Countdown to Mifid II

Remember Y2K and the global fear that the turn of the millennium would bring IT systems crashing to a halt?

It’s worth mentioning Y2K because Mifid II – new EU legislation for financial markets that comes into effect on 3 January 2018 – has echoes of the Y2K problem. (Which turned out not to be that much of a problem, but did cause a lot of work and overtime for the IT sector).

Some say that Mifid II (the second Markets in Financial Instruments Directive) is a welcome piece of securities market reform, for others it’s the worst change to hit the City in years.

The first phase of Mifid was activated in November 2007 and was an attempt to increase competition in financial services and harmonise rules. The latest phase, much delayed by the financial crisis, aims to strengthen protection for investors and improve transparency.

The changes follow the principle of ‘unbundling’. This will mean stockbrokers have to charge fund managers separately for research produced by their analysts. Up to this point, most have lumped in the cost of this with their broking commission, which in effect means the clients of the fund managers pick up the tab.

Today, 1,248 analysts across 65 individual sub-sectors within the FTSE All Share Index cover listed companies within the UK.

But the fear is that Mifid II will lead to a fall in the number of analysts, because the brokerages simply will not pay for a long tail of analysts to cover companies or to produce low-quality, me-too research. In turn this will put new pressures on investor relations teams who will have to find new ways of communicating their companies’ story to the fund managers and investors that buy their shares.

As fund managers and brokerages prepare for the changes, a price war has broken out over the sale of research to asset managers. There are concerns that independent providers of research could be driven out of business. Ultimately the amount of commentary about quoted companies could fall by as much as a third, according to some predictions.

Scott Fulton, director of Capital Access Group, a consultancy that helps companies communicate with their investors, carried out a survey on its FTSE and AIM-listed clients and concluded that unbundling broker research could lead to a situation where just a third of the analyst community will be paid by investment managers and meetings with companies are not paid for at all.

‘Paying for analysts and company meetings from other sources is unlikely to be allowed under the new regime, potentially placing considerable pressure on investor relations to maintain capital market communications,’ Fulton says.

While this is less of a concern for the UK’s biggest companies like Vodafone and Shell, it is an issue for smaller companies, who already struggle to get analysts to cover them. There is a real challenge here for investor relations teams. But there is also an opportunity.

‘I speak as an ex-broker but from an investor relations perspective this change should be liberating. UK plc has been somewhat cosseted because of corporate broking. Since Mifid II will impose limits on corporate broking, investor relations will need to become more of a core function. Perhaps IROs (investor relations officers) will even need to become officers of the company,’ Fulton suggests.

Because fund managers will now be paying for research alone, Capital Access Group predicts three tiers of analyst will emerge. Big-name firms will charge a premium for a full subscription, second tier will offer research on an ‘on demand’ basis and the third tier will produce Mifid-exempt, non-specific ‘market commentary’ paid for by corporates and given out for free.

Further down the line, Mifid II could lead to an even more fundamental shift in analysts' roles, says Fulton. ‘Star analysts’ in the City's top firms may realise that their research is raking in millions for their employers, and decide that they could keep a better cut by operating on their own.

Lyndsay Wright, director of investor relations at bookmakers William Hill, says: ‘It will take five years for the implications to be fully understood. However, there are some good things that may come about. In particular we may start to see analysts taking a longer-term perspective on companies and focusing less on financial results. They may provide more substantive, longer pieces. We are already seeing analysts moving to more thought pieces already.’

Cressida Curtis, interim head of investor relations at British Land, agrees. ‘This is probably good from the company point of view. It’s an opportunity to get much closer to investors and it works in the investors’ interest – that doesn’t mean it won’t be a pain in the backside.’

As far as analysts’ coverage is concerned there will be greater scrutiny on the accuracy of their forecasts. Does this mean that analysts will be more provocative or punchy in the way they cover stocks?

Curtis says: ‘If you’re not putting out a ‘buy’ or a ‘sell’ what will be the point? We may see the ‘hold’ recommendation disappear.’

There are many more implications for IROs to get their heads around, and that also means implications for directors of communications, where they have responsibility for the IR function.

For a start, there may need to be more people added to the IR team, to deal with greater demands for access from investors and analysts. There is likely to be more work generated by responding to analysts’ requests for new data points as they seek to provide better coverage.

IROs will probably have to take more control of institutional targeting and directly organise shareholder meetings.

Even booking meetings with investors – the company’s actual owners – will be a challenge, as IROs in the UK have often used brokers to arrange these. Wright says: ‘We are certainly seeing a lot more direct access requests at the moment.’

She also foresees issues around consensus management, where a company seeks to manage the consensus of forecasts that analysts have for company. Wright says it sounds counter-intuitive but it can be easier to manage 25 analysts and their forecasts, than ten.

There are new ways of producing consensus figures, including crowd sourced forecasts such as Estimize, which operates in the US, or tools based on algorithms. However, these are not thought to be as reliable as company-distributed forecasts. Certainly it may be harder to explain outliers to the executive team and to investors, when there are fewer analysts covering the stock and when the highest rated analysts are behind a paywall.

‘I expect there will be a period of transition where we are having to deal with a lower quality of reporting, before the economic consequences kick in and weed out some analysts,’ Wright says.

It is not yet clear how ‘roadshows’ – when a company’s executive team are taken to meet investors – will be affected.

If smaller and mid-cap companies are not getting the coverage they want or seek, they may have to turn to paid-for research to get their story out, in much the same way that companies pay a credit agency for a rating when they need to issue a bond. This could lead to the emergence of more boutique analysts.

Smaller companies could yet be exempted from parts of Mifid II, as the European Union has said it will review the implications for them over the next few months. However, the UK’s Financial Conduct Authority has previously said that it is minded to embellish rather than lighten the EU legislation.

Brexit will certainly not provide any get-out clause for UK listed companies, either.

Some people have suggested that since sell-side analysts will need to get access to companies, they will inevitably become more positive to win favour. But Wright dismisses the idea that IROS would be so easily influenced. ‘I certainly relish the idea of going into see an analyst with a sell recommendation,’ she says.

Those IR professionals who have been busiest preparing for the changes are clear that their companies will need to spend more time targeting investors directly, in order to develop a diversified shareholder register.

There are also implications for communications teams who deal with business journalists who often talk to sell-side analysts.

Financial journalists have long used analysts’ notes to help them get up to speed quickly and to assess whether a company has managed or failed to deliver what was expected. There are concerns that quality research may be harder to come by in future but Fulton is not worried.

‘If anything the financial media will be more important in terms of communicating companies’ messages to wider investors, including retail investors. Corporates will have to make more of an effort to try to speak to fund managers and investors through the channels that are available to them, so that could be good for the financial press,’ Fulton says.

Those analysts that want to be ranked highest in their sector will no doubt use the press, as many do now, to communicate their value.

Fulton thinks that FTSE companies are largely underprepared for Mifid II, mostly because they lack the large IR teams of European companies – which don’t have corporate broking intermediaries. Fulton says there are probably only 45 companies in the FTSE 100 of leading businesses that are able to conduct their own IR and communications.

He adds: ‘This is not a regulation that anyone really wants, especially in the UK where there is a corporate broking structure that doesn’t exist elsewhere. But unbundling is consistent with the Financial Conduct Authorities views on the customer and transparency.

‘You could say that the UK’s championing of unbundling [within the EU] has come back to bite us, to an extent.’

Laura Hayter, head of policy and communications at the IR Society, says: ‘This is an opportunity for IROs to take control of their investor relations programmes. However, they will need the commitment of company management to empower and fully resource IR when the changes come in. But the basic tenets of good investor relations will not change. IROs will always need consistency of message, in good and bad times; clarity of the investment story and investor communications; and credibility in both the management and the IR team.’

As to what will happen on 3January, pessimists can sleep easy. Like Y2K we are not going to wake up and find the world in chaos. This is an evolution, not a revolution.