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To bundle or not to bundle? UK’s Investment Research Review in favour of ‘rebundling’ research fees with execution costs

16 Jan 2024

By Xi Yu, Compliance Consultant

The Investment Research Review (IRR), published in July 2023, examines levels of financial services investment research in the UK and how this has contributed to UK capital markets competitiveness. Ultimately, it seeks to bridge the gap between UK and US markets and renew interest in small and mid-cap UK equities.

One of the systemic – and perhaps unintended – consequences of MiFID entering into force has been the conflict between regulations regarding research payments.

It used to be that investment research was funded by trading commissions paid by asset managers who then expensed these costs to their end investors. The prohibition of inducements under MiFID required broker-dealers to charge research costs separately from execution fees, thereby ‘unbundling’ the former packaged structure.

This has created a gap between asset managers subject to MiFID in the EU or the UK versus brokers based in the US – a gap that the IRR aims to remediate. In this article, we’ll detail the outcomes of the review and the potential solutions identified.

The IRR’s findings

Chapter 4 of the IRR highlights the following points of interest surrounding the UK investment research market:

  • Overall, the availability of investment research in the UK is comparable with other global financial centres. However, a commonly held view (albeit not without dissent) is that the UK is “perhaps no longer as pre-eminent” as a location for research as it was a decade ago. It is worth noting that the IRR specifically compares the UK investment research market with that of the US, where greater coverage of public markets is available both in terms of breadth and depth
  • Analyst coverage is responsive to the nature of the companies publicly traded in a specific market. For instance, technology companies are better covered by analysts in the US and certain Asian markets. However, the IRR notes that a number of respondents to the government’s Call for Evidence expressed concern about a perceived lack of expert investment analysis. Notably, the market has witnessed over the last few years a “juniorisation” trend whereby investment research was usually undertaken by more junior staff with fewer resources, thus potentially impairing the quality of research
  • Investment research in the UK is marked by a significant disparity in coverage between companies with capitalisation in excess of £1bn (larger-cap) and smaller-cap companies, the latter being under-researched. This links back to the growing concerns raised by the government regarding the quality and quantity of research available for high-growth sectors such as life sciences
  • The unbundling requirement prescribed by MiFID has undoubtedly had an adverse effect on the availability of investment research. The IRR questions whether this set-off effectively enabled EU and UK markets to enhance fee transparency as initially intended. Under MiFID, asset managers must fund research either from their own funds or via a separately held research payment account (RPA). The IRR notes that buy-side firms rarely use RPAs due to their complexity (e.g. client communication, annual budget review, periodic qualitative assessment). Simultaneously, a number of asset managers have simply reduced the amount they spend on research to decrease expenses, instead focusing on integrating research capabilities in-house. Nevertheless, the IRR rightfully points out that institutional investors had been moving away from UK equities and secondary trading as part of their risk-averse strategy before MiFID was enacted

The IRR’s recommendations

Based on its findings, the IRR issued seven recommendations to help foster and develop the UK market as a centre of excellence for investment research:

1. Introducing a research platform to enhance coverage and availability

The IRR suggests that a central facility for the dissemination of research should be created. Access to the platform would be free of charge and would focus on smaller-cap companies which, at the time of writing, suffer from a lack of coverage. The proposed platform would improve coverage of small-cap companies and promote interest and liquidity in UK markets.

Such a platform would need to set minimum standards to guarantee the quality of produced research, including the underlying methodology. This research platform need not be a permanent measure but could be used as a levy to enhance coverage of the UK public markets.

The IRR proposes three potential ways to fund this platform: (a) by a levy on issuers, asset managers and/or the wider financial services industry, (b) by the relevant markets, and (c) by government subsidies.

2. Allowing optional payments for additional research

The IRR suggests giving asset managers the option to pay for research via either their own resources, by charging the end investors, or through a combination of research and execution costs. The recommended ‘rebundling’ of investment research would still require asset managers to disclose research fees to their clients in an attempt to preserve transparency.

It is worth noting that the review explicitly argues the importance of remaining in alignment with other major financial jurisdictions such as the US.

3. Granting retail investors access to investment research

The IRR points out that restrictions on the dissemination of research may prevent or discourage the wider consumer market from accessing material information to make enlightened investment decisions. Consequently, it recommends that the UK’s Financial Conduct Authority (FCA) review its rules relating to the communication of investment research to enable more retail investors to access it.

As it stands, the Conduct of Business Sourcebook (COBS) distinguishes between independent research and non-independent research; the latter being deemed as mere marketing material. To make research publicly available would require the FCA to review its rules on financial promotion and, perhaps, create a bespoke regime for the communication of investment research.

Although there’s a likelihood of causing havoc in the existing regulatory regime, making research available to consumers could serve an important role in enabling good consumer understanding of financial products. Conversely, the FCA and the wider industry would need to consider market stability and potential claims arising from retail investors making investment decisions based on disseminated research.

Investment tips are currently available to the general public through various online magazines and newsletters. These are not regulated despite explicitly being advertised as “share tips” or investment advice for beginners. A review of the regulatory framework relating to research analysis would need to settle the perimetre of what amounts to regulated research and what is simply news.

4. Involving academia and bursaries to boost research

The IRR suggests that academic institutions should be considered as a potential resource for enhancing the quality and quantity of investment research. The review argues that the involvement of scholarship may further catalyse innovative ventures to develop from research outputs. It also argues in favour of funding academic involvement through the research platform.

5. Supporting issuer-sponsored research by establishing a code of conduct

Issuer-sponsored research should be made available on the proposed research platform.

The IRR suggests that trade associations should establish a voluntary code of conduct to deal with inherent risks of conflicts of interest. The code of conduct would apply to all issuers seeking to sponsor investment research.

In our view, if a code were to be designed, its provisions should enable readers to clearly understand the methodology, presumptions and caveats of the output to minimise the risk of such market analysis being deemed as mere puffery.

6. Clarifying aspects of the UK investment research regulatory regime

Currently, inducement rules, including those relating to investment research, are enshrined under COBS 2.3B and 2.3C. The IRR suggests a review of the existing regulatory regime to remediate areas that are unclear, unnecessarily complex or irrelevant for the purpose of regulating investment research.

From a broader perspective, the IRR also calls on the government to review its regulated activities framework. The provision of investment research does not in itself amount to carrying out the regulated activity of “advising (bringing about) deals in investments” as defined under Article 53 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001. However, most research features characteristics that brings it within the purview of Article 53.

A reform may facilitate non-authorised persons to provide investment research. That being said, we note that permitting the unrestricted dissemination of research would necessitate a review of existing case law regarding the exact scope of “advising (bringing about) deals in investments”.

7. Reviewing the investment research rules in the context of IPOs

When MiFID was transposed into the FCA Handbook, it was thought that this would encourage unconnected analysts to produce research relating to IPO candidates. Currently, MiFID requires IPO candidates to grant unconnected analysts access to management information at the same time as connected analysts, the latter only being allowed to publish their research one day after the prospectus’ issuance.

However, most issuers tend to withhold material information from unconnected analysts until the transaction is almost complete, for reasons such as to control the narrative surrounding the IPO. In this case, COBS requires connected analysts to wait at least seven days after the prospectus’ issuance before publishing their research, thereby considerably extending the standard IPO timetable.

Within this context, a number of respondents to the government’s Call for Evidence expressed their view that on the one hand, unconnected analysts did not benefit from the access conferred by MiFID. On the other hand, respondents also felt that the current prolonged timetable may put the UK at a disadvantage compared to other global financial markets.

The IRR thus suggests making research from connected analysts available on a similar basis to the prospectus so that all investors can access the same information at the same time. The review further recommends that the FCA restricts the ability of connected analysts to speak with IPO candidates prior to an investment bank being appointed to arrange the transaction.

The merits of a rebundling exercise

A key recommendation supported by the IRR is the rebundling of research expenses with trading commissions by providing flexibility on research analysis covering smaller and mid-cap companies.

It was previously suggested to amend Article 24 of MiFID so that a “safe harbour” for investment research fees be included in the definition of “acceptable minor non-monetary benefits”.

In the EU, as of February 2021, firms were able to bundle research and execution costs for research relating to small and mid-cap issuers, subject to a market capitalisation ceiling of €1bn. This quick-fix measure, established by Directive 2021/338 to cope with the depression caused by COVID-19, was welcomed by market participants.

The following year, the FCA broadened the outer boundary of “acceptable minor non-monetary benefits” under UK MiFID to include research relating to (a) issuers with a capitalisation below £200m, (b) fixed income, currencies and commodities instruments, and (c) research produced by independent providers. Note that the capitalisation ceiling in the UK remains significantly lower than that which is currently implemented in the EU.

Despite the FCA’s attempt to deregulate research fees, this safe harbour primarily relies on statutory interpretation, which leaves buy-side firms in a state of uncertainty until a higher court settles on the matter. To overcome this legal void, the IRR goes further by recommending that an express statutory exemption be established to allow asset managers to rebundle investment research while still requiring the former to disclose the portion of fees spent on research outputs. This would fill in the existing gap between MiFID and the Advisers Act.

Although the IRR was generally well received by both the government and the industry, several market participants have already questioned the merits of a rebundling exercise in light of the extensive operational and compliance costs that buy-side firms had already incurred to comply with MiFID when it originally entered into effect.

In the aftermath of the IRR, the FCA issued a press release, committing to take “swift actions” to engage with market participants by the end of H1 2024. However, we note that wider regulatory changes proposed by the review – such as a potential amendment to FSMA and the RAO may only be actioned by HM Treasury.

Across the English Channel, the European Commission introduced a proposal to amend EU MiFID on 8 December 2022. The proposal, which forms part of the EU Listing Act bill, seeks to increase the existing threshold from €1bn to €10bn in an effort to facilitate research coverage and foster the EU’s attractiveness to potential investors. The Listing Act is currently being negotiated between the Council and the European Parliament.

Despite this regulatory saga, research continues to be a significant industry in its own right. In 2022, investment analysis of global cash equities generated a global revenue of approximately $11bn, with Europe and the UK making up roughly $3bn of the aggregate figure.

In our view, rebundling research costs could be part of the solution for renewing global interest in small and mid-cap UK equities. However, it is unlikely that asset managers will be switching their post-MiFID research process before any definitive reforms are promulgated. In the meantime, the FCA is expected to begin a public consultation later this year.

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