Analysts Warn on Research Commission Changes

Terry Flanagan

The proposal to stop fund managers paying for research from client commissions would have a disproportionate impact in the UK and lower industry profitability by up to 30% according to analysts at Berenberg, the German bank.

The European Securities and Markets Authority has consulted on the legislative text for the revised Markets in Financial Instruments Directive which will make changes to trading in the region. One of the proposals in MiFID II is that fund mangers should pay for all valuable research themselves, rather than including these charges in client commissions, in order to reduce conflicts of interest.

Berenberg warned that if the changes proposed by Esma are adopted in full there could be unintended and damaging consequences for the asset management industry and its international competitiveness.

The analysts estimated that the buyside spends approximately €3bn on sellside research in Europe, with about half spent in the UK which holds 80% of assets run actively in Europe.

The report said: “In a worst-case scenario where research costs would have to be absorbed on the asset managers’ profit and loss in full, the £1bn to £1.5bn spent in the UK would equate to a 20% to 30% hit to industry profitability.”

Berenberg said it is unlikely that asset managers would be able to to pass on the additional costs to customers and would slash research spending leading to consolidation on both the buyside and sellside. The analysts said global equity research budgets have fallen from $8.2bn in 2007 to $4.8bn in 2013, and could drop by another 30% by 2017 according to estimates from Frost Consulting.

“With this in mind, we believe the high ratio of sellside to buyside firms is likely to be unsustainable. We would expect the number of sellside firms to shrink,” added Berenberg.

As a result smaller asset managers could end up being cut off from sellside research.

The UK has many more hedge funds and smaller asset managers that may be most at risk as they have more reliance on third-party research. The analysts cited data from consultancy Booz Allen which found that external research is relatively more important for the 75% of funds that manage less $200m.

“If these smaller hedge funds were forced to pay for research out of their own P&L, this would likely push the break-even point higher still,” added the analysts. “As such, this could trigger a sharp increase in fund closure and attrition rates.”

In their responses to the Esma consultation paper, asset managers said that some smaller investment managers that are heavily dependent on external research may be forced out of business while new entrants will face higher barriers to entry if the proposal is adopted.

Berenberg also warned that European fund managers could be severely damaged if unbundling is adopted in the region on a standalone basis and US firms would gain the most benefit.

“The US asset managers could be winners in this situation as they are best placed to relocate investment hubs and take market share,” added Berenberg. “US firms are already a large part of the European industry, making up six of the top 20 groups by assets under management.”

Axa Investment Managers agreed that US firms, who could operate without Esma restrictions, would benefit form the proposed rule change.

Axa IM said: “Clients of purely EU firms would be disadvantaged relative to clients of the European arms of US firms, who would undoubtedly have access to research from the US paid for through commission by clients of the US arm, which results in more, rather than less, cross-subsidy and market distortion.”

Berenberg suggested that Esma could compromise by asking asset managers to set and track research budgets and commission targets which could be disclosed to clients and signed off by management.

“This could be incorporated within the existing commission sharing arrangement framework, with limits placed on the payments that can be set aside for research,” added the analysts. “This would address the regulator’s concerns regarding research being tied to trading volumes.”

Last month David Lawton, director of markets at the Financial Conduct Authority, said the UK regulator supported Esma’s proposals for fund managers to pay for research.

The FCA held a MiFID II Conference in London on September 18 to begin discussing implementation issues.

Lawton said at the conference: “The FCA believes, in line with the results of our recent thematic work, that a more effective market for research and more efficient asset management sector will develop if dealing commissions are not used to fund these goods and services. Therefore, the FCA has been supportive of Esma’s proposal.”

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