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28/09/2017
MIFID II: The emperor’s new clothes

While I was on holiday last week, one of Edison's UK mid-cap (c £500m market cap) clients came into the office. Among the topics of conversation was the management team's desire to hear our view on MIFID II. It was prefaced by the statement: "we know you’re fine, because every bank or research provider we talk to about the impact of MIFID II says they’re fine."

Those of you who have heard me speak on MIFID II, will have heard me set out that clearly not everyone can come out of this enormous regulatory change unscathed, but I keep hearing from each sell side business I speak to reiterate that they are fine. The Ostrich Effect is well documented in behavioural finance - the same reason why investors tend to look at their portfolios more when they are rising than when they are falling - we’re prone to avoid looking at negative financial information.

However, this is not particularly helpful if you are a listed company. Peel Hunt’s CEO Steve Fine sums it up pretty well in his video interview: “the corporates, as is always the case unfortunately, are the last to find out about these changes.” This view was also supported in a June 2017 survey of FTSE 350 companies by Orient Capital who received a 97% response rate of “no” to the question: Have your brokers been clear about how MIFID II will change their role and/or have they been clear about the changes?

The consensus is that we are going to see a c 30% decline in commission pools for research payments. We cited the figure in our white paper “The Future of Equity Research” and this view is repeated in the recent McKinsey & Company paper “Reinventing equity research as a profit-making business”
However, if anything, I think the consensus is going to underestimate the fall in payments made for research. When we came up with our figure, we were aware that there were two principle routes asset managers would take to pay for research: (1) out of their own P&L and (2) using dealing commissions to fund RPA’s to procure research services. When we published the white paper, we were expecting c 25% of asset managers to go down the P&L route. The recent headlines of Vanguard and Blackrock’s EMEA business taking costs on their own P&L have led to many other asset managers (Schroders and Invesco) to reverse their previous positions and move to taking research costs on their own P&L. This is well documented by Sandy Bragg in his recent article “Eating research costs becomes the consensus for European asset managers”.

The key reason I believe we will now underestimate the impact of falling commissions is that when research was funded through dealing commissions, (a) the client rather than the asset manager was paying for the costs and (b) the funds were effectively ring fenced to pay for research. When paying out of your own P&L, this spend on research is now competing against every other priority an asset management business has: hiring new people, spending on IT infrastructure and marketing. This excludes the debate around whether this spend is now subject to VAT which also adds to the potential haircut. The evidence of this is borne out in the pricing discovery we are seeing for research, with lower and lower rate cards emerging from the sell side. Consequently, I now feel we are more likely to see the bear scenario in the McKinsey report than our original consensual c 30% fall in research spend.
It feels like the emperor’s new clothes. As some point, someone has to shout: “we can’t all be fine”. Either the asset management industry is about to take a significant hit to its margins or the sell side is going to see a significant reduction in its payments for research. The exhibit below is from the “Future of Equity Research” white paper. It shows how if the asset management industry was to absorb the costs (the minimal price under MIFID 2 you can price your research) of investment bank research globally, its margins would halve. Somehow I don’t believe that the CFO’s of those asset management business are going to allow that to happen.

We’re now a quarter away from the new MIFID II rules coming into effect. What do we advocate for the different stakeholders:

1. If you are a listed company, it’s worth your while understanding how these new rules have the potential to impact your liquidity, your research coverage, your access to potential shareholders and ultimately your rating. We conduct IR audits to support you on this.
2. If you are an integrated sell side bank, be aware that the primary strategic drive we are seeing is one of capturing market share. The buy and sell side know that the primary earnings driver of a bank is the ability to raise debt and equity finance for corporates. It’s much easier to do so if you haven’t dropped off the lists of the buy side.
3. If you are an asset manager, we can help you understand the important exemptions from the inducement rules and give you an overview of what we are seeing as best practice. It is likely that you should be prepared for the following:
• In January 2018: Having the regulator request a copy of your written investment research policy outlining the approach to research including how the firm will allocate costs fairly to clients’ portfolios. A clear red flag if you don’t have one.
• In mid 2018: Have the regulator examine your payments for research and examine the correlation to execution payments.
• By end 2018: Having your approach to valuing research payments examined with guidance suggesting that consumption data alone will not suffice.

My colleague Annabel Hewson kindly made up a “Keep Calm and Love MIFID II” mug which sits on my desk. It reflects my belief in creative destruction. MIFID II will bring about change. The future landscape - well it will be different. In the coming weeks I plan to set out my views on some of those changes - most notably the growing importance stock exchanges will have in facilitating these changes.

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