MiFID II is a term you are bound to hear more often over the second half of 2017. It is the European Union’s Markets in Financial Instruments Directive II, a financial services regulation in the EU that will unbundle broker/dealer research and corporate access services from execution services. It is scheduled to become effective on January 3, 2018.
As an executive of an American public healthcare company, you might be asking yourself why you need to be aware of a European regulation. The answer: Because many major institutions operate on a global basis, the impact, while initially centered in Europe, will ultimately be felt in all corners of the global financial markets.
The parameters of MiFID II are clearly defined. What remains to be seen is how the industry will adapt. Regardless of how it plays out, we believe that it will likely affect the interaction of U.S. public companies, especially smaller ones, with investors and sell-side partners.
At issue is how research is paid for. In the current model, commissions (soft dollars) paid to broker/dealers by investment managers represent the fees paid for both execution services and research services, including research reports, access to analysts, and access to the management teams through non-deal road shows and conferences. Because commissions are incorporated into fund expenses, they are ultimately paid for by the clients of the investment manager and there is no transparency regarding the cost/benefit of the services those commissions represent.
Under MiFID II, each one of these services will be its own line item, priced separately and paid for with hard dollars by the investment manager.
Therefore, when designing new payment policies that will comply with the new regulation, investment managers will have to either pay for these services out of their own P&L or through research payment accounts (RPAs) funded by their clients. It is likely that the majority of managers will choose the latter and thus offer their clients full transparency on the cost/benefit of the services employed.
With all of that in mind, here are four important ways MiFID II will affect companies everywhere.
MiFID II Compliance Will be Implemented Globally
Although MiFID II is an EU regulation, multinational investment managers will likely implement globally the research payment policies they design for MiFID II compliance. Cross-border clients will demand in all markets the same transparency and granularity they will receive in Europe, and firms will tout their proactive adoption of such policies to win new business. Besides, it will soon be more logistically efficient to follow a uniform research payment model worldwide, not to mention the correct approach from a fiduciary standpoint.
ITG published a survey this past January of 100 U.S.-based investment managers which indicated that 82% plan to unbundle their brokers globally.
The Research Landscape Will Change Dramatically
It may not happen overnight, but a gradual shift in brokers/dealers’ research offerings will undoubtedly take place. In an unbundled world, a broker’s research department becomes its own P&L, no longer a cost center supported by transaction commissions.
The challenge will be pricing the research based on the value it creates. Many firms will cull their research offerings and focus on the highest value-add companies, potentially at the expense of the small and microcap names. High-profile analysts may choose to leave banks and establish independent research shops where they can price on an à la carte or subscription basis.
Investment managers will bolster their internal research capabilities and focus their external research needs on the expanding category of data-driven empirical research providers. Research exchanges will likely become prevalent, allowing investment managers one stop for a menu of independent research they pay for on an as-needed basis.
The bottom line is that the overcapacity of research that exists today will be rationalized as value recognition materializes and marginal providers go away, unable to support their cost structure. No longer will 40 or more analysts be covering one company.
Company-Sponsored Research Will Become More Prevalent
Under MiFID II, research reports that are paid for by a public company fall outside of the research budgets for investment managers and can be accessed by anyone. Therefore, in a shrinking research environment that adversely affects smaller companies, you will likely see more independent firms picking up coverage paid for by those companies. While this might be a worthwhile practice to maintain the company’s visibility in the investment community, especially among the smaller, more retail-oriented investors, objective investment theses will always be questioned given an inherent conflict of interest.
The Value of Corporate Access Will Be Defined
Meetings with company management teams, whether it be at a conference or a non-deal road show, have always been one of the services most highly valued by investment managers. However, when commingled with other research and transaction services, there is no way to measure the relative value of those meetings.
So what will happen when they become a line-item paid for in hard dollars? Is a meeting with a large or midcap company valued the same as one with a small or microcap company? Most likely, the answer is no. In the unbundled environment, as research departments get winnowed down and excess industry capacity gets rationalized, it will be the small and microcap companies that will most likely face a scarcity of support from sell-side partners. The narrower investor audience and lower value of management access will make such companies prohibitively expensive to cover.
The full repercussions of MiFID II in the U.S. financial markets remain to be seen. What we know is that, ultimately, a tectonic shift will occur in the way research and corporate access are provided, valued, and consumed in the institutional investment community. In this new reality, executives of small and microcap companies will need to be more proactive in executing investor relations strategies that maximize their visibility with investors and fill the void left by more limited sell-side sponsorship.
As the largest healthcare-focused IR advisory firm in the U.S. and one with a broad footprint in Europe, devising and executing such strategies is something Westwicke can help with. For a conversation about how this shifting landscape may affect your IR strategy, reach out.