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MIFID II: starting to impact the sell side hard. A gloomy outlook for small cap research.

Conclusion: Research budgets will remain under pressure in 2017 and 2018, with less research published by investment banks. Companies must face up to this issue and consider ways to help themselves. Paying "Hard" Jupiter Asset Management's decision to absorb £5m of research payments through its own P&L in 2017 has not really garnered much attention from the financial press. The main focus, for those that have commented, is that Jupiter has decided to pay these costs rather than charging them back to clients. This is known as "paying hard". The focus for Heartwood Partners is the rate that Jupiter is paying and the read through for the rest of the sell side. Jupiter's budget of £5m for sell side research (meeting analysts, getting access to analyst's notes, some bespoke work etc) amounts to just a mere 1.2bps based on its year end AUM of £40bn or roughly 3-4bps per trade assuming a 30% turnover rate of the portfolios managed by it.

Many fund management houses have not yet shown their hand and divulged whether they are going to charge clients for research they use, or pay for research out of their own P&L. However every fund management house that announces it will join the growing list of fund managers paying for research themselves, puts more pressure on the rest to fall into line. So far Aberdeen Asset Management, M&G, Jupiter, Woodford Funds have all taken the purist line. In an interview with the FT, Maarten Slendebroek, Jupiter's urbane CEO said of the research payments "Now I can look clients in the eye when they ask me 'What else do you charge to our funds?' The answer on research will be zero."

Jupiter is mainly a retail fund manager, with no index or passive product. It has its in-house research teams and totals 57 investment professionals according to its website. That is a budget of just under £90k per investment professional for sell side research. Some industry participants have indicated to Heartwood that some of the bulge bracket firms want a minimum of £100k per person / account for a waterfront service. Based on the Jupiter maths, their fund managers would only be able to afford the research and stockbroking service from 1 large investment bank favouring the all you can eat model that is currently prevalent. Therefore it needs to be pretty amazing if you are going to spend your entire research budget on one broker, or there is simply not going to be enough to go around.

Research payments already falling When I first started managing money just after the year 2000, we used to pay a bundled rate of around 20 bps on each trade. As the turnover of my portfolio was roughly 35% pa, this equated to around 7 bps pa across my client's portfolios. This covered the costs of execution (buying and selling of shares) and sell side research. This commission rate started to fall in ernest from 2012 after the FSA issued a Dear CEO letter questioning the legitimacy of the purchasing of corporate access through the use of dealing commissions. A rough split for a mid sized firm these days may well be in the region of 4-5bps for research and 5-6 bps for high touch dealing. With the advent of so called 'dark-pools' the cost of execution for firms using these alternative venues will be definitely lower. It must be stressed that there is no set commission rate, it is up to the fund management firm and the provider of the research. When asset managers look at Jupiter's 1.2bps compared to 4-5bps they may be paying, I am sure someone from the COO's office or equivalent will want to know why they are paying that much. There appears to a race to the bottom on commissions.

Baillie Gifford have gone on record as saying the costs of bank commissions to Baillie Gifford investors will fall by at least 30%. Martin Gilbert, CEO of Aberdeen Asset Management, has said that Aberdeen has already started to pay for research out of its own P&L and that its payment to investment banks and independent brokers has already "gone down significantly". Heartwood Partners, though our discussions with asset managers in the UK, thinks the trend for research payments to fall vigorously will continue throughout 2017 and 2018.

Consolidation of Asset Managers - more to come The announcement of a nil premium £11bn "merger" between the larger Standard Life and its smaller Scottish contemporary Aberdeen Asset Management, is a trend that we expect to continue. We do not see this as a merger that facilitates growth, rather a cost cutting merger. The combined entity will have £660bn of AUA and management are talking up scale in the distribution channels and product diversification. From Heartwood's point of view the key driver is the £200m of identified pre tax synergies. In a world where active management flows are under pressure, especially in active equities, fees are also under pressure from passive and ETF products and costs are rising from having to absorb research fees, we see this as a defensive move. The main question is who is next?

Scale is very attractive when you are able to offset costs against a wider fund base. However one must question whether scale brings advantages to the client? Offering a one-stop shop with capabilities in multi asset, fixed income, cash products, equities, property and alternatives looks attractive on paper. The offer of a more diversified revenue base to the parent company is attractive and may result in a higher valuation relative to a mono-line specialist. However investing in asset managers is really about investing in those with positive AUM flows. So will the Aberdeen / Standard Life combination generate value for shareholders? Cost cutting tends to attract a lower valuation. Making 2 plus 2 equal 5 in the case of Aberdeen / Standard Life will only happen if the combined entity is able to harness its wider distribution scale and turn that into positive AUM flow.

Consolidation bad for Investment Banks

Investment banks on the other hand must also be worrying that a consolidating fund management world would place even more pressure on their incomes from trading and especially research. Imagine this scenario: 2 asset management firms merge. Each has 10 UK fund managers and analysts. There is likely to be a fair bit of overlap in which equity sales people they speak to. If that team becomes 15 as 5 are made redundant in a vigorous cost saving exercise, is it likely that research payments remain at pre merger levels? Very unlikely. It is not just the largest asset managers feeling the heat. In general, smaller firms will have less scale and tighter profit margins. A reduction in fees, a rise in costs will place more pressure on the smaller fund managers than the larger players. It is therefore likely that we see further consolidation in the smaller end of the spectrum and that will result in lower payments to the sell side.

Worse impact on Small & Mid Cap research Heartwood Partners feels the trickle down effect of lower research payments will be most keenly felt in the bulge bracket and small cap brokers.
Bulge bracket firms, of which there are probably 7 or 8 in London whose management consider themselves a one stop shop, are in for a tough time. A combination of falling research payments from fund managers, over staffed research teams and a pricing model that hasn't really been questioned by the buy side until now, is coming under real scrutiny. In our conversations with fund managers, we believe there simply is not the demand for waterfront coverage from this many brokers. Increasingly fund managers have to justify paying for research, formally noting where the analyst has "added value" whereas in the past the research costs were just passed straight back to the client. These notes need to be logged and referenced if the regulator questions how research budgets have been allocated. In doing so, it is forcing fund managers to really question the value they derive from research and making them hone in on research teams that add value. Middle of the road, me-too or filler research has little value in the new world.
At the other end of the scale, we believe small cap brokers will be in for a very painful 18 months. There is a wide swathe of smaller listed companies with only 1 or 2 brokers covering the company. The likely reductions in research payments will most likely result in a fall in the number of research analysts across the whole industry as investment banks and research boutiques look to cut their own cost base. At the larger end, if you are a FTSE100 company with 15 or 20 analysts covering your company, the loss of 1 or 2 wont really affect the fund management community's ability to access research on your company. However if you are small cap company with only 1 or 2 analysts covering your company and 1 gets made redundant or reallocated to a different sector, then that is a serious impact on the analytical coverage of your company.

This may not be immediately felt by the company in question, but if over the long run it results in a lower valuation, it may reduce some of the strategic options open to the company. One example would be a property company which drifts well below NAV due to lack of coverage. Issuing equity to take advantage of a sale of distressed properties becomes problematic as shareholders could complain at the dilution they would suffer.

Over the longer term the EUs project with MiFID II, which aims to increase transparency of costs and align the financial services industry with the end client, may have the unintended consequence of raising their cost of capital for smaller companies relative to larger their rivals.

Do more yourself We believe that companies should not under estimate the impact that MIFID 2 will have on the sell side and the potential reduction in analytical coverage, especially at the smaller end. However companies can do more to help themselves. Gary Player said "the harder I work and practice, the luckier I seem to get", this is a mentality companies need to bear in mind when dealing with investor relations.
It is frightening how many companies, even in the FTSE 250, do not have a section in the investor relations part of their website outlining the investment case in their company. You don't need a dedicated Investor Relations Officer (IRO) to do this. Your investment case doesn't have to be very long or very detailed, but should allow potential investors to quickly understand the merits of your company. Make sure to mention any details of change strategy that an investor may not ordinarily know. We run 'health checks' on corporate websites every day. I would encourage all CEOs and CFOs to log on to their own corporate website and adopt the mentality of a potential investor. Ask yourself "Can I easily find out information about this company that would allow me to make a balanced investment decision". If your answer is "no" or "maybe" then please give us a call or email. We are here to help.

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