Revitalising investment research is key to repairing London’s reputation as a financial centre
By Neil Shah, Director of Content & Strategy, Edison Group
The recent Investment Research Review conducted for the UK government by Rachel Kent has rightly won praise for highlighting the crucial part that investment research can play in reviving the UK equity market. The review’s proposals demonstrate a thorough commitment to redesigning a flawed mechanism which leaves especially small and mid-cap companies without the necessary exposure to garner investor interest.
The review’s conclusions were endorsed by the government, and Chancellor Jeremy Hunt, who also indicated that Rachel Kent’s suggestions will be carried by mid-2024. It is encouraging to learn that the government recognises the value of research in enhancing market competitiveness and assisting UK companies, particularly SMEs.
Why do we need research?
The most recent headline instances of Arm and We Soda withdrawing their initial intention in floating on the London Stock exchange have led to a public re-examination of the UK’s attractiveness for investment. While both companies have their own, multifaceted reasons for listing elsewhere, the recent track record for IPOs in London is anything but encouraging – an issue which has persisted for years.
This issue has been made worse by the state of the wider UK economy and post-Brexit uncertainties, as well as the composition of FTSE companies, which is lacking in flagship names compared to Wall Street. UK equities have been trading at a discount for years now, but investors remain reluctant to take advantage, while M&A and private equity bidding adds to a slow de-equitisation of the UK market. The problem is that many interesting small and mid-caps with excellent fundamentals are being thrown out with the bathwater.
Some of the current liquidity problems may be resolved by the chancellor’s plan to drive pension fund investments into UK stocks, but companies outside the FTSE100 must first gain the requisite exposure to be noticed by investors. High-quality investment research is the key. The problem is that since MIFID, far less research has been focused on small and mid-cap companies. Regulations limiting payment options for third-party research have had the unforeseen effect of constraining fund managers’ budgets since the MIFID unbundling rules went into effect in 2018. As a result, most research expenditure is funnelled into well-known equities with greater market capitalisation.
MIFID II – What went wrong?
MIFID is currently being rolled back in both the EU and the UK because it is seen by many as a failed experiment. Ironically, while having ardently advocated for unbundling adoption across the EU before 2018, the UK has the post-Brexit benefit of being able to cut regulations more quickly than the European bloc.
The suggestion made by Rachel Kent to do away with the MIFID II unbundling regulations also provides much-needed flexibility that makes it simpler for UK managers to access non-UK research. The UK can now meet US regulations, something the existing model does not permit. Fund managers will be able to distribute resources more freely, charge investors for research expenses, and revive demand for research coverage across the board, not just high-profile names.
Abandoning unbundling regulations alone won’t be a solution in and of itself. Fund managers now have protocols and pricing in place, and it may take time for processes to change again. We may not immediately notice a significant influence on the distribution of research since it will require patience to adjust to the new restrictions, including fund level transparency on research funding.
A “Netflix” for investment research?
One of the key recommendations from the Investment Research Review is the creation of a research platform designed to successfully balance supply and demand for equity research – a Netflix to source investment research, if you will. This is likely a short-term solution intended to create a market between issuers and research providers and to encourage open access to research on smaller companies.
Similar programmes have been tested successfully in other jurisdictions. A promising example is the Deutsche Börse Scale exchange, whose research programme acts as a catalyst for connecting SMEs with fund managers and investors. The Scale research programme currently in place offers a fundamental level of freely accessible firm coverage on a regular basis and consistently, encompassing macroeconomic trends, market sensitivity, and the competitive environment. Regular investor talks in several European cities are held in addition to the research to help link Scale firms with the right investors.
We are yet to hear about the platform’s exact funding model, and it will be critical to have sufficient funding in place in order to connect issuers and providers efficiently without placing undue strain on budgets. In any case, the policy is a step in the right direction towards addressing the supply-demand imbalance and reviving the crucial role investment research can play in increasing the visibility of UK stocks for investors, both institutional and private.
Although the move away from unbundling regulations presents difficulties, Rachel Kent’s suggested revisions in the Investment Research Review offer considerable advantages. The valuation of UK stocks and the amount of liquidity on the capital markets will both benefit from increased access to investment research. The creation of a research platform, along with improved openness, high standards, and a higher coverage of small and mid-cap stocks, will revitalise the UK investment landscape and take some positive steps towards emerging London’s status as a top location for IPOs.
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