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Long-stable ECM on watch for upset from tech or regulation

The equity capital market, foundation of the economy, has changed little for 20 years. It remains able to transfer huge quantities of risk at lightning speed — though it is also buffeted by investor stampedes. But as Jon Hay reports, forces are moving in the market that could bring radical change.

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Equity capital market participants are feeling good in 2017. Volume is up and the major visible risk, that Marine Le Pen would become president of France and break up the European Union, has been put off for five years.

“We are seeing broad-based evidence of risk-on activity, with better flows into the European equity markets from various quarters of the globe and better stock prices across a broad number of sectors,” says Neil Mitchell, head of EMEA ECM at Credit Suisse in London. “Therefore more issuers are deciding to come to market. It’s entirely possible the market will become busier than in the strong years of 2013 to 2015.”

Nevertheless, the market is not relaxed. Participants, though enthusiastic, are in a state of alert. Something big, they sense, may be about to happen.

“Change can have a more fractal profile and not be constant or linear,” says Craig Coben, global head of ECM at Bank of America Merrill Lynch in London. “Sometimes very little changes for a long time and then there’s a sudden disruption. The question with ECM is: are we at risk of being disrupted?”

Could some fissure — perhaps algorithmic trading, blockchain or artificial intelligence — upheave the equity capital market, which still works in much the same way as 20 years ago? 

When or how disruption may come, no one is sure. But the room is crowded with elephants. 

The day of the MiFIDs

For many, the biggest is MiFID II, in gestation since 2010. Just seven months before its due date of January 1, 2018, equity specialists have little idea what its effects might be.

Crucially, it will make asset managers pay investment banks for equity research out of their own money — widely expected to make them more selective.

“The wallet for research is going to shrink very considerably, which brings into question the sustainability of some banks’ research platforms,” says Tom Johnson, head of Europe and Middle East ECM at Barclays Capital in London. “In time that may impact their credibility as distributors for primary issues, as the buyside is expected to consolidate down to using fewer brokers. This is a significant issue for the industry and will hit a lot of players, many of which are already finding it tough.”

The squeeze could force a shake-out in what many say are overbroked equity markets. Some banks are still convinced investors will value research and that being good at it will be key to being competitive.

“The resource that a global investment bank has is invaluable in a world that is getting smaller,” says Mitchell. “If you are a portfolio manager who wants to invest in tech, you must understand what happens in Silicon Valley. Only global research houses can provide the breadth of perspective and insight these investors are seeking.”

But even the big banks may become more selective about what research they do. Coverage of small cap stocks, in particular, may crumble.

“It will be no good being average at everything,” says Johnson. “You’ve got to have centres of excellence. The big banks will want to continue with waterfront coverage for the primary issuance, but even then they may want to over-invest in certain sectors.”

If only four or five analysts in a sector end up attracting the lion’s share of investor payments, star analysts could become extra-valuable to banks.

Tinkering with IPOs

Up to now in Europe, equity research has been intimately related with ECM — although that relationship, too, could be about to change.

The UK’s Financial Conduct Authority is reviewing the way initial public offerings are done in the UK, and that could influence other markets.

Bankers are enthusiastic about some of the changes, such as that prospectuses should be produced at the beginning of a four-week IPO period, instead of halfway through. But others could be more problematic. Issuers would be forbidden to meet analysts from potential lead managers before awarding mandates — preventing them hiring banks whose analysts have a favourable view of the stock.

Some ECM advisory firms are horrified by this. It is essential, they argue, that if an issuer engages someone to sell stock, they should be enthusiastic about it.

Others are calmer about the role of research in IPOs. “It might change, and maybe it should,” says Mitchell. “The relative contributions of ECM origination, syndicate, investment banking and research during investor education processes might adjust. There isn’t a monopoly on insight based on an individual’s technical role within an investment bank.”

Dumb money

Also encroaching on the market’s traditional business models is technology. Trading has become increasingly electronic, which is cheaper for investors and denies banks a revenue stream that used to support larger salesforces.

Meanwhile, an ever-growing share of money is held in passive tracker funds, which charge investors lower fees.

The notion that active managers are at fault because many fail to beat benchmarks has gained wide currency — even though this complaint is illogical, as benchmarks are merely records of the average performance of all active investors.

Bankers have noticed a thinning of the investor base for equity capital markets deals. Many investors, including passive ones, only buy in the secondary market.

“You are moving toward a bifurcation on the buyside, between on one hand cheap beta, ETFs etc, and on the other uncorrelated, idiosyncratic, concentrated exposure,” observes Coben. “ECM tends to market deals to those investors in between those two extremes.”

Others see no cause for concern. Mitchell argues that as investors are increasingly international in their appetites, there are still plenty of buyers for deals — they are just more widely scattered.

Other parts of the deal-seeking investor base have grown, however. In the US, especially, the stockmarket now has an anteroom where much of the exciting work of picking winners goes on: the world of private funding rounds, especially for tech and biotech start-ups. 

Single investments made by venture capital firms like Andreessen Horowitz can become widely known to the public. Also playing here are sovereign wealth funds and family offices.

Banks are keen to develop business intermediating such deals in Europe, too. A boost came in May when SoftBank put $500m into Improbable, a UK virtual reality start-up.

Barclays set up a team to do private raises in the US a couple of years ago and has done a handful in Europe too. “I don’t expect it to be a huge part of the business, but it is growing and by doing those raises, even if it’s $50m, you are bedding yourself in for the IPO in future,” says Johnson. “We want to go on a journey with companies and private rounds are just another part of that.”

Where will deals come from?

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It is possible to imagine all kinds of disruption to ECM, but for the time being — which is all anyone can foresee — it continues to operate. That means hunting for deals in cyclical markets.

Will these be forthcoming? Despite the buoyant mood and investors’ keen appetite for risk, volume could be challenged. Particularly now that the IPO market for smaller companies has shrunk, the two biggest sources of ECM issuance in Europe are the banking sector and the private equity industry.

With this year’s big rights issues by UniCredit and Deutsche Bank finished and Credit Suisse’s about to be, the rolling series of post-crisis bank recapitalisations is expected to peter out. This will choke an important source of nourishment, especially for smaller ECM banks.

Private equity is also in a cyclical trough of issuance, which may continue for some time. Not only did PE firms sell many companies in the IPO boom of 2013-15, but they have not been restocking the IPO market’s larder with many new buy-outs.

Despite this, bankers are generally optimistic that enough new companies are being formed — or split up, merged or sold — to generate ECM business. “There are companies out there,” Johnson is sure. “There is also an increasingly thriving tech pipeline across Europe, in London, Berlin, Paris and Madrid too.”

“Timing is everything,” concludes Coben. “We can imagine changes — the question is how do you position yourself. There is one big positive: the market has always been very flexible. We are practical, not ideological or dogmatic people, so I hope we’ll be able to adapt.”

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