What is MiFID II?
MiFID stands for The Markets in Financial Instruments Directive. It provides the framework for legislation regarding investment services in Europe. MiFID II is the second installment of the initial directive aimed at addressing issues that were not fixed in the first version. Effective January 3, 2018, MiFID II’s mission is to improve the transparency and accuracy of research in the market and to enhance investor protection. Although MiFID II was legally introduced to the European Union last summer, The European Securities and Markets Authority (ESMA) was given until January of 2018 to create detailed rules for the member states to implement. The directive has set forth to change parts of how the market functions including overall market structure, governance, investor protection, business conduct, investor research, client categorization, algorithmic trading, best execution, pre-post trade transparency, transaction reporting, trading rules, and third-country access.
Technically, MiFID only applies to firms located within the European Union. However, the proposed regulations will have major global implications. One of the most impactful changes outlined in MiFID II for non-EU firms prohibits asset managers from paying for research through bundled advisory or execution commissions. Instead, buy-side institutions will pay for research from either their own pockets or via supervised Research Payment Accounts (RPAs). International buy-and-sell side communities operating in Europe will have to embrace MiFID II in order to effectively continue their practices within Europe. For those not interacting with Europe, MiFID will likely disrupt a company’s practices through either compliance policies or the competitive pressure to provide transparency to clients. Experts predict that there will be a global shift towards transparency in research payment in the post-MiFID II market.
What does it mean for research and brokerage? Because asset managers are required to begin paying for their research explicitly, they will no longer receive the extensive amount of research for cheap that they do today. Instead, sell-side analysts will price their research services for asset managers to purchase. As a result of this explicit pricing and scrutiny from end-investors, asset managers will become more selective in their approach to research spending. Buy-side institutions will most likely opt for high quality, sector-specific analysts to conduct their research instead of using broad, largely generic research providers that are common today.
Due to increased selectivity among asset managers, research brokerage firms will have to adjust their services. Since MiFID II demands disclosure in research pricing, brokerage firms will compete to provide the best value for research. Additionally, less demand from the buy-side means narrowing coverage and big cuts for research providers. Experts predict that this shrinkage will lead to a reduction in coverage for smaller companies or unattractive sectors as analysts hone in on the bigger, more lucrative businesses. This could mean a dramatic drop in the quantity and quality of coverage for small to mid-cap companies. However, as the larger brokerage companies drop coverage on smaller stocks, opportunities will arise for mid-to-small tier brokerage firms to provide high quality research on small to mid-size enterprises.
What does it mean for small public companies?
The demise of small cap coverage is not a new topic, but MIFID II only accentuates the trend. Here is what a small public company should do:
Support your existing analysts to minimize risk of losing coverage
Support of existing covering analysts is increasingly important. Attend their conferences, selectively go on the road with them, and support the best covering firms with your investment banking business.
Take destiny into your own hands; don’t rely on the sell-side for buy side introductions
Institute your own strategic targeting program with investors. As research spending shrinks, the buy side may be more selective in taking management meetings from firms who they are not paying. This will not be a barrier should the company, or its investor relations agency, reach out directly.
Add more industry perspective to your investor communications
One of the many values of sell-side research is the industry perspective it provides investors. Frequently public companies limit their industry and competitive landscape discussion more than they should as they do not want to publicly mention, or “advertise”, peers and competitors in their material. Now is the time to explore ways that you can more proactively depict where your company fits and excels in the competitive landscape.
Does shrinking sell-side coverage mean you should provide guidance?
No. But it elevates the importance of providing a clear picture of the strategic direction of the business and realistic goals the company can obtain. Projections and specific time frames are not necessary; but long term targets pertaining to such metrics as revenue growth rate and composition, margins, and ROIC provide a good method to align the buy side with how management is thinking about where the business can go.
Mariana Ferreira, Associate - IMS