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Nov 21, 2016

What's next for equity research in Europe? [AUDIO]

IR teams are primed to lose coverage as estimates say Mifid II could shrink the research industry by a third 

At a glance

New rules
Mifid II will force new levels of transparency and accountability on research payments, forcing investors to either pay out from a pre-agreed account or directly from their P&L.

The coming squeeze
The full impact remains to be seen but some commentators estimate the research industry could shrink by a third, with some brokers pulling back from full coverage.

Ripple effects
The legislation could open the door to more independent research in Europe. Beyond the continent, global asset managers may decide to follow Mifid II rules wherever they operate.

Fears that the latest Markets in Financial Instruments Directive (Mifid II) would bring the practice of using trading commissions to pay for equity research to a screeching halt have proven to be overblown. And yet experts say the reality – that there will soon be a very real unbundling of commission and research payments in Europe – is already having profound consequences for asset managers and sell-side analysts in Europe and beyond.

‘For years, equity research worked on an all-you-can-eat buffet model,’ says Tom Conigliaro, managing director of trading services for IHS Markit, a global nancial technology rm. ‘By pushing out research as far and wide as they could, investment banks hoped a few nuggets would pay off.’

The sheer breadth and volume of equity research are almost certain to decrease, he adds. ‘Every piece of research in the door will soon have to be paid for so, ultimately, there’s a lot more pressure on budgets,’ he explains. ‘There’s going to be a significant decline in the traditional research model and the quantity of research generated.’

Conigliaro feels convinced by estimates that a $15 bn research industry in Europe could soon shrink to $10 bn after the unbundling of research fees through Mifid II takes full effect in January 2018. ‘Significant asset managers have already cut their research lists – in some cases by 20 percent – before the regulations have even hit,’ he points out.

Martin Liedemit, deputy head of investor relations for chemicals manufacturer BASF, also predicts a decline in the amount of equity research available. ‘One thingis clear,’ he says. ‘The entire sell-side research landscape will de nitely change.’

Consolidation on the buy side

Today’s equity research model hinges on commission-sharing arrangements (CSAs), which enable the buy side to access an avalanche of research paid for through execution fees. Under the new rules, the murky accounting of the past will be prohibited and Europe based asset managers will have to nance their research budgets in one of two ways.

First, they may establish a research payment account (RPA) that will allow the buy side to continue to use client money to pay for research but demands greater transparency and accountability; brokers will have to put a price on research and charge for it separately. Second, European asset managers could choose to fund research directly from their own P&Ls. While the latter option is attracting far fewer takers, Baillie Gifford in Edinburgh, Woodford Investment Management in Oxford and M&G Investments in London are all reportedly taking this route.

Whatever payment model is ultimately chosen, asset managers will face pressure to develop more research capabilities in- house, says Neil Shah, director of research at London-based Edison Investment Research. Greater research expenses will drive managers to try to grow their pools of assets, so the number of buy-side mergers should climb.

‘If you’re a middle-sized company, that’s where there will be quite a lot of pressure,’ says Shah. ‘It will be grow or die.’

Less coverage ahead

As with any game-changer, Mifid II will breed winners and losers on the sell side, too. Asif Abdullah, director and principal consultant at GreySpark Partners, expects the rms that usually provide full, or ‘waterfront’, coverage to succeed, with some niche players also gaining ground. Here, he predicts, ‘it’s the middle that’s going to get squeezed, as usual.’

Change has begun even before Mi d II takes effect. Sanford Bragg, principal at Integrity Research Associates, anticipates that purveyors of equity research may become ‘more focused’ in their offerings. As examples, he notes that Barclays shuttered its Asian cash equities group at the beginning of the year, while Nomura quit European equities in April, transferring its US equity research staff to its Instinet subsidiary. Meanwhile, Dutch firm Rabobank closed its equity research department in June.

‘If asset managers are becoming more parsimonious in how they allocate their commissions for research and [the sell side] ends up getting fewer commission dollars, [research providers] will have to cut back,’ says Bragg. Even among the successful research arms of investment banks and brokers, consolidation is a distinct possibility. While today there are nine bulge-bracket investment banks providing waterfront coverage in Europe, he expects there to be only three to ve in the not-too-distant future.

Liedemit notes that less research coverage is not a hardship for BASF, which has 30 active analysts, but it would pose serious challenges for IROs at smaller and mid-cap companies. He says his fellow IROs are ‘reporting that in the last three or four years, there is a trend toward declining coverage’, and this trend will intensify once the new rules are in place.

Rise of independent research?

But Mifid II is not necessarily driving changes in the European equity research market as much as accelerating trends already under way. Since the nancial crisis, commission levels have fallen and not recovered, according to Bragg. What’s more, as markets become increasingly volatile and passive investing commands a larger share of investment dollars, the appetite for equity research is waning. Bragg describes the shift to quant and passive strategies as ‘Chinese water torture: a very slow process that’s always there in the background.’

Bragg cautions that how Mi d II will be interpreted by each country’s regulators remains to be seen. ‘Asset managers will be starting to implement these new controls and procurement processes over the course of the next year,’ he explains. ‘There’s a lot of nervousness and concern on the part of the sell side about how this is going to affect business.’

‘Asset managers are waking up to the fact that they’re not beholden to receiving research from investment banks,’ says Shah. In practical terms, this means European asset managers might become more adventurous when it comes to purchasing research, using independent providers or even hiring niche experts, such as brand or supply-chain experts, that offer unique perspectives.

‘I see more independents springing up,’ adds Shah. ‘As the sense of I need to trade with you to pay you is no longer there, more independents can come in and give better, more focused service for the same price – or even cheaper, because they’re not carrying the same overheads.’ 

Mifid II, says Jack Pollina, managing director at ITG, is ‘creating an opportunity for a lot of independent research providers to enter the research space in Europe.’ He notes that while independent research providers have ourished in the US for years now, far fewer have gained a foothold in Europe.

What Mifid ii means for IROs

For IROs facing little or no coverage in the Mifid II future, one possibility is commissioning research. Shah notes that Edison has borrowed the model used for bond ratings, in which companies pay Standard & Poor’s or Moody’s to write research reports. Edison, which has 440 issuers paying for commissioned research, gets business from companies that are ‘seeing a paucity of coverage and a lot of experienced analysts disappearing from the Street,’ he says.

With more public companies ghting for the time and attention of both the buy side and the sell side, Shah advises IROs to redouble their efforts to make their companies easy to follow. This means reviewing your website and presentation materials and regularly producing key performance indicators. He also recommends that IROs get more creative with targeting, looking beyond traditional institutions to family of ces, private wealth clients and retail owners.

With a shrinking sell side, Liedemit has begun to see ‘an increasing trend of being directly contacted by investors’, which other IR professionals have also noticed. As the changes from Mi d II continue to unfold, he is investigating new ways to reach more investors without a larger IR team. Rather than hosting additional investor eld trips, for instance, he’s mulling virtual presentations. Although much remains unclear, Liedimit is convinced IROs in the coming environment should prepare for investors to be ‘using a lot more in house resources.’ 

How far wil the aftershocks from MIfid II reach? 

Mifid II may be a European rule change, but it’s almost certain to prompt soul-searching on a grand scale. Asif Abdullah, director and principal consultant at GreySpark Partners, predicts ‘a ripple effect’ and anticipates that investment clients in the US, Canada and Asia are going to begin taking a hard look at research charges, wondering why they aren’t more transparent. ‘We’ll see some pushing investment managers to really justify research charges,’ he says. ‘And we’ll see that increasing on a global basis.’

More than just transparency may be at stake, contends Neil Shah, director of research at London-based Edison Investment Research. He believes asset managers operating globally will balk at the practical dif culties of maintaining different systems for paying for research on different continents. ‘I think [some asset managers will] want the same systems globally in order to apply some kind of uniformity and set a bar that everyone needs to follow,’ he predicts. Maintaining different systems for research payments in the Americas and Asia might result in asset managers winding up with ‘very large compliance teams,’ he adds.

Tom Conigliaro, managing director of trading services for IHS Markit, agrees. ‘Even though Mifid II is a European regulatory directive and is targeted primarily at European asset managers, research is global,’ he points out, adding that US-based asset managers are still competing for European assets. ‘There’s going to be pressure on those managers to adopt many of the Mi d regulations because clients will expect all of the reporting and all of the transparency that the Mi d regulations demand.’

In the end, Conigliaro says, Mifid II will have far-reaching consequences because the new rules will change the expectations of asset managers that control the research purse strings. ‘This regulation is de nitely a global one,’ he concludes. ‘Even if it’s not necessarily intended to be so at face value.’ 

This article appeared in the winter 2016 issue of IR Magazine