James Ashton: Research purge will cost smaller firms dear

THE procession of fund managers declaring last week that they would soak up the cost of external City research would suggest that the introduction in January of new European rules covering the securities and derivatives markets is cut and dried. Nothing could be further from the truth.

One element of Mifid II is designed to protect investors by ensuring research notes are not offered by banks as an inducement to trade. The consequence of this shake-up threatens to curb the volume and value of work that is pored over when investors assess where to put their money. The blue-chips will be fine. Smaller stocks that already struggle for shareholder attention will find life harder.

While fund managers can easily offer to buy analysis, investment banks and brokers must decide whether they want to sell it. Research is in many cases a loss leader, with analysts regarded as importantly for their introductory service to companies and clients as their considered views. Banks and brokers must decide whether to persevere. Which way they turn is apparently already impacting the New Year pipeline of flotations.

Expect the market to consolidate, leaving big teams sustained at the bulge-bracket banks and a handful of independent research houses. It is a continuing trend. Frost Consulting found that research budgets at the big banks have halved to $4 billion (£3 billion) in the eight years to 2016 and research jobs have borne the brunt of cost-cutting drives.

That the “teenage scribblers” are under threat will not concern some in the Square Mile, who hold them in the same regard as Nigel Lawson when as Chancellor he coined the expression. One theory runs that a lot of broker notes pull their punches for fear of losing clients and that a clear-out is overdue so top-quality analysis is no longer drowned in a glut of marketing materials.

That doesn’t help companies with market values of up to £1 billion that fund managers expect to see a decline in coverage amid the purge, and with that, a corresponding decline in shareholder interest. To say those stocks should simply spend more on their investor relations does not solve the problem. Introducing greater transparency to the model is laudable but flawed if it comes at the expense of the flow of information.

Another concern, raised with the Treasury by small and mid-cap lobby group the Quoted Companies Alliance, is that unbundled research will be liable for VAT. QCA boss Tim Ward has suggested the funds raised could be redeployed into tax incentives for small businesses who might think twice about using equity markets to grow their business if their shares trade in a vacuum.

Access to funding streams remains a live issue because too many small firms fail and too many of those that survive the first few years sell out instead of forcing their way into the FTSE 100. The UK’s top companies’ club features many that have a long heritage with centuries-old brands on which they trade. Unlike the US, too few were set up and have flourished from scratch in the past decade or so.

The London Stock Exchange has just closed its consultation on the future of the alternative investment market. A while ago it gained a reputation as home to illiquid stocks with questionable governance and with memorable blow-ups such as Quindell, no place for widows and orphans.

Overall, Aim has performed better in recent years and it might improve again if the LSE takes a closer interest in the nominated advisers that bring firms to the junior market and sets standards about the free float of shares.

One reason Aim can afford to mature is that smaller, riskier investments have turned to crowdfunding to raise growth capital. This model has been spectacularly successful at attracting money, but is far from fully formed. Spurred by some high-profile failures, these alternative platforms such as Seedrs and CrowdCube are going to have to tighten up on the transparency of the firms they peddle when the Financial Conduct Authority publishes its industry review shortly.

At a dinner recently, I sat next to a technology entrepreneur who praised the public markets. By listing shares in his firm, he had been able to take money off the table, incentivise staff and gain a currency to go on the acquisition trail. Yet if he had stayed private years ago and let one or two institutions fund growth behind the scenes, he estimates his company would have been four times the size by now.

Without sufficient information on which investors can make decisions, it is no wonder that passive investing is sharply on the rise. That is little comfort to those companies that would become the UK’s world-beating corporate giants of tomorrow.