Broadridge and blockchain

When someone says they own shares of X, what they typically mean is that a broker owns shares of X on their behalf in “street name”¹. 

But wait, no, the broker doesn’t really own the shares either.  Shares are held and legally owned by Cede & Co., the nominee of the Depository Trust Company (DTC)², one of the largest central depositories in the world, because it is more efficient to have a single third-party, the DTC, credit and debit broker accounts in its database than have brokers bilaterally reconcile trades between each other.  The broker, in turn, electronically keeps track of which of its accounts own how many of what shares.  So the DTCC keeps track of share ownership between brokers and each broker keeps track of ownership between accounts.  These nested ownership layers, combined with a perplexing legal setup whereby the holders of record are entitled to vote under Delaware law but beneficial owners dictate how shares are voted under federal law, give rise to a funky superposition of voting rights that is collapsed when Cede & Co. pushes its Delaware law voting rights up to the broker and the broker, through Broadridge, delivers proxy materials to and collects votes from you and me and all the other investors who “beneficially own” the shares. 

Without Broadridge, a corporate issuer or mutual fund that wanted to get proxy statements and other governance material like fund prospectuses and annual reports to the beneficial owners of its shares – the 140mn+ retail shareholders and the 150k+ institutional investors – would have to work with each of the 1,100+ brokers with whom beneficial owners have accounts, an unwieldy and impractical burden redundantly born by over 5k corporate issuers and 24k mutual funds.  Instead, how about this…

…Broadridge Financial replaces all those bilateral relationships with a single hub into which all the issuers, mutual funds, and banks/broker-dealers connect.  In its unique position at the center of this ecosystem, Broadridge assumes the responsibility of distributing and processing proxy materials to investors and ensuring that investors’ votes are accurately tabulated and conveyed to the corporate issuer³. 

Network effects are certainly germane (brokers <-> issuers/mutual funds), though they probably aren’t as insuperable as management makes them out to be.  The company isn’t solving a matchmaking or discovery problem the way an exchange or marketplace might – the needs of corporate issuers are mostly routine, uniform, and well specified, and the participants on the both sides of the intermediating platform are easily identifiable.  Rather, it’s alleviating an administrative burden.  I think the more significant entry barrier may just be that there is no compelling reason for everyone in the ecosystem to collectively agree to switch to a competing hub. 

Here is a breakdown of ICS recurring revenue:

More than half this segment’s revenue is recurring, driven by the number of equity and mutual fund positions held in street name, which has experienced remarkably resilient growth over time. 

Customer communications and fulfillment includes revenue from delivering prospectuses to new ETF/fund shareholders and billing statements to telco/utility/bank customers.  Event-driven revenue is what Broadridge gets for distributing communications related to M&A and other ad hoc events.  Distribution is mostly no/low-margin pass-through revenue that Broadridge recognizes for physically mailing proxies.  When we strip out distribution and customer communication revenue, we’re left with ~$1.3bn of core governance revenue, ~$700mn of which comes from the mundane but vital job of managing and delivering materials for corporate issuers and mutual funds on a recurring basis ($436mn of equity proxy + $278mn of mutual fund and ETF interims)⁴⁵. 

Broadridge’s ICS segment distributes and processes 99% of all US proxies.  In its monopolist position, Broadridge realizes 30%+ EBITDA margins⁶ for what basically amounts to glorified e-delivery, which can be done at ~0 marginal cost.  And because most of Broadridge’s revenue comes from corporate issuers and mutual funds, shareholders indirectly bear the cost.  Some people hate this or at least act like they do.  Members of an SEC-hosted roundtable late last year all agreed that today’s proxy plumbing required “major overhaul”.  In 2010, the SEC remarked that “one of the most persistent concerns that has been expressed to the Commission’s staff, particularly by issuers, involves the structure and size of fees charged for the distribution of proxy materials to beneficial owners”⁷.  And yet, despite all this big talk, neither the proxy system nor the assessed fees has undergone material change.  It doesn’t seem that most shareholders care enough about systemic faults in the proxy process to raise a stink.

But from an investment perspective, what matters more than some nebulous normative assessment of whether Broadridge “deserves” to make the money it does is whether the $700mn of revenue that Broadridge generates for e-delivery is so onerous that issuers and brokers would risk the downside risk of moving to an untested service provider offering the same service for half the price.

I don’t get the sense that proxy distribution is particularly difficult, but it’s something issuers are loath to screw up.  Broadridge is the de facto utility for investor communications.  Its ProxyEdge electronic voting platform is synced to nearly 6,000 institutional investment firms and processes 80%+ of all shares voted in the US and Canada.  Replacing the company would mean ripping out a critical part of today’s capital markets infrastructure and installing something new.  It’s too monumental a task for too small and uncertain a benefit.  That’s why Broadridge has consistently retained 98% of its customers each year.

From its founding in 1989 ICS has, through acquisition and organic wins, become Broadridge’s largest and most well-known business today.  But it grew out of the infrastructure of Global Technology and Operations (GTO, ~25% of Broadridge’s revenue), a business that originated in 1962 as the Brokerage Services division of ADP⁸ and has since been augmented by a slew of acquisitions. 

At a high level, brokers route buy/sell orders from investors to an exchange and the exchange matches buy orders with sell orders.  A clearinghouse guarantees the trade by acting as the buyer to the seller and the seller to the buyer, and then sends the settlement obligations to the custodian of the buyer and seller.