MiFID II, a lesson in unintended consequences
This month marks the third anniversary of the implementation of the MiFID II directive, which offers us a point to reasonably reflect on any meaningful changes to the landscape and behaviour of its inhabitants that the regulation has engendered. There is little value in revisiting the ample coverage this document received pre and post-launch, other than to remind of its scale, a multi-year gestation period, a purview covering all participants in multi-asset markets and a total page count stretching to an unfeasible 30,000. As is often the case with straplines, the laudable target out-turn of the regulation was to make markets in the post-financial crisis world “more transparent, efficient and safer”. Targets that have driven the regulated universe to spend inordinate sums of money and expel equally onerous amounts of time and emotion in firstly trying to circumvent and latterly acquiesce to the new rules. Taking a practical approach to one of the areas of greatest contention, what have the changes been in and around the provision of, and payment for, equity research?
Implementing a distinct equity research payment between providers and asset manager consumers was going to be problematic from both a structural and cultural perspective. The over-riding driver of any behavioural reaction on the “sell-side” was easier to gauge; it would come from an understandable foundation of economic self-interest. I suggest this DNA hard-coding was also part of why, at the twelfth hour, many of the largest asset managers decided to foot the bill from their management companies, rather than recharge it to the underlying investors. This represented a longer-term interpretation of the best commercial approach but was still driven by the profit imperative. It gave the FCA a saving to the end consumer relating to an observable metric and saved laborious discussions and scrutiny of differences between historic and post-MiFID II research budgets. Knowing the producers of research would act in their economic best interests did not necessarily clarify for observers the actions that would be taken, just the intent. Decisions on costs and revenues based on their economic impact would inherently require an element of forecasting, in both financial and behavioural science terms.
And there it is folks… an ambiguous outcome for the intended beneficiaries and a demonstrably negative one for small corporates
Please view the following with a tacit acceptance; it is a set of observations of a heterogenous set of participants and, with specific regard to the mainstream equity research producers, its aim is to capture the substance of broad and meaningful structural and behavioural changes.
Sell-side equity research departments have generally served two customer groups: internal corporate broking/corporate finance teams and external asset managers. Apportioning costs to be allocated and absorbed internally vs those externalised represented an arduous first task. Secondly, on what basis are external product pricing decisions to be based? Unsurprisingly, anecdotal evidence suggests in many instances the answer is derived from an unholy alliance of historically achieved revenues, spotty usage and consumption data, and a touch of “what the market will bear” – all shoehorned into a rough tiering system. Participants should be afforded some latitude, given this is arguably the first time a prospective price has been required for a product that has been sold and consumed for decades without detailed contract agreements. There are examples of some scale providers setting a relatively undemanding “one size fits all” price for unlimited user access across assets and regions, implicitly seeking to either markedly change their competitive industry position or pivot organisational focus to other revenue streams.
Interpretation and action have seen commonalities and some clearer divergence from research providers. It is almost ubiquitous, however, that in an area where the world view is dominated by numbers, the comfort blanket of data was a common starting point. It is an unfashionable view to express but most practitioners on both sides of the aisle would quietly agree volumetric measures regarding a research product’s “value” are deeply flawed. The value, if any, of a research report is different for different parties and at different points in time. It can only really be fully evaluated post-fact – in many instances, multi-periods after publication and consumption. For an overt evidential example of this, see the more negative original “PPI” related banking notes and their forecasts for industry redress payments (and the initial castigation they generated). Hence, brokers trying to sell research with reference to questionable volumetric data on emails opened and reports downloaded in any given period were more likely to generate a lack of any engagement or an endless life-sapping conversation about the mismatch between the buyers’ and sellers’ datasets, rather than an efficient and timely signed contract at the requested price.
The other key dichotomy within UK focused sell-side brokers arising from MiFID II was the requirement to balance the monetary research payment received vs retainer income generated from brokership clients, this element being more art than science. The target being to price research at the optimum point to each tier to retain/gain as many asset management clients as possible, to then use this breadth of distribution sales pitch to existing and prospective corporate broking clients, the complicating factors being that research on quoted paying corporate clients could be sent to “all of market” as marketing material. In addition, some asset managers decided to embargo the receipt by their employees of all output, regardless of nature, from any counterparty where a paid for research agreement was not in place. Some brokers mirrored this stance by deciding that no research (corporate or otherwise) would go to any client without an independent research pricing structure in place. An interesting two-way market in brinkmanship on product pricing and value, and a debate reminiscent of the Buffett quote, “Price is what you pay, value is what you get”. It is a pragmatic statement but not one that moves the Mexican stand-off between buy and sell-side firms much further forward.
Breaking out research pricing and effectively devaluing it in the process has driven renewed cost discipline focus and in turn a more concerted migration to “juniorise” research staff, shrink sector teams and cease coverage of peripheral industry sectors. It has, from an efficiency perspective at least, given clarity on which teams and people within research fund manager customers are paying for and it should have stopped payment being made for “non-substantive”, superficial, journalistic product. It empowered sell-side management with the optionality to better choose where and who to cut from the headcount and in turn who within the pool of survivors warranted reward. The structure “should” have been a positive for quality independent research specialists, but this has not proved to be a meaningful factor yet. Likely a poor observation regarding fund management organisations’ willingness to move away from the comfort blanket of mainstream providers to seek genuine insight and edge, rather like “hugging” the benchmark in the day job. This might be inertia or a perceived fear of losing status or access, even in a peripheral sense.
Robust MiFID II impact related statistics remain sparse and the subjective nature of research itself makes it tougher again to assess. At this juncture, the appearance from an experienced practitioner’s perspective is that quality, independent coverage has become starkly thin or absent at the lower market cap end of the UK market. The reasonable counterargument, and one observable in selective bright spots, is an uptick in analytical output and quality from selective individuals based on a touch of animal spirits – greater visibility on votes and payments meaning a greater chance to claim a higher personal apportionment of the available spoils in the annual bonus round. With little surprise, I note that the FCA reports still state they have “found no evidence of a material reduction in research coverage”. Industry documents have a more negative flavour; Reuters’ analysis suggested after ONLY the first six months post-implementation that the MSCI small cap universe had seen constituents’ average number of analysts covering them fall by one. Industry analysis from 2019 suggested more than half of UK listed companies felt they had less analyst coverage and more than a third felt the quality of their coverage had fallen. Not all analysts or reports are created equal. From my experience, initial coverage “adjustment” is generally made up of two things: increasing the breadth and number of senior stock analysts’ cover and aggressively employing more junior resource. There’s little comparison between a respected and rated industry veteran writing a vigorously researched 60-page in-depth stock note, and an associate-level three-page Christmas trading update.
We return to the economic imperative inherent in research provision. As a rational provider, you ration units of resource and direct them to the highest return homes in order of priority. This hierarchy likely drives the following order, starting with IPO and high margin project work, servicing corporate broking clients where retainers are high and recurring, writing on companies with a paid for research agreement and thereafter addressing real or perceived prospective business in all its guises. MiFID II in practice, as it pertains to the lower realms of the quoted UK market, has simply sharpened the focus on the paying corporates on the books vs asset manager clients. Patently not the regulator’s desired result, simply an important case of the reoccurrence of the law of unintended consequences. In some instances, there is no plausible research coverage of a stock, independent or otherwise – reliable forecast numbers or a consensus is a long-dated aspiration at best. Less coverage in turn sees less secondary liquidity and reduces the market’s inclination to provide funding. The next step sees more analysts departing traditional roles; at some juncture, a tipping point is reached and expertise is lost. The result of this from a purist’s point of view is a negation in large part of domestic capital markets’ ability to deliver on their key raison d’être, the most efficient provision and allocation of funding to their most productive UK corporate homes. The optimist, however, might well see a Schumpeter-esque wind of change gathering momentum, a little creative destruction requiring and delivering new ways of facilitating support and funding for smaller quoted companies and greater levels of domestic economic growth thereafter.
As it pertains to equity research, regulation might have changed the visible cost outcome at the margin for the end purchaser of funds but it is not clear if it has also moved the less visible but far more material metric, the achieved net return. The man on the London Omnibus can only spend the net financial outcome of his financial decisions in nominal pounds; the constituent parts of that outcome have far less bearing. The bigger clearly observed product is the change brought on by requiring producers and sellers of research product and services to agree a clear and distinct price with buyers, the outcome of which has been a wholesale change in the economics of the business. The emphasis and focus for these purveyors of product and service has firmly shifted from institutional shareholders to corporate customers fitting certain criteria. Ideally those with a large enough market capitalisation to feel they require and can bear the cost of a large cap corporate and service provider structure, the secondary turnover and liquidity to match, founders with large enough holdings to periodically require lucrative sell-downs, an acquisitive M&A policy and the habit of recurring equity issuance to fund deals and organic growth. There are many exciting and worthy growth stories that fit these criteria but there are many very laudable ones that do not. The service landscape is changing but needs to change further to give these firms the voice and support they need in marshalling more limited resources to fulfil exciting and worthwhile growth aspirations. Capital Markets should provide this support in as seamless a manner as possible. The speed of change in the investor relations service provider landscape will continue to build in momentum but the requirement for it to do so should also serve as a wake-up call to corporate managements. They should take stock of the reality of the coherence of their current investor engagement programme and in many instances do a full independent “IR audit” to maximise its efficiency and impact.