A trader speaks on a fixed-line telephone as the second iteration of the Markets in Financial Instruments Directive (MiFID II) comes into force, at the Frankfurt Stock Exchange, operated by Deutsche Boerse AG, in Frankfurt, Germany, on Wednesday, Jan. 3, 2017. After seven years of preparation, $2 billion in compliance costs and one false start, the biggest shake-up to European regulation in a decade is finally here. Photographer: Alex Kraus/Bloomberg
© Bloomberg

Just after the market closed on February 1, US investment bank Jefferies delivered a sucker punch to Purplebricks, the UK online estate agent.

Anthony Codling, an analyst at Jefferies and long-time critic of Purplebricks, published a research note disputing the company’s claim that 88 per cent of customers had managed to sell their homes within 10 months. Mr Codling put the figure at a little more than half and raised concerns about the company’s method of recognising revenue. The share price had fallen 13 per cent by mid-morning the following day.

But Purplebricks — a favourite of high-profile UK manager Neil Woodford and which plans to launch in New York in the coming months — hit back. In an unscheduled trading update, it contested Mr Codling’s findings with its own figures.

The spat raises several questions about the implementation of the Markets in Financial Instruments Directive, or Mifid II, the sprawling European market reforms that came into place last month. Under the new rules, only fund managers that specifically pay for research should have access to it. This was introduced to restrict inducements, where brokers offer research for free as a ploy to attract managers to trade with them. But when Purplebricks quoted the Jefferies note in its rebuttal, it made its contents public.

“It’s making a mockery of the whole inducement idea,” says Nick Burchett, UK equities manager at Cavendish Asset Management. He believes such situations raise questions about whether companies should be able to respond publicly to research notes, and if so, whether anyone would pay for research if they can expect to get a sense of its contents for free from company responses.

“It creates a really dangerous situation for companies to comment on broker research,” he adds.

Mifid II is less than two months old and for many fund managers the practicalities of complying with the rules on paying for research are already throwing up plenty of challenges — in particular, for those investing in small and medium-sized companies.

“The days of walking in the office in the morning and finding 100 emails [from analysts] waiting for you is over,” says Andrew Neville, a global small and mid-cap portfolio manager at Allianz Global Investors. “I can see the business models of brokers changing.”

Investment bank research has been in slow decline for years, but the increased emphasis on its cost, highlighted by Mifid II, has led fund managers to question its value and pull back from all but the most worthwhile analysts. Many fund companies are now boosting their own internal research teams.

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Allianz has long had an internal team of 70 to 80 people and Mr Neville says its analysts who began covering large companies have been switching to smaller stocks because they feel they can add more value to the less well-covered end of the market.

Mr Burchett says Cavendish has cut the number of brokers whose research it buys by a quarter over the past year and it prioritises those that cover tradeable stocks and help generate investment ideas. But he says cutting back on brokers could lead to him pulling out of some investments.

“If there is only one broker covering a company we own and we don’t buy their research, are we going to still want to invest in it? We may no longer get access to management,” he says. “We have our own ideas, but we want reassurance to reaffirm what we are looking at. It’s a worrying situation for us as shareholders of small companies.”

One of the main fears among investors throughout the planning of Mifid II was the impact it would have on liquidity at the smaller end of the market. If fund managers are more selective about the research they buy, fewer brokers may end up covering the smallest companies. Those that continue are likely to have reduced distribution lists. The largest companies will also be hit by the drop-off in research. But because they typically have tens of analysts covering them, the impact will not be as big. For companies covered by just one or two analysts, any reduction will be significant.

With fewer investors at the smaller end of the market, liquidity will reduce. This is also likely to affect performance. Numis Securities, the broker, calculates that small companies with the most analyst coverage outperformed peers by 2.5 per cent — while those with low coverage underperformed by 0.7 per cent.

Mr Neville says he expects to see a lot less research of smaller companies by the end of the year as brokers’ arrangements with fund companies are renegotiated. He says this will make it harder to determine the price of small company shares. As a result, the companies will probably find it harder to attract investors and their cost of capital will rise.

Some fund managers, however, see opportunities in the upheaval. Those with strong internal research teams feel they will be able to benefit from a lack of widely available research in the market.

One such manager is James Hanbury, who oversees Odey Asset Management’s absolute return fund. He recently told clients in an investment update that Mifid II would benefit his fund. “Having moved into a Mifid II world this year, we feel that as a house and a franchise we are very well positioned,” he wrote. “It is highly probable that capacity is reduced on the sell side this year creating a less efficient equity market . . . We feel this new Mifid II world plays to our strengths.”

Issuers are also having to respond to the new market dynamics. Some small and medium-sized companies have set up dual broker arrangements, where they use specialist small-cap houses to distribute research to small-cap fund managers, and larger brokers to send their research to funds focused on mid-caps.

These companies are also having to be more proactive in attracting investors. “Ten years ago it would only be companies at the top end of the FTSE 250 that would have investor relations people — now all the FTSE 250 have them, as well as some small-caps,” says Mr Neville. “It tends to be someone who used to be an analyst on the sell side. The onus is now on companies to attract shareholders through their own endeavours.”

As the Mifid II rules were being drawn up, the prospect of a dearth of research at the smaller end of the market was raised. One response from regulators was to include a loophole in the rules that allows for research that has been paid for by the company the broker covers to be made freely available. This is classed as a minor, non-monetary benefit.

Small companies that are not covered by the bigger investment banks are making use of this ability by commissioning research on themselves from certain brokers. These notes are published on the broker’s website or sent to distribution lists that anyone can sign up to.

But John Young, a financial regulation counsel at law firm Ropes & Gray, says: “You might say that the Mifid II payment for research rule is having an existentialist crisis. Where research is provided for free to everyone, the rule ceases to have any force.”

Some large fund companies have been put off from using freely available research for fear of breaking the inducement rules. The UK’s Financial Conduct Authority has said it will keep a close eye on this area to see how it develops, but Mr Neville says there can be value in research even if it is paid for by the companies it covers. “I don’t see that as inducement — not at the moment,” he says. “I can’t see that being high on the regulator’s to-do list.”

Mr Young agrees that he does not think the FCA will try remove the exemption, but adds: “If the research is substantive, useful and what people may have paid for before, it does raise some legal questions.”

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