Today sees the start of the new MiFID II requirements for the investment management industry, one of the EU’s most ambitious packages of financial reforms.
Designed to provide greater investor protection and transparency across all asset classes, the Directive represents the most notable change in UK equity capital markets since the ‘Big Bang’ in 1986. Included in the reforms is a dramatically changed investment research model, requiring fund managers to budget separately for research and trading costs payable to brokers. Managers will need to split out the cost of research, which is used to help make investment decisions, from the cost of buying and selling securities.
Portfolio managers will no longer be able to receive generic or even tailored investment research from brokers unless they pay for that research themselves, raise management charges to absorb the extra costs or, if the client agrees, use research payment accounts that are funded in advance.
A key decision therefore for investment managers is whether to pass on the cost of research to clients. If they do, they will need to justify this expenditure. While, initially it appears that most fund managers will charge the expense to their own P&L rather than passing the cost onto clients, some are still undecided, given the complexity of the decision. In particular, this will pile on pressure on the smaller asset managers who may not be able to afford the research themselves and may well result in portfolio managers being more selective about the investment research for which they pay. A number of commentators1 are predicting that research spend will fall between 10-30%, and could even fall as much as 50% if there is a full-blown price war.
In our opinion, while the intention is to address the perceived conflict of interest between asset managers and their buy-side customers, a likely unintended consequence of these MiFID II changes will be reduced research coverage of smaller quoted companies. Micro and smaller cap companies are already under-researched as it is often not economically viable for brokers to cover these stocks unless it is paid for by the company itself.
But what does this reduced coverage mean for investors, particularly those interested in smaller growth companies? In areas where there are only a handful of analysts there is already less data and insight available to investors. Indeed, there are some asset managers who are heavily reliant on the research produced by sell-side analysts to maintain their knowledge of a particular stock or sector. With less insight and research, investors considering smaller quoted companies will be faced with less information with which to base investment decisions.
However, this limited coverage of smaller companies offers investors with a real opportunity to secure exposure to stocks which may be undervalued, yet high quality. These stocks are under researched and will likely be even more so from 2018 leading many to trade at a valuation discount to their larger better understood peers. Fund managers who can offer insight and are properly resourced to conduct their own research in this area will be potentially well-placed to deliver strong returns.
At Livingbridge Equity Funds, there are almost 50 sector specialists and researchers across the wider business who can bring a private equity lens to the public markets. We have always been well placed to identify potential growth companies which are profitable, cash generative and with the potential to pay dividends. So while MiFID II will likely result in even further reduced analyst coverage of smaller companies, investors can still turn to specialist managers who know and understand the growth company market to look for returns.