Tim Human analyzes the European Commission’s proposal to soften payment rules for small and mid-cap company research
Photocredit iStockphoto.com/GoodLifeStudio
It didn’t take long for Europe to roll back some of the strict rules surrounding research payments contained in Mifid II. As part of a Covid-19 relief package, the European Commission (EC) has proposed an exemption to unbundling rules for research on companies of less than €1 bn ($1.2 bn) in market cap. The aim is to stimulate more research on smaller issuers, which have witnessed declining analyst coverage for a number of years.
The tough unbundling rules contained in Mifid II, which force investors to pay for research either out of their own pocket or via a research payment account, were promoted by the UK’s regulator but opposed by authorities in France and Germany. With the UK now out of the EU, the field is clear to unpick some of the more contentious elements of the legislation.
Research rethink Announced in July, the EC’s proposals would free asset managers from unbundling rules where the research covers companies under €1 bn in market cap, calculated by looking at a 12-month average. To make use of the exemption, investors would have to enter into an agreement with the research provider and inform the client. Fixed-income research will also be exempted from unbundling under the changes.
‘The exceptional circumstances resulting from the coronavirus pandemic have instilled a sense of urgency into the debate on investment analysts’ research,’ says the EC. ‘Increasing the visibility of European companies, in particular [small to medium-sized enterprises (SMEs)], to investors will promote more investment for the economic recovery.’
One advocate for such a change is DIRK, the German IR association. ‘Mifid II is, as expected, having a huge impact on research on small companies: it’s dead,’ says general manager Kay Bommer. ‘My hope was always that we would have more paid-for research but that hasn’t materialized yet.’
Critics have been quick to highlight perceived flaws in the plan, however. Some argue a return to bundled commissions for SMEs will be unworkable, given that asset managers will be unwilling to operate two separate systems for payments.
Cyril Gérard, Kepler Cheuvreux
‘I would consider [the impact of the Mifid II rollback] as limited,’ says Cyril Gérard, head of corporate brokerage at Paris-based Kepler Cheuvreux. ‘The trend of less research on smaller companies is not going to be slowed. The main pushback I have seen on this evolution is that it is already very complicated for asset managers to evaluate the service of a broker. They are not going to add an extra layer.’
‘I don’t expect this to make a meaningful difference,’ agrees Clive Murray, head of equities at Investec. ‘It’s going to be very difficult for the fund managers. You’ve got Mifid systems that took a lot of effort to set up, which you would now have to undo in order to ‘rebundle’ research and trading. It’s another layer of complexity that I imagine they will not adopt.’
For the changes to have a chance of success, the EC would need to broaden the exemption beyond €1 bn, Murray says. He suggests €5 bn as a ‘more meaningful number’ that would allow firms to grow significantly without hitting the threshold and triggering changes in the way research is funded.
The Association for Financial Markets in Europe, which represents European banks and other major financial services firms, has also questioned the changes. ‘Our position that introducing a bespoke research regime for some businesses could add further regulatory complexity and other drawbacks still stands,’ a spokesperson told the Financial Times.
Others believe the rollback does not go far enough. BVI, an association for German asset managers, welcomes the option to bundle costs but says the threshold should be increased.
‘The planned limit of €1 bn for the market capitalization of SMEs seems too low,' notes the association in a statement. 'For example, in Germany, this would apply to only around half of the 70 companies in the SDAX small-cap index.’
Impact of Mifid II The debate on how to boost SME coverage is complicated by confusion over the impact of Mifid II.
It’s widely accepted that research coverage on smaller issuers has been trending down for several years. But studies have come to differing conclusions on whether or not Mifid II has accelerated that process.
French financial regulator the AMF, a long-time critic of strict unbundling rules, released a report in January 2020 that said ‘most participants in the Paris marketplace consider that the reform has undermined financial research production capacity… especially for small and mid-caps.’
By contrast, the UK’s Financial Conduct Authority (FCA) said in September last year that research on SMEs in the UK had ‘not seen a material reduction to date’.
Another study, conducted by Columbia Business School PhD candidates Yifeng Guo and Lira Mota, finds that coverage of European companies has declined since Mifid II – but the fall has been concentrated among larger issuers. ‘When looking at the size of the firm in particular, small and mid-cap firms’ coverage remains almost unchanged,’ write the authors in an article for IR Magazine. ‘By contrast, large firms’ coverage has dropped on average by 10.74 percent.’
Bommer says his belief that Mifid II has pushed down small-cap coverage is based on conversations with issuers, rather than any specific study.
‘There is no one who says it has been the same all along,’ he explains. ‘Small caps have always had a hard time, but the little coverage they had has died since Mifid II.’
Regulators are not just split over the impact of Mifid II but also increasingly over their approach to research spending. While the FCA has declared itself happy with how Mifid II’s unbundling rules are working, European regulators are now easing their approach. Meanwhile, the US continues to operate a system of soft-dollar commissions to pay for research, although an SEC no-action letter allows companies to pay for research directly where they need to abide by European rules.
Following the introduction of Mifid II, some global asset managers adopted hard payments for research across their worldwide operations. This fueled the belief that Mifid II-style unbundling could go global. But Europe’s rollback on SME research may mark an end to the expansion of strict unbundling rules.
‘It’s the high-water mark for unbundling as it has played out in the UK, in which the majority of large long-only managers decided to pay for research out of their own resources,’ suggests Sanford Bragg, a principal at Integrity Research Associates, an advisory company focused on the global investment research industry.
Other options Even among backers of the EC’s proposals, there is a belief that other ways to encourage SME research must be nurtured. Rewriting aspects of Mifid II will not solve what is a long-term problem far predating the legislation. One solution already under review by the EC is encouraging the use of sponsored research. In July, alongside its SME research exemption, the EC proposed the creation of a ‘clear set of rules on how to address the conflicts of interest that are commonly perceived to make both issuer-sponsored and exchange-sponsored research less reliable and useful for investors.’
This plan is not, however, the EC’s preferred short-term option as implementation would be ‘complex and would require further analysis with research providers and national competent authorities to ensure the conflict-of-interest rules are conceived in an appropriate manner.’
With or without regulatory help, issuer-sponsored research is already expanding in the wake of Mifid II. Edison Group, the UK-based provider of issuer-sponsored research, says business has been growing 10 percent year on year and now covers more than 400 companies, according to head of research Neil Shah.
At Kepler Cheuvreux, sponsored research is growing strongly and now accounts for 10 percent of the 1,100 companies covered by the broker, according to Gérard. Given the level of demand, he estimates the figure will rise to 15 percent over the next one to three years.
The long-term decline in commission payments has made it less and less economically viable to cover small caps under the normal system, Gérard adds – leading to some difficult conversations with firms Kepler Cheuvreux has followed for years.
‘It's hard to say to a company, We are no longer making enough commission to cover you, so you will need to pay to maintain the research,’ he says. ‘It’s easier to say to firms that are new or haven't been covered for some time.’
Gérard says the firm is ‘very often’ challenged on the independence of its issuer-sponsored research. ‘We have the same standards for all our research in terms of independence,’ he says. ‘The company doesn’t have a say on the target price or rating.’ He adds that investors are not really focused on a rating, anyway. Rather, they want to know someone has done due diligence on the company.
‘There are thousands of companies with less than €1 bn in market cap in Europe – and a small-cap asset manager doesn’t have time to view them all,’ he points out.
New relationships Beyond simply paying for research, a growing number of small caps in Europe are also signing up for UK-style corporate broking relationships. This trend underlines that written research is just one piece of a package of services SMEs need to boost visibility and access to funding.
Gérard says his firm offers a bundled package of research, corporate access and liquidity enhancement for a fixed annual fee. Companies can take all three services or pick and choose, depending on their needs.
A retained broker model offers a potential long-term solution for Europe’s SME coverage, says Murray. ‘Ultimately, we want to help the economy and certainly across our bank we are doing a significant amount of SME lending,' he points out. 'From a pure research perspective, however, there needs to be some commerciality for us, whether that be commissions or fees at some stage.'
Clive Murray, Investec
He points out that companies need to access a range of services, not just research, as they grow: ‘We need to find a way that is commercially viable for people to provide a full research, sales and liquidity or market-making service in these shares. Ultimately, people only really want to read about companies if they're able to invest in them.’
While Investec is a UK specialist, Murray says he has noticed a growth in retained broker arrangements in other European markets.
'You can see why it would move in that direction,’ he says. ‘I know in France it is starting to build. There is also a bit of movement in the Benelux countries. There’s no reason why something that has worked for decades in the UK shouldn’t be adopted. We wouldn’t do it if it wasn’t useful to our corporate clients.’
