Is there a structural issue in the London stock market for growth firms? I believe there is.
The Alternative Investment Market (AIM) section of the London Stock Exchange offers a wide and diverse range of opportunity for investment in small and mid-cap stocks. AIM provides a regulated environment that facilitates entrepreneurial companies to raise the funds necessary for growth through investor incentives such as Inheritance Tax exemption.
However, there is a structural issue in the market that is becoming more apparent, threatening AIM’s reputation as a secure and safe environment for both investors and companies alike.
In 2018, the EU introduced MiFID II, a series of legislative reforms aimed at promoting efficiency in financial markets alongside increasing protection for investors. A component of MiFID II was the changes to equity research, requiring brokers to charge fund managers separately for research rather than the previous structure of a single bundle containing both research, transactions and other services. As fund managers were now given the option to pick and choose the research for which they paid, this led to a decline in spending, which subsequently resulted in brokers cutting back on research costs.
As brokers’ research budgets shrank, this particularly affected independent research on small-cap companies, due to reduced analyst capacity and increased focus on larger, more liquid stocks. A survey conducted by the CFA Institute in 2019 across 449 firms with 496 individual responses, demonstrated that 47 per cent of buy-side respondents and 53 per cent of sell-side respondents reported a decrease in coverage of small and mid-cap stocks.
Broker coverage is an important tool in helping companies to raise cash, as the research is distributed across a network of fund managers with significant access to capital. In addition, third-party research plays an important role for investors, with analysts’ forecasts and recommendations helping investors to take more informed positions on a stock.
Independent research on small-cap companies was not extensive prior to MiFID II, and following the implementation of the MiFID II changes, small-cap companies were struggling to get research from institutions outside their house broker.
In recent years, this demand for independent research by small cap companies has led to the rapid rise of paid-for research firms.
Initially, this was straightforward. The paid-for research firms charged small-mid cap companies a fee, for which they delivered independent analyst research. This research was distributed across a large network of investors, helping to raise a company’s profile in the investor community. It was an arrangement that worked well, given the companies and investors still needed the level of research that existed prior to MiFID II.
However, a small percentage of these paid-for research firms then decided to expand their offering into other services, such as offers of loans or substituting cash payments for shareholdings. These tactics are usually aimed at small companies that are typically not generating cash and nearly always undercapitalised, making them highly susceptible to these strategies.
Last year, the Financial Conduct Authority (FCA) announced that it would scrap the MiFID II rules on separating research from transactions for companies with a market cap below £200 million to promote independent research on small-cap companies. This policy came into place in March 2022.
However, many brokers still have the same reduced research budget that followed the introduction of MiFID II, so small-cap companies are likely be dependent on paid-for research in the foreseeable future.
If this is the case, then the FCA should consider what additional services are now being packaged up with the research and whether they are truly beneficial to the financial health of small-cap companies or whether they are being foisted on them as unwelcome extras.
Small-cap companies are always going to receive less attention from brokers than their larger counterparts. However, every company that is listed on the London Stock Exchange should have the ability to access independent research that is not subject to inherently disadvantageous arrangements, regardless of its size.
