The spaghetti western renowned for having launched Clint Eastwood into stardom has much to say about the current Mexican standoff between the sell-side, buy-side and public companies as the costs and merits of equity research and corporate access payments come under increasing scrutiny.
“The Good, the Bad and the Ugly”…
…ends in a three way duel, a classic Mexican standoff with each participant staring down the other, waiting for someone to make the fateful first move. The sell-side, buy-side and corporates have found themselves in a Mexican standoff of global proportions, each in a position of precariously balanced power, waiting for the event that will force the other to make their move. Could MiFID II trigger the re-balance of capital markets power between the three key players?
If you’re not up to speed on the implications of MiFID II, you are probably North American-focused and don’t read the Financial Times very carefully, and indeed it’s a European directive that does not target non-EU capital markets. But on the basis that it’s very difficult to imagine global sell- and buy-side firms fundamentally restructuring their compliance and economic relationships in only one of their major geographies – and the key drivers of those economics are global, not EU-specific – if MiFID II has real impact in London and across Europe, it will have the same in the US.
Much about “The Good, the Bad and the Ugly” comparison adds a bit of fun and glamour to the MiFID II story. You can choose from the Big Bang, the move to electronic distribution of research, the end of the partnership culture in the City and Wall Street, among others, as the kick off of the “Dollars” trilogy that ends with our current Mexican standoff. “A Fistful of Dollars” and “For a Few Dollars More” have led us to this final installment, the “Good/Upside, the Bad/Downside and the Ugly/What needs to be fixed in the capital markets.” Discussions about whether “Blondie, a.k.a. The Man with No Name” (Clint Eastwood), “Angel Eyes” (Lee Van Cleef) or “The Rat” (Eli Wallach) better correspond with the sell-side, buy-side and corporates, and who deserves the stash of stolen gold, will be left to the reader. Regardless of who’s who, for the cowboys and the capital markets, it’s all about the money, as it should be, especially when it comes to ascribing the commercial value of sell-side research and corporate access to all three participants.
The potential power of MiFID II is to force one and thus all the participants in our capital markets Mexican standoff to make a major move they have been avoiding. But all three could call the regulator’s bluff and not comply and see if it has any teeth; regulations, laws and directives that are on the books and unenforced are relatively common. But more important than any piece of legislation and the real reason for this stalemate is not that any of the participants believe the current system works well, but that they cannot see a market-wide alternative to the current approach to corporate/investor/capital markets engagement. Problems with the existing approach increase by the quarter, so while MiFID II might come and go with a whimper in 2018, tomorrow one of the major players among the three “shooters” could announce a major change in their business that anticipates the planned outcomes of MiFID II. This is most likely to come from a leading investment bank such as Goldman or Morgan Stanley, possibly one of the top global fund managers, and sadly not very likely from a group of leading public companies. Reviewing who has the most to gain, and who the most to lose provides some clarity regarding potential outcomes.
For the buy-side, the downside is the end of broad access to sell-side research and a fear of losing the inputs that come from meeting with managements. Traditional sell-side research has already been devalued and serves more as a security blanket than an idea generator for the information overloaded portfolio manager. When “research” works in a way that adds value in today’s marketplace – defined as “draws focus and/or adds investment clarity to a company’s stock or industry” -- it tends to be a combination of 1) incisive, timely and even intuitive (e.g. next or even same day description of how investors perceived a capital markets day) corporate and market news aggregation, 2) imaginative engagement with and communication of management/investor/market interactions (e.g. snap investor polls and news mind maps), and 3) big data analysis and bespoke, specifically commissioned research and market intelligence available to a limited number of buy-side clients. None of those approaches are well-suited to the size and scope (including compliance strictures) of major sell-side firms. The upside for the active management buy-side is that there is an opportunity to stand out and outperform the indexer and benchmark by constructing sources of analysis and information that differ measurably from those of the competition. And once the volumes of commoditized sell-side research dry up, new entrants with skills and services like these will step up to fill any buy-side intellectual and budgetary bandwidth.
For corporates, the risk is picking up the tab for a variety of tactical initiatives – e.g. “free IR” services such as sell-side corporate access and conference presentations – that they have been seduced over time to entrust to an increasingly conflicted and resource starved sell-side. Managements’ reward is the ability to more efficiently and effectively direct their own capital markets profiles and initiatives, running their investor relations towards strategic goals as they would the other mission critical marketing functions of their businesses. This potentially means a more durably higher valuation, more efficient and successful fundraisings, and better supported mergers and acquisitions aligned with investors’ expectations. Ultimately it means those best at advancing their businesses and competing for capital will more clearly stand out and be rewarded more quickly and efficiently. Re-forming “research” is already underway, and keep in mind hundreds of companies’ IR efforts function reasonably well with very limited sell-side research coverage. One of the concepts that keeps the research re-formation out of corporates’ focus is the stubborn myth that more “traditional” sell-side coverage is a panacea for lack of investor interest and engagement. This conflicts with the reality that sell-side coverage that helps advance corporate interests and IR goals is comprised of ideas that are marketed and prioritized by the analyst, not the research report itself, lists of “analysts in-print” or ranges of earning expectations.
This brings us back to our capital markets Mexican standoff. One of our on-screen shooters is caught in a death spiral of cutting analysts' pay, giving them ever more companies to cover, shuffling managements in and out of meetings and speed dating IR conferences with little or no attention to their interests -- and then asking those same managements to pay them astonishing fees as part of fund raisings and mergers and acquisitions. Congratulations, you guessed which one!
A twist to this story is that the bulge bracket sell-side doesn’t have much at all to lose from MiFID II, it could be a blessing in disguise for them as they are engaged in their own Mexican standoffs with their sell-side competition. None of them really want to be in this part of the equities business but they are afraid of making the first move to get out, because it will be perceived as a sign of weakness. With regard to traditional models of equity research and plain vanilla equity trading the economics must finally close in and at some point there will be a quick departure from this part of their business by most or all of existing major sell-side firms. That there seems little relative pressure on transaction and capital raising fees says that the first sell-side shooter in the standoff will announce “We’re focusing on high value and higher margin businesses and taking better care of our corporate and institutional clients.” In essence, this is what the growing number of successful boutique and partnership-based capital markets and M&A advisory firms have already done. Whether MiFID II forces the sell-side’s hand depends on what’s currently happening outside of the camera frame in their senior managements’ minds as we watch our MiFID II Mexican standoff on the IR screen (In “The Good, the Bad and the Ugly Director Sergio Leone does not allow the characters to “see” what’s off frame at important moments). Right now we’re not sure when the credits will roll, but we all know there must be an ending soon.
It’s both fascinating and a little frustrating to watch the increasing attention on the Mexican standoff in the IR-centric parts of the capital markets: fascinating because the years have proven that neither the timing nor the nature of the outcomes follows right reason or the principles of fair competition for capital; frustrating because the clear and compelling benefits of conducting Best Practice IR have yet to become the real story. But some combination of a surrender, a gunfight and a closing of this story in the ongoing saga of the cowboy capital markets is bound to come.
“What you put into life is what you get out of it.” - Clint Eastwood