INFORMED ARTICLE BY RICHARD DAVIES

All Things Small & Beautiful

The honeymoon is over. The invoices are finally going out from the sell-side to the buy-side for research and access. The buy-side is waking up to the new reality, and issuers are finally being made aware that MiFID II really does have a bite.

Our research tells us that there has already been an average 15% reduction in the number of investor meetings for FTSE 350 issuers in the first half of 2018 against the same period last year, with smaller companies faring worse than larger companies in terms of number of events and number of meetings. The anecdotal evidence suggests lower quality of investors being put on schedules and the return of the ‘hedge fund only’ roadshow is definitely with us.

On the sell-side, the predicted analyst ‘brain-drain’ seems as yet to be more at the bulge-bracket banks than the mid-tier brokers, with sectors being dropped on a case-by-case basis and the related folk moving to the buy-side or hedge funds.

The mid- and small-cap oriented stockbrokers are clinging on to life in some cases (though some are in robust health) but we have a crisis of over-supply that is being driven by forces outside MiFID II. As discussed in previous columns, the number of equity issuers in the UK continues to fall at what some  may see as an alarming rate, as fewer companies come to the market than drop out of the listings due to M&A or heading into administration.

Clearly, as with the asset management industry, consolidation of the sell-side is going to gather pace over coming months but those who predict the death of the sector are as mistaken as those doomsayers of 20 years ago. This is not, however, to deny the major dent in support for small-cap companies that the current scenario induces in terms of research and equity distribution.

Much has already been written about the role of independent research, especially with regard to small- and micro-cap companies, and clearly this has been a growing industry over recent years – but companies often view this research as a necessary evil. While some private investors may relish independent research, the effect on the professional investor is less clear as this is less researched. The more problematic issue is the number of funds and fund managers that will buy outside of the FTSE 350. Independent research needs to be read and acted on to make commissioning it worthwhile.

In terms of equity distribution, the same problems apply – the thresholds for investment have gone up at many small- cap funds as the appetite for risk has decreased, thus exacerbating the lack of liquidity from which many small-caps suffer, especially those with lower free floats.

The role of the broker

Many small-cap companies do not have a dedicated IR resource and so rely on their broker or brokers completely for their equity distribution in the sense of meeting new investors. In this world, ‘targeting’ means having a roadshow set up by your broker, not a thorough and in-depth piece of global market research as one would otherwise understand it. The company’s equity investor horizons are limited by the broker’s institutional investor client-list – and this limited distribution model is now even more restricted because many of those institutional clients are refusing to pay the broker the ‘concierge’ fees required under MiFID II to set up the meeting.

The broker client-list distribution model is often restricted geographically at the smaller brokers. They do not generally offer distribution to investors outside the UK. This means that growth companies may not get the maximum capital support they need because they do not have access to otherwise suitable funds in Europe or elsewhere.

Of course, many non-UK investors have constraints on investing into AIM stocks but for Main Market issuers it seems sub- optimal that they may not receive the benefit of wider relevant distribution due to the distribution model. However, it seems likely that the smaller brokers not offering more widespread distribution will not survive the market cull that MiFID II will bring, directing issuers towards the larger mid-market brokers who do offer a more global reach.

Conundrum

The conundrum is that the companies which are likely to fare the worst under the new rules are those least likely to have a dedicated in-house IR team – or indeed, use an external IR adviser. We are seeing a ‘trickle-down’ currently in the sense of more small-cap companies taking on an IR professional, but it is certainly not yet a flood. This is understandable – if senior management did not understand the partial nature of the equity distribution model pre-MiFID II, then they are less likely to comprehend fully what the new rules mean for their company and equity, especially if, for the moment, the world seems a lot like it was before the change.

Given the decreasing institutional interest in small-cap stocks, the next layer of capital has to be discretionary retail investors: private client stockbrokers, wealth managers, family offices, private client fund managers etc. These investors are a lot easier to reach and handle than ‘pure’ (self-directed) retail due to the collective nature of their investment, but there has been an uptick in the hurdle number to get on their stock lists over recent years. Many PCBs will now only include FTSE 350 companies on their buy-lists.

There is a strong tailwind the UK towards individuals using online execution-only platforms for their investments, eschewing the role of the investment professional to manage their money. The discretionary retail sector remains (and will remain for many years hence) a valuable source of capital for smaller companies, but keeping private non-discretionary managed investors informed of the equity story via active and ongoing media campaigns must also be part of the small-cap IR strategy.

Contrarian

Some commentators have provided a contrarian view to the more standard ‘doom and gloom’ scenarios for small- and micro-cap stocks. The argument is that with less sell-side coverage and with less ‘old- school’ institutional money flowing into the sector, there will be more opportunities for the nimble ‘boutique’ specialist investor to find hidden gems and make spectacular returns. Some predict a new Golden Age for small-caps in the UK market, but I wonder if this is somewhat farfetched. Certainly, there is likely to be a price uplift in this sector of the market due to the increasing scarcity value of small-cap stocks. Given that there are still over 1,700 equity issuers across the Main Market and AIM at the time of writing, the market place remains crowded and small-cap companies need to shout loud to get noticed.

Small-cap and large-cap IR practice is broadly similar in terms of basics but the upside potential for smaller companies who have not carried out systemic IR in the past can be tremendous. One merely has to get past the inured acceptance of historical market practice among some small-cap senior management to the realisation that reliance on the broker equity distribution model alone may not provide them with the optimal share price performance they may well deserve.