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ECM: MiFID II — shake-up of research carries risks for capital raising

MiFID II is finally upon us. To many, it is simply a monster compliance burden. But in the world of equity trading and research, the effects could be profound. In 2018 for the first time, most asset managers will be paying for research out of their own money. If that means research provision is decimated, it could be bad news for small companies — and new research models may be needed. Jon Hay reports.

By the time this article is published, the most far-reaching reform of European equity capital markets for at least a decade will have come into force. Market participants are divided on how much MiFID II is going to alter the landscape — but at the high end of the range of possible outcomes, it will be the biggest change to the way equity investing and capital raising is done since the UK’s Big Bang in 1986.

Many ECM specialists are wary of talking on the record about the likely effects of the European Union’s second Markets in Financial Instruments Directive.

“This is a tectonic plate shift event,” says the head of ECM at one investment bank. “I think there is real change in the offing — there will be a lot of unexpected consequences.”

The main thrust of MiFID II is to make sure markets are fair, efficient, transparent and competitive. But rather than trying to set the right incentives or principles and let market actors choose to behave well, the regulators are enforcing and micro-managing almost every aspect of that fairness.

MiFID’s harsh reorganisation of how certain costs are allocated could put pressure on both sides of the market: investment banks and asset managers. Each is already squeezed by the effects of technology, as electronic trading eats banks’ lunch and passive asset managers free-ride on the investment choices of active managers.

The players, on both buy and sell sides, most likely to exude confidence are the biggest, and with reason — they are the best placed to withstand any change. 

It is in the lower reaches of capital markets where MiFID II could be more jarring. And since one of the essential purposes of stockmarkets is to raise growth capital for small companies, regulators are tinkering with a crucial engine of Europe’s economy.

Trading disruption

The parts of MiFID II that directly govern ECM are generally felt to be liveable with. They involve more regimented documenting of how shares are allocated to investors after a bookbuild, and laborious procedures of other kinds, but will not stop banks doing deals in the optimal way for clients. (See separate article on these issues here.)

It is the parts that concern trading and, above all, research, that could disrupt the market more profoundly.

The rules on trading are complex, but most of them tighten constraints. The first MiFID gave asset managers a duty to achieve ‘best execution’, meaning trade as efficiently as possible and at the best prices.

“The best execution regime is going to become a lot tougher,” says Michael Horan, head of trading in London at Pershing, the asset manager and services firm owned by BNY Mellon. Asset managers will have to “work a lot harder to evidence best execution to their clients.” 

He argues this is far easier to do when trading liquid blue chip stocks, so the rules could put investors off trading obscure small caps — or investing in their IPOs.

Meanwhile, regulators are changing the rules for trading venues. Dark pools operated by banks to enable large share trades between clients without moving the market will have to be registered as either multilateral trading facilities — a kind of exchange, which is fully lit, tightly regulated and cannot discriminate between investors — or systematic internalisers (SIs). This kind of platform has lower fees and will remain dark for trades above what is called standard market size. 

However, Horan does not expect banks to hoover up much more volume this way, because of their capital constraints. In an SI, the operator has to be a counterparty. 

Instead, this could at last be the opening non-bank electronic market making firms such as Citadel Securities, Virtu Financial and XTX Markets have been waiting for. “They have always been there and interacting with buyside liquidity, but not directly,” says Horan. “They have been interacting via dark pools or on lit books, but always via a broker. This time, for the first time, they are going to be able to interact directly with the buyside.”

In the long run, if market-making can be liberated from the grip of capital-strapped banks, it is conceivable liquidity might improve. 

In between could come a period of disruption, in which the offerings of various trading facilitators are shaken up. If that leads to worse liquidity, it could make investors reassess their appetite for ECM deals.

Research scrum

Yet the scythe of MiFID II is going to swing most wildly at research. The closing months of 2017 were a mêlée among investment banks and investors, as all parties tried to work out what the new cost of research services should be. Some banks are trying to maintain high prices, others are discounting. All are trying to work out what kinds of package are most attractive to clients.

Salespeople at one firm complained they were being turned into research salespeople, as they were spending so much time trying to sign investors up to take the bank’s output.

MiFID II completes the process of making research provided to investors by external firms a service they have to pay for, rather than a freebie given away by banks to encourage them to trade.

Up to now, it can be argued that end investors — whether retail or pension funds — have footed the bill for research. Asset managers paid banks for it out of trading commission, which is a cost to their clients’ portfolios.

Henceforward, asset managers will have to treat research as a completely separate cost. They will be forbidden to accept free research from banks, since this could be seen as an inducement to them to trade.

Asset managers can still get their clients to pay for research, but this must be done using a discrete, pre-agreed budget. MiFID imposes very detailed scrutiny of what the money is spent on and whether the research bought was useful.

To avoid this hassle, and please their clients, most asset managers are taking the other option: to pay for research themselves, as a business cost, like computers or milk for the office kitchen. 

“We have decided to internalise the cost,” says David Thomas, CEO of Seneca Investment Managers, a multi-asset value investing firm in Liverpool with £500m under management.

“We don’t think clients ought to pay a direct extra bill. They are paying an investment management fee: it’s reasonable for them to expect us to manage the funds based on that fee. If we choose to use third party research, it should be a cost that comes from the fee.”

This trend is self-reinforcing: the more asset managers suck up research costs, the harder it is for their competitors to insist clients pay.

Pinch those pennies

Human nature being what it is, if you have to pay for something yourself, you tend to examine the cost carefully. An extra irritant is that research paid for separately is liable for VAT, whereas trading commission is not, adding 20% to the cost.

Asset managers have already reduced their spending on research since the crisis. A study by Frost Consulting reckoned the global research budget of investment banks had halved from about $8.5bn in 2008 to a little over $4bn in 2015.

Almost all expect this to fall further as a result of MiFID II. The new law, says Thomas, “has made us think harder about what research we use and don’t use. Third party research has its uses, particularly in the knowledge some analysts have of their industries. That said, the actual research we base our decisions on is overwhelmingly done in house.” 

The question is: how much will research spending be cut, how fast and who will be the losers?

Charging upheaval

At one extreme, some bankers have begun to wonder whether research has a long term future within investment banks. Most believe it has, but they admit analysts’ pay has been falling in recent years and their numbers have dwindled.

Several banks, such as BNP Paribas with Exane and Crédit Agricole, UniCredit and Rabobank with Kepler Cheuvreux, have already outsourced equity research.

The bulge bracket ECM banks are outwardly confident. “Research becomes a proper business where you need to charge clients,” says the head of EMEA ECM at a US bank in London.

“Institutional investors have only a limited wallet, so they will try and concentrate it across platforms where they can get global coverage across sectors. The bigger will get bigger and there will be a flight to quality. A lot of research analysts who are sitting on platforms that are not going to be winners will move to those that are.”

It will not be a comfortable time for analysts, though. “Wrapped up with MiFID II you already have quite a focus on star analysts,” says the head of ECM syndicate at another US bank in London.

“If research teams are paid separately, that’s going to put greater emphasis on analysts actually earning their money, so there will be greater discrepancies between analysts’ pay.”

But the big banks are still nervous about how the charging models are going to end up. The figure that seemed to alarm rivals was JP Morgan’s offer of a flat charge of just $10,000 a firm for all the written research investors could want. 

The bank expects most clients to want more than just written reports — conversations with analysts and meetings with issuers would bring up the average cost.

But that price, from one of the top firms in the market, could make it hard for other banks to charge more. They may have less scale than JP Morgan and less ability to offer higher-priced extras. Small investors that cannot afford a large budget may be tempted to go for JP Morgan’s bargain basement deal.

This illustrates how much is still to play for in working out what regulators will consider fair pricing and practices under MiFID 2. It is not even clear to many whether banks will be allowed to run research at a loss, or at break-even, implicitly cross-subsidising it from investment banking or trading revenue; or if it will have to make a profit. And then: how granular will regulators go when they try to compare costs and revenues?

What many observers hope is that as the sellside analyst community is winnowed, much of what gets blown away will be the less interesting half of the 40-odd analysts that cover some blue chips. What they fear is that the two or four analysts who cover many mid and small caps will be the ones who can no longer be sustained. 

Pain for independents

MiFID II is supposed to lead to a fairer research market, in which customers have a good choice of providers and can choose what they want. But it is not at all clear this will be the result.

Many predict smaller investment banks’ research platforms could suffer, or be forced to specialise in niche areas.

Independent firms, such as Arete Research and TS Lombard, which do not trade or act for issuers, but live just by selling research to investors, are exactly the kind of provider regulators want to encourage.

But competition could actually get tougher for them. Clients that have been able to afford their services because they got swathes of other research from banks free will now have to pay for that, too. The independents will have to compete directly for investor dollars with UBS and Morgan Stanley. The investment banks have many other revenue streams that make it easier for them to price research cheaply.

Euro IRP, the independents’ trade body, has broadly supported MiFID II, but Chris Deavin, its chairman, says there are short term concerns. “One of the issues is a race to the bottom in prices, mainly on the FICC side but it also includes the equity side,” he says.

“There is a form of cross-subsidisation in terms of the investment banks’ trading, wealth management, M&A or corporate arms. It does undermine one of the key goals of MiFID, which is to create a level playing field.”

In the longer term, Deavin is confident: “Quality will out. There is always a premium for good research. But the guys with the deepest pockets can maintain that price pressure for longest.”

Research’s role in ECM wobbles

What happens with research is of great importance to ECM because research plays a central role in how equity capital is raised in Europe. 

John Lane, head of the ECM practice at Linklaters in London, reflects: “If some research platforms are slimmed down or discontinued, it could affect the breadth of availability of pre-IPO research, which is pretty intrinsic to the way European IPOs are conducted.”

The big global banks, which also operate in the US market where IPOs are done without written research, would be happy to downplay this part of the process, which they see as adding cost and work to doing an IPO, and lengthening the deal’s exposure to a potential disruption in the market.

UK regulation is about to take a small step in the direction of the US model, with the requirement that IPO issuers publish a registration document, equivalent to a US SEC filing or French document de base, with all the main information about the company, before the bookrunners publish their research. 

With the new registration document, “investor education is probably less important,” says the syndicate head at a US firm — it could be reduced from two weeks to one.

At the same time, the UK’s Financial Conduct Authority has banned companies from interviewing banks’ analysts when they are considering which banks to appoint to run an IPO.

Nevertheless, the trend towards thorough marketing does not seem to be going away. 

“There’s a lot of value for the analyst to be involved in the IPO,” says the head of equity syndicate at a European bank.

It is much easier for management of an issuer, he argues, to go and see investors that analysts have met during investor education.

“I find the quality of questions is much better because the investors are not asking the basic questions, they are asking the final questions that determine if they will invest or be willing to be talked up in the range,” he says.

If investor education is going to remain central to European IPOs, while banks’ research teams might be squeezed, and analysts cannot attend IPO beauty parades, one consequence could be a change in the role of the ECM banker.

“The calibre of the ECM origination banker has to be higher,” says the ECM head. “Clients will probably be demanding a different type of skillset.”

If ECM bankers partly replace analysts in interaction with the issuer, and even perhaps investors, as they do in the US, they will need the kind of deep sectoral knowledge analysts have.

The ECM head has already reorganised his team from the geographical teams common in Europe to sectoral ones — not in response to regulation, but so that bankers understand industries better.

Small firms at risk

Big companies will always attract bankers and research analysts to help them float, and to cover them after they are listed.

The case for smaller firms is very different. Hardman & Co, an equity research firm in London, published a report in December arguing that liquidity in UK stocks with market caps below £1bn is already low. For companies in the top half of that size range, only about £250m-£500m of stock is traded a year.

If about half the trading in most small and mid-cap stocks is done by the house broker, and assuming an average commission rate of 10bp (in reality retail investors would pay more, institutions a lot less, Hardman says) there is precious little revenue to pay for traders and research. Hardman reckons the breakeven for a non-house broker to cover a company is about £30,000 a year, meaning that “there is no commercial case for non-house brokers to cover a main market or Aim stock smaller than £200m”.

This is before MiFID II makes investors press down on commission and research costs. If that happens, and brokers cut back on research coverage, the liquidity in some small caps could shrivel, making them unattractive to many investors.

“This will be an issue for many portfolio managers,” says David Hussey, head of global ex-US equities at Manulife Asset Management in London. “It’s likely lots of smaller cap stocks may go uncovered by research and prices will become undervalued, leading to great opportunities for genuinely bottom-up active investors and venture capitalists. We might see businesses taken private in due course.”

Not such good news for companies, or retail investors.

Hardman has an axe to grind: it produces research paid for by issuers. This is one business line that looks set to grow as a result of MiFID II. Firms of this kind are still so marginal that many in the equity market have not heard of them. But Edison Investment Research, the largest of them, is expecting to grow its business as a result of MiFID II.

In the debt market, Moody’s and Standard & Poor’s operate on this model, and issuer-paid research will remain free to investors. As it is classed as marketing, is available to all, and does not come from a firm that trades shares, it cannot be seen as an inducement to trade.

But few see this as an adequate replacement for the kind of rigorous and sceptical analysis investor-paid independents — and, at their best, sell side analysts — pride themselves on.

If MiFID II ends up weakening research coverage of smaller companies, making survival tougher for independent research firms, or hobbling smaller asset managers trying to compete with the giants, it could be damaging for Europe’s capital markets. 

The pious creators of MiFID II wanted it to bring blessings. They may arrive eventually, but in the next few years, this law may feel to some of the intended beneficiaries more like a curse.

Most in the market are optimistic that a sensible set of market practices will emerge eventually. But Michael Horan at Pershing expresses the potential downside neatly: “We are sleepwalking into a world of pedestrian, defensive investment. Wealth protection instead of wealth creation.”   

For more MiFID II-related articles in our Review 2017 & Outlook 2018 see: MiFID II — enforcing virtue, risking stability and Who will win from MiFID II in fixed income?

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