MiFID II is creating some unintended side-effects, especially within the field of investment research.
Legislation that focused on more transparency for investors is now threatening to choke off the supply of information that informs investors about opportunities within smaller listed companies.
The new rules attack the longstanding sell-side practice of sinking the costs of analyst research into transaction fees. The new rules that came into force at the beginning of the year require that the costs of research must now be broken out and made transparent to all.
The result is that investment research budgets are being slashed, and the likely victims (apart from sacked analysts) will be small/mid cap firms. Sell-side investment research on these stocks has often been subsidised by more profitable large cap research; smaller listed firms have always had the attention of far fewer analysts than large firms. Post-MiFID II, coverage of smaller stocks is now at risk, as brokers and investment banks reset their analyst business models to focus on large cap stocks and any smaller firms that stand out from the crowd.
A white paper by Capital Access Group (CAG) forecasts that the number of sell-side analysts in the UK will fall by more than 50% during 2018, and by two-thirds over three years. It also predicts that UK fund managers will cut their spending on bought-in research from around £200m in 2017 to £90m in 2018.
Exane BNP Paribas, in a recently-published MiFID II survey stated: “For sell-side research houses, the economics of providing coverage on large cap shares look set to become relatively much more attractive than covering small or mid caps. We expect to see a significant reduction in sell-side coverage of smaller companies.”
It added: “While relationships between brokers and investors are becoming more transparent, the visibility of corporates in the European equity marketplace – particularly small companies – is shrinking… Both the number of sell-side analysts covering each stock and the number of investors they speak to are likely to decline. Many small investors will no longer have access to written sell-side research content at all.”
To add to the challenge for IR professionals in small/mid caps, MiFID II is likely to undermine the traditional system in which brokers handle investor road shows and other corporate access on behalf of listed firms. Guidance on MiFID II issued by the European Securities and Markets Authority last year stated that broker costs around corporate access could no longer be bundled with research, and must be properly charged at “commercial” rates. According to CAG, now that access costs are transparent, a majority of fund managers say they will not pay brokers for meetings with corporates.
This predicted sell-side disengagement from the smaller end of the research market is a significant problem for IR professionals. Smaller listed firms have long benefited from broker support, which has given them valuable visibility to potential investors. Ironically, although inherently riskier, small and mid caps have a strong case for informed investment; over the last five years, the FTSE Small Cap Index delivered 13.2% annual return, whereas the FTSE 100 delivered 7.7%.
Some stock exchanges are offering help to smaller listed firms; but others are not. For example, Deutsche Börse was quoted in the Financial Times as saying that MiFID II was a significant factor in last year’s launch of a new small company index a year ago, with listed firms receiving written research from Morningstar and Edison as part of their €20,000 listing fee. In contrast, AIM told the FT it did not think such intervention was required.
Even where exchanges are willing to help, it seems clear that small and mid caps need to take steps to ensure continued visibility among potential investors. How should IROs deal with this need? I will tackle this crucial question in my next article.
Steph Osborn is a business analyst at Invicomm. This article was repurposed from a longer piece written for the Investor Relations Society’s ‘Informed’ magazine in March 2018.