research, he began to buy shares of game maker Electronic Arts Inc. (ERTS) in May. A longtime user of Gerson, he says: "We found Gerson could give us a ton of people who were willing to talk, and it would be the exact kind of person we were hoping to find."
Expert-matching services such as Gerson have boomed in recent years. New rules have led companies to tighten the information flow, forcing hedge funds and other money managers to push harder for any sort of edge that could earn them profits. The services line up the likes of middle managers, academics, consultants, engineers, and recently retired executives, and pay them fees that average $400 an hour -- and can top $1,000 -- to speak by phone with Wall Streeters. Standard & Poor's Vista Research Inc., which like BusinessWeek is owned by The McGraw-Hill Companies (MHP), maintains a network of 90,000 experts. "We cut out the analysis that clients are perfectly capable of doing themselves," says David Teten, chief executive of New York's Nitron Advisors LLC, which set up shop in late 2003. In fact, the firms prohibit their experts from making stock recommendations.
Big investors pay top dollar -- between $60,000 and $120,000 a year -- for the services, generating combined annual revenues for the top half-dozen firms of $200 million to $250 million, according to Michael W. Mayhew of Integrity Research Associates LLC, which tracks the research business. In return, investors hope to obtain fresh information from professionals at the sharp end of the economy, such as staffers at hot new wireless-technology firms. And they seem to like what they get. Portfolio managers voted Gerson Lehrman the first or second most valuable independent-research provider in the energy, health-care, and technology sectors in Institutional Investor's latest annual survey. "In our business, the more people we can speak to about investments we are considering, the better off we are," says Ryan Jacob, portfolio manager of the Jacob Internet Fund.
But for observers such as Mayhew, National Investor Relations Institute (NIRI) President Louis Thompson Jr., and others, these services raise significant legal and ethical issues. They worry that the services could be used to make end runs around the tough restrictions on how companies can release information to investors under the Securities & Exchange Commission's Regulation Fair Disclosure. (Adopted in 2000, Reg FD requires companies to make potentially market-moving information available to all investors at the same time.) Also, they fret that employees may be inadvertently passing along proprietary information that their companies or customers would prefer to keep under wraps. The SEC declined to comment on how the firms operate.
The top three research firms say they work hard to prevent any inside information from leaking out. They require both the experts and the investors to enter into agreements that they won't disclose or ask for proprietary information. In fact, Gerson, Vista, and Nitron say they would never set up an investor interested in a company with someone who worked at that company -- the discussions are supposed to focus only on industry trends or technical questions. The experts must also attest that they aren't violating any employment agreements by signing up. Mark Gerson, the 32-year-old chief executive and founder of Gerson Lehrman, said in an e-mail that "every interaction is subject to a set of rules and signed agreements by each side" to make sure no laws are violated. Gerson and Vista say they will stop using experts from any company that objects, which has happened. Vista Managing Director Stanton Green points out that stock analysts have always called on industry experts, usually without any signed agreements, adding that he believes "it is much safer to be having these conversations within our service than not."
It isn't clear how much employee moonlighting may be happening under the companies' radar, despite the agreements. Intel Corp. (INTC) spokeswoman Colleen Rubart says: "It's not something we would want our employees to do obviously. [But] we don't have guidelines." Adds portfolio manager Jacob: "In the back of my mind, I've always assumed these people are acting with the consent of their employers. But that's not really for us to police."
That task falls to corporate investor relations officers. "In an era of equal access to material information, these services can be an investor relations nightmare," says NIRI's Thompson. While companies are trying to comply with Reg FD by not favoring one investor over another, they worry that some employees may be divulging all sorts of sensitive information -- such as regional sales figures.
If any inside information is being passed along, it may be happening unwittingly. "Talking to the investment community is a real art," says William G. Lawlor, a partner with Philadelphia law firm Dechert LLP. "It requires a high degree of experience and sophistication to make sure you don't trip on any minefields." In some instances, malcontents may pass on proprietary information maliciously. Integrity Research's Mayhew says he has been told by people in the business that this can -- and does -- happen.
If these experts-for-hire always knew how their information was being used -- for example, for shorting the stock of a drug company -- they might think twice about it. According to Journal of the American Medical Association data, 1 in 10 doctors engage in this type of consulting. JAMA warns them against doing so. "You have to make sure your expertise is being used for patient care and not for someone making a heck of a lot of money using it the wrong way," says JAMA Editor-in-Chief Catherine D. DeAngelis.
Some experts who do sign up become disenchanted. Christopher Whalen, who runs financial and regulatory consulting firm Institutional Risk Analytics in Hawthorne, Calif., says he recently stopped working with a research firm he declined to name. He says he got annoyed with a hedge fund fishing for nonpublic information, such as whether the Justice Dept. was investigating a particular bank. "Some of the more reckless players feel they are entitled to any and all data," he says. Some potential recruits decide not to get involved. "We get contacted often, but we have not done this," says Michael Yavonditte, CEO of private online-search company Quigo Inc., a rival of Google Inc. (GOOG) "We don't feel it is right for us to comment on a competitor in that way."
All the same, investors will keep fishing for information. Picking the brains of people in the know can be lucrative -- though there can be some ups and downs along the way. Consider Electronics Arts. Its stock is up 17% since May. But it suddenly fell almost 5% on July 15, on news that its video game based on The Godfather movies will be delayed, before resuming its rise.
By Amey Stone in New York, with Amy Borrus in Washington