It’s the perfect storm. The mad rush to get ready for MiFID II has only set the stage for what’s coming. MiFID II has not claimed its pound of flesh yet. But it has the next 12 months to do so. By the end of 2018, when the dust settles, we will know who’s left standing.
The first thing to happen? The great unbundling. Or, in plain terms, clients will have to pay for what they get and, at the same time, research providers will have to up their game and focus on relevant information that clients are willing to pay for.
Then, the changes in the industry will follow.
Who Will Pay for What
A client will want two key things from their research houses: access to management and actionable insights. And now, because they will actually be obliged to pay for the product and the product alone, these two aspects will have to work together to build up the intrinsic value of the research delivered.
At the same time, a company’s attribution of value to research may well be directly reflected in its net performance. The lower the budget, the less valuable the information attained.
Large asset managers have, at any given time, up to 200 research providers on their books. These firms will – in theory – provide them with a plethora of information to make investment decisions.
Putting together the pieces of the puzzle is not easy. Research providers who are able to deliver the right type of information in order for the client to be able to move quickly on their decisions, will thrive. And everyone has to move and adapt pretty quickly, as clients are set to cut research budgets by a third and even by half in some cases. The number of providers on their panels is set to go down by similar percentages.
The New Playground
One thing that will keep the wheels of the industry turning, for now, is the “me too” effect. Before clients start cutting the number of their providers, they will worry first about what coverage their competitors have so as to not miss out on any potential alpha.
However, the main problem has been that the quality and the end value of the research has been limited – many providers would bundle together anything from interim updates to company reports and analysts’ opinions, and hope something sticks. It’s been the industry’s worst kept secret that there’s a lot of junk that’s being provided to the client. Research was in some cases seen as a means to an end – for example, keeping the line open for other transactions and other types of business relationships between parties.
Now, MiFID II pushes for clarity on who’s paying for what, and regulators want to make sure that the money exchanging hands is actually meant for the purposes stated and that the research is used for investment decisions, not as an extra to “grease” other mechanisms. So all actors in this play will have to make significant changes.
Research providers will have to actually seep through the data and create specific packages for specific clients, and they will also have to make sure to follow some cardinal rules. The first one is transparent pricing: this client is paying for that service.
The second requirement is that they must be MiFID compliant at all times, for those firms opting to pay using a research payment account (RPA). They will need to keep track of the research consumption and have an audit trail. This way, they will avoid any regulatory conundrums when it comes to reporting. The rules are especially strict for those using an RPA to pay for their research. For those opting out of the model – which is the majority, from what we’ve seen – compliance is much easier to achieve.
And MiFID II comes at a good time: the perceived value of sell-side research has been in steady decline for almost two decades – since Eliot Spitzer shook bankers and analysts alike, forcing a Chinese wall between the two sides. Still, everyone carried on paying for different reasons: corporate access, liquidity, trade execution (particularly in fixed income) and the somewhat rare, but good, trade idea. The relationship angle is also very important. However, the good old days of assigning immediately actionable information to one’s favourite broker for the old “quid pro quo” are done.
However, quality might still continue to decline on the sell-side research front. As they get squeezed on fees, they will find it more difficult to hold onto their experienced analysts. While there is always new, young and hungry talent in the market, those who have been through the economic cycles and have seen the ups and downs of the last few decades are in short supply. And those are the people that can interpret the data for clients, as well as know where to get the relevant information from and have the right top-tier connections to get input from current and former management, analysts or industry experts in order to move the needle for their clients.
These very valuable individuals will probably leave to start up their own shops, or will join independent research houses – that’s something we have been on the lookout for – and they will be helping the research houses that truly add value for their clients to move forward and thrive.
With all the commotion in the market, the industry is bound to see a turbulent time. In the short to medium term, consolidation will occur amongst the small to medium players.
At the same time, the big investment banks might decide that trying to make research profitable is a losing game. This translates into top players potentially closing down their research departments altogether. Which means, in brief, that nobody is safe until they can find a way to provide something critical to their clients.
This is where independent research houses, such as Third Bridge, can have an edge, considering their freedom of movement and access to great talent.
Players will also have to find the right balance between quantity and type of research provided on the one side and pricing mechanisms on the other.
The name of the game will be: bespoke; targeted; relevant; specialised. Basically, providing something that others cannot.