As with most regulations, several unintended consequences emerged following the roll-out of the EU’s Markets in Financial Instruments Directive II (MiFID II) in 2018. One was the reduction in the availability of investment research.
Prior to MiFID II, the costs of investment research were transferred through the buy side, such as large defined contribution pension schemes, to end investors. However, the directive mandated sell-side firms to separate, or unbundle, analyst research charges from execution costs.
“MiFID II’s objectives were to provide transparency around those costs, not necessarily to stop them from being passed on. But the compliance requirements that were put in place around the ability to pass them on were thought to be sufficiently onerous such that it was generally decided that it was easier for the buy side to take those costs onto their own P&L. This led to greater scrutiny of the research’s value and a reduction in demand,” says Rachel Kent, financial services regulation partner at Hogan Lovells and chair of the Investment Research Review (IRR).
While large cap UK companies have not been hard hit by the declining availability of investment research, it has impacted the mid and smaller cap firms. “There was a perfect storm brewing because these companies are largely from the ‘innovation economy’, such as social media, artificial intelligence, quantum computing, or cloud, which is an area ripe for research,” she explains. “We hope to see increased demand for investment in those spaces, but currently there are limited ways of funding the research that will be needed alongside it.”
The UK government commissioned Ms Kent to investigate investment research challenges and possible solutions. The IRR published its recommendations on July 10, which included: additional optionality for paying for investment research; a research platform to help generate research; and greater access to investment research for retail investors.
Importantly, according to Ms Kent, the IRR did not mandate bundling, but opted instead to leave it up to the investment managers to decide if it is appropriate.
The market has responded well to this recommendation, she says. “Certainly, the issuers seem to be keen because they want the attention that investment research provides. The providers of research are delighted because there’s a possibility of them being able to charge fair value for the research that they provide. I believe that the buy side are content with this because of the flexibility this provides, so they shouldn’t be in a worse position.” But she also suggests that there needs to be an industry debate around the equitable allocation of research costs.
The research platform concept, which will provide a central facility for the promotion, sourcing and dissemination of research, has also attracted much interest and positive response. “Importantly, if the research platform works, it will not be reliant on solving the problem of who pays because there will be a funding mechanism. I don’t know which mechanism the government is going to choose yet, but there will be more money in the system to pay researchers to cover the areas where the gaps exist today,” explains Ms Kent.
This is an opportunity for the UK to be a market leader in research
“The research platform is a much bigger idea than just how to solve this problem of matching issuers and researchers, including data collation,” she adds. “This is an opportunity for the UK to be a market leader in research, with an offering that is broad, comprehensive and useful as it needs to be.”
Addressing the “information asymmetry” between the institutional side and the retail side is the IRR’s third recommendation. “The solution could either be to make institutional research available to the retail market, or to come up with a better regime to provide retail research in a compliant way,” she says. “But clearly, that is broken at the moment because, in the main, it isn’t being provided.”
The report also advocates closer ties with academia, where many innovative start-ups originate. “The market doesn’t really understand them and they don’t have the visibility that they deserve to give the support they need to grow to be the listed companies of tomorrow. This knowledge partly resides in academia, as it is the universities that are creating these spin-offs,” says Ms Kent.
“So, we’re keen to liaise more with universities to see what can be done to capture and capitalise on all that knowledge and expertise, whether that’s analyst training, some type of professional qualification in the relevant sector, or academia becoming involved in the production of research.”
The UK chancellor, Jeremy Hunt, has confirmed that the IRR’s recommendations will be adopted; the new rules are expected to be in place by the end of 2024.
Clearly, investment research is a key component of oiling the wheels of the capital markets, helping to draw the attention of potential investors to issuers. It also results in better – if not higher – valuations, leading to more liquidity as well as increasing the attractiveness of the UK capital markets.
Joy Macknight is editor of The Banker. Follow her on Twitter @joymacknight
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