A Lyft car in San Francisco, as Lyft prepares for IPO

Lyft’s IPO May Be Oversubscribed but Investors Are in for a Bumpy Ride

By | General

After all the anticipation, it’s Lyft that has kickstarted the year of ride-hailing IPOs, much to the enthusiasm of investors. The market has been waiting for the ride-hailing startups to go public for years, perhaps more Uber than its US rival, but that hasn’t stopped Lyft’s listing from being oversubscribed, according to media reports.

And that’s despite Lyft (or Uber, for that matter), not being anywhere near profitability and actually reporting significant losses. Where have we heard this before?

Cast your memory back to March 2017, when Snap Inc, another tech darling, held its own oversubscribed public offering despite iffy financials. People were looking for the next Facebook, and Snap looked like it might be it. 

Three days after listing, Snap’s stock price plunged more than 12 percent and never really reached anywhere near its initial value again.

Obviously, this is comparing apples to automobiles but there are common elements here. For one, both Snap and Lyft are unprofitable tech startups entering the public markets with oversubscribed IPOs.

Also, they are both up against a much more powerful and deep-pocketed incumbent: Facebook proved to be Snap’s ultimate nemesis, while Uber commands a much bigger market share and has a much larger war chest than Lyft.

It’s hard to think market history won’t repeat itself, looking at Lyft’s numbers. It’s enough pressure even without considering the fact that Uber may be after a US$120 billion valuation on NYSE.

Lyfting the Veil

In a comprehensive note on Smartkarma, Insight Provider Douglas Kim asks a question that should be on the mind of every investor looking into Lyft:

“Is US$2-2.5 billion enough for Lyft to last in the next two to three years without concerns about additional secondary offering during this period?”

In his analysis, Kim points out the company will need at least US$2 billion to make ends meet in the next two years. If it manages to raise roughly that much through its IPO, chances are it needs to raise more funds in two or three years. That would potentially mean a secondary share offering, diluting existing shareholders’ stakes.

Lyft revenue, profits and losses, base case scenario

Chart by Douglas Kim

Like several tech hopefuls who believe in super-fast growth, Lyft seems like it will be posting losses for a while yet – Kim’s base case scenario doesn’t expect the ride-hailer to turn a profit before 2025. This increases the possibility of more fundraising in the meantime, with everything that entails for shareholders.

It doesn’t help that Lyft fails to disclose some pretty vital numbers for the analysts to properly evaluate the business. “Without the quarterly active driver numbers and the full picture of the extent of shared rides, one can’t develop an accurate picture of the business,” points out Sumeet Singh of Aequitas Research in a pre-IPO analysis on Smartkarma.

Future Promise

So how can Lyft reduce costs and improve the bottom line? Autonomous cars seem to be a big part of the narrative – after all, much of Lyft’s revenue has to go to the drivers who, well, make ride-hailing services possible. Fewer drivers to pay, more money for the company.

The problem is, truly autonomous cars that will allow Lyft and Uber to do away with drivers altogether still have a ways to go before they take to the streets in large enough numbers.

It’s not just that there isn’t a clear consensus on when full self-driving technology will go mainstream. There is uncertainty in how the technology will be regulated and what it will mean for companies operating fleets of self-driving cars. There is also distrust from the public, not to mention the POTUS himself.

Diversifying the business seems to be a better strategy for Lyft. “Management seems to be aware of the need for business diversification as Lyft has pitched itself as an inter-modal transport network,” says Insight Provider Johannes Salim in a recent piece on Smartkarma. Salim highlights moves like Lyft’s acquisition of bike-sharing provider Motivate as an example.

It remains to be seen whether Lyft will follow Uber into sectors like food delivery to boost revenue – it certainly worked for Uber – or whether it will seek to expand to more markets outside the US and Canada. Unfortunately for Lyft, many markets in Europe and Asia now have their own well-established and well-funded incumbents with their own ambitions for growth.

Ride-hailing companies private valuations - Uber, Lyft, Didi, Grab

Private valuations of ride-hailing companies based on their latest funding rounds

Tech IPO Angst

So is Lyft’s IPO bound to disappoint investors like other tech IPOs before it? Citing data by Jay Ritter from the UF Warrington Faculty at University of Florida, Rohinee Sharma of Investory notes in a brief article on Smartkarma that only 16 percent of the 38 US tech IPOs of 2018 were profitable – a figure that hearkens back to the dotcom bust of 2001.

It’s not uncommon for investors to finance tech companies’ fast growth in hopes of stellar future returns. But it’s trickier to ask public markets to do the same. “Barring very few profitable IPOs marked for this year – AirBnB for example – would the market be subsidising profits for future growth potential?” Sharma asks.

Scrollable Gif of Smartkarma Platform
Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Scrollable Gif of Smartkarma Platform
The wolf of wall street

What a Popular Hollywood Film Tells Us About the Symbiotic Link Between IPO Performance and Corporate Governance

By | General

Let’s take a trip down memory lane to the year 2013, when Hollywood released infamous film The Wolf of Wall Street.

Those who caught the movie would easily recall the questionable and audacious manner in which Jordan Belfort “conned” and separated everyday individuals from their hard-earned money.

Not as many, however, might remember Steve Madden’s cameo at the time Stratten Oakmont (Belfort’s company) took his female shoes firm public.

His character may have played a bit-part role in the film. But in reality, it was far from minor.

The severity of Madden’s involvement in Belfort’s ponzi operations came to full light when, in June 2000, US federal authorities arrested him on several counts of securities fraud and money laundering.

Prosecutors then alleged that in 22 IPO deals underwritten by two of Belfort’s companies between 1991 and 1997, Madden bought stocks at a predetermined price and sold them back at an agreed rate to artificially inflate their market value.

In return, he received a cut of the profits for services rendered as a “flipper”.

Madden had also deployed similar tactics to manipulate his own company’s share performance after it went public (Ticker: SHOO) in December 1993.

That SHOO’s stock ended up plunging nearly 15 percent the same day news of his arrest broke – nearly seven years after the IPO – shouldn’t have come as a shock.

Knee-Jerk Reactions

Shady practices, like those mentioned above, tend to draw the ire of shareholders as soon as they surface, resulting in sell-offs that send stock prices into a tailspin.

Even so, not all “shady” IPOs take years to unravel like SHOO’s.

Often the consequences of such illicit actions – should they be made known – are priced into stocks by the market within days, weeks, or at the longest, within months of going public.

Case Study: The Proof Is in the Data

In January this year, boutique research outfit Aequitas Research published a report on Smartkarma about IPO performance trends and their contributing factors based on deals analysed since 2015.

Part of the independent study aimed to showcase the positive correlation between good corporate governance and alpha generation – and that it did.

Aequitas filtered 209 past deals through 10 different parameters, which included related-party transactions, dividend/cash pull-outs before listing, partial asset listings, and legal disputes, among others.

True to their initial assumptions, the 55 percent of deals that scored positively for corporate governance outperformed those with a negative score across three time frames – on average.

Corporate Governance score impact on IPO price performance

“Deals with a positive score returned 7.4 percent on the first day, 6 percent by the end of the first month, and 8 percent by the end of three months,” wrote Sumeet Singh, Head of Research at Aequitas.

“In contrast, returns for the deals with a negative score were 1.4 percent, -0.4 percent, and 1.9 percent, respectively.”

The landmark revelation here, however, is not so much in proving how the presence of strong corporate governance drives relatively stronger post-listing returns.

While true, the bigger, underlying point is that, absent objectivity, such revelations might not even see the light of day.

Nowhere is this invaluable quality more entrenched than in the realm of independent investment research.

Why Research Independence Matters

Several characteristics underpin the strengths of independent research, but these three are most relevant in the context of Aequitas’s study:

  1. No Conflicts of Interest – Unlike analysts that work for the sell-side, their independent counterparts are not constrained by the high-value relationships a bank must preserve.
  2. Trust – For the buy-side, placing wagers in the millions (or billions) is no game. As such, asset managers frequently demand transparency and accuracy in the research they consume and on which they act. Unbiased reports produced by independent analysts provide this reassurance.
  3. Transparency – Similar to how the free press serves as the watchdogs of society, independent analysts function as the gatekeepers of corporate governance for the companies they cover.

Karma (Always) Has the Final Word

So, what’s the key takeaway?

At the crux, companies with weak corporate governance set themselves up for relative IPO underperformance.

And for those, like Steve Madden, that get away initially, karma eventually finds its way over, no matter the time frame.

Now how’s this for an ironic conclusion: Money stolen from embattled Malaysian state fund, 1MDB, actually helped fund the production of The Wolf of Wall Street.

Scrollable Gif of Smartkarma Platform
Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Scrollable Gif of Smartkarma Platform
A 5G cell tower, China's Master Plan to counter the US attacks on Huawei

Dominate 5G: China’s Master Plan to Counter the US’ Attacks on Huawei

By | General

The market’s obsession with 5G has reached fever pitch. Unsurprisingly, it was the main talking point at the Mobile World Congress (MWC), the world’s most prominent conference on all things mobile tech, which happened in Barcelona this past week.

Upgrading to 5G networks is no small feat for telecommunications providers. According to a report presented at MWC by GSMA Intelligence, the research arm of mobile industry body GSMA, mobile operators worldwide are investing around US$160 million per year to expand and upgrade their networks so they will be ready for 5G.

The returns, at least, should be worth all that capex. The report predicts that 5G-powered technologies – streaming services, smart city and smart home applications and devices, autonomous vehicles, and so on – will contribute US$2.2 trillion to the global GDP in the next 15 years.

However, the mobile industry’s next big milestone also coincides with a flurry of geopolitical developments that complicate things, with China at the epicentre.

Its homegrown mobile powerhouse Huawei is one of the world’s most important suppliers of mobile communications equipment. Products and services of companies like Huawei are pivotal to the development of 5G communications networks.

But Huawei has found itself entangled in a brawl with the US government over allegations of spying on behalf of its homeland. This has led to several other countries reexamining their relationship with the Chinese firm, in a move whose impact is now reverberating across the global 5G market.

Nowhere are those rumbles felt more than China itself. In a lot of ways, the US-China spat over Huawei is an extension of the greater trade and financial dispute between the two superpowers (read more about this in The End of Fair Trade, our special report about the trade war).

5G Spending Spree

The Chinese government dictates how much its state-run telcos spend on 5G infrastructure. And in 2018, companies like China Mobile, China Telecom, and China Unicom jointly prepared for a measured and controlled 5G expansion.

The rationale was that 5G infrastructure would initially be aimed more at business-oriented services and products and there wouldn’t be as much need to cover most of the country right away.

However, as New Street Research points out in a series of Insights on Smartkarma, the United States’ ongoing tussle with industry leaders Huawei and ZTE changed those dynamics. US intransigence closed off several key markets for the Chinese companies, including Australia and Japan, who cited security concerns.

European markets like the UK and Germany are still evaluating their relationship with Huawei, although they have yet to come down on one side or the other.

“In such times, great leaps forward are more appealing and 5G will open up use-cases for the economy such as smart cities and autonomous driving, even while the revenue opportunity for the telcos remains modest,” the Insight Provider writes in an Insight with a bearish outlook on Chinese telcos. “The disconnect between what is good for the telcos and what is good for China Inc. is widening.”

Simply put, China wants to be a global leader in 5G technology, and there’s a risk that it would require its telcos to spend as much as it takes to achieve it – even if the capex is much more than is healthy or desirable by the telcos themselves.

In what New Street Research terms as its “extreme case”, 5G cell sites in China would double, while existing sites would upgrade rapidly to achieve a geographic coverage of 50 percent and population coverage of 98 percent.

But even if it went that far, the problem is that, at least in the first few years of the roll out, not many commercial applications would be available – leading to lower returns for all that investment.

China telco capex for 5G expansion and upgrade

Extreme-case capex in China (amounts in RMB bn). Data and chart by New Street Research


Huawei Shunned

Elsewhere in Asia, South Korea looks to be the first country to launch commercial 5G services as early as this month. Along with selected markets in the US, these are some of the first places to see the benefits of 5G, helped by the arrival of all-new, 5G-compatible smartphones.

South Korean telcos have broadly chosen to go with partners outside of China. In fact, South Korea is evaluating whether Huawei’s products and services are a security threat, notes Insight Provider Douglas Kim on Smartkarma.

Two major telcos in the country, SKT and KT, have decided to go with companies like home player Samsung and Western firm Ericsson. Finnish provider Nokia has announced a collaboration with KT to develop and trial 5G network solutions.

Only LG Uplus has committed to working with Huawei in its 5G infrastructure. The telco’s share price saw a 17 percent drop in early February, and Kim muses that there could be more to blame for this than just the company’s poor 4Q18 results.

The uncertainty and tension are not likely to let up in the coming year, especially in light of the broader conflict. China, especially, will probably want to push the spending pedal to the metal, despite the telcos’ business concerns. As far as the government is concerned, this tactic has worked in the past.

“From the government’s perspective, past over-investment by the telcos (both 3G and 4G) has been monetised many times over,” writes New Street Research. “[I]t has underpinned the growth of the Chinese internet economy, which has transformed China, propelling the country to the forefront of the global internet economy.”

Scrollable Gif of Smartkarma Platform
Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Scrollable Gif of Smartkarma Platform
Big bank investor flight fuels outlook for mergers and acquisitions

M&A Crystal Ball: A Fund Run on Big Banks Raises the Spectre for Further Sector Consolidation

By | General

2018 was not kind to the world’s biggest banks.

Faced with the perfect storm of global economic headwinds, whipsawing markets, and a raft of compliance scandals, the most staid names in the sector were handed the near-impossible task of preserving and/or restoring investor confidence.

Steven Holden of Copley Fund Research clearly illustrated this deep impact in a study published on Smartkarma.

Holden swept through 255 global equity funds and the holdings of the 18 largest financial institutions (by total assets) from across three regions – the US, EMEA, and Asia.

What he discovered was nothing short of alarming: Bank share ownership plunged through 2018 for all but four stocks, with the number of funds selling far outnumbering those buying.

Large global banks - key changes in ownership 2018

“It is clear that global investors are shying away from exposure towards many of the global mega-banks. Though most of these stocks have already endured a tough ride in 2018, the severity of the exodus points to a broader drop in confidence among global investors,” wrote Holden, summing up his findings of the study.

M&A’s Uplifting Effect

What could this worrying trend of investor flight possibly lead to? It shouldn’t come as a shock that such dips in confidence might actually spur increased bouts of M&A activity among the “mega-banks”.

Mergers and acquisitions have historically proven to be a near-surefire way to reverse risk-off moods, as well as usher in much-needed stability during periods of uncertainty.

About a decade ago, with the global financial crisis in full force, Bank of America (BofA)’s acquisition of Merrill Lynch (ML) helped stave off a total unravelling of the retail brokerage.

Fast-forward to early 2019, under relatively healthier economic conditions. News of BB&T’s decision to acquire SunTrust and rebirth the combined entity as the sixth-largest US commercial bank by assets lifted shares of both companies.

These two mergers may have happened under different circumstances but they have one key benefit in common: the promise of cost savings – and lots of them.

For BofA and ML, it meant shaving as much as US$7 billion in expenses over a four-year period.

For BB&T and SunTrust, the lure of a more than 10 percent cut in running costs, thanks to shuttering redundant branches and digital systems.

Lower operating expenses widen operating margins, which, in turn, free up cash for other purposes. Whether using that cash to pay down existing debt or to invest in digital transformation, a strengthened financial state almost always builds confidence in investors.

Deutsche Bank-Commerzbank

But the BB&T and SunTrust marriage may only be the tip of the iceberg of what’s to come for the year ahead.

Also red-hot on the prospective list is Germany’s Deutsche Bank (DB) and Commerzbank (CB).

The catalyst? DB’s persistent struggles to pull itself out of a financial quagmire after four years of declining revenues, with no viable plan to reverse its misfortunes.

Add to the challenge a constant string of lawsuits, regulatory investigations, heavy fines (US$17 billion in the past decade), and soured bets, like the US$1.6 billion loss it incurred on a pre-financial crisis municipal-bond wager. It’s not surprising DB features among the six banks suffering from the highest investor flight, based on Holden’s study.

Adding insult to injury, the current weakened state of investor confidence could deteriorate still further: A credit-rating downgrade on the bank has led to higher borrowing costs, making a recovery even more difficult to achieve.

Just like BofA-ML, the common narrative put forward by market pundits is that either DB find some miraculous way to turn things around, or be subject (quite possibly) to a government-arranged marriage with domestic competitor CB.

Barclays-Standard Chartered

Elsewhere in the UK, a merger between Barclays and Standard Chartered doesn’t seem so far-fetched, either.

The idea was initially mooted in May 2018, when Barclays began studying the viability of merging with another international bank.

Since then, the impetus to go through with it has only increased with a no-deal Brexit looking more likely than not.

Creating this hypothetical British banking juggernaut will bring the duo financial security and business synergy.

Financially, their combined balance sheet would help withstand any Brexit fallout post-29 March. And, on the synergistic front, Barclays’s established UK business will more than complement Standard Chartered’s entrenched presence in far-flung emerging markets, like Africa.

A merger of this magnitude, at least in theory, carries the potential to deliver a confidence boost for investors seeking stability and room for growth.

More Reasons to Deal

In addition to the aforementioned factors, there are other reasons why more consolidation could happen in the financial services sector this year.

For example, looser US regulations and a tax overhaul are freeing up increasing hoards of cash on bank balance sheets – ammunition to do deals with in the States.

In fact, an M&A report prepared by Ernst & Young showed that the value of M&A activity in 2018 (US$196.5 billion) rose by 139 percent from the year before (US$82.3 billion).


Annual increase in financial services merger activity 2018


Then, there’s the argument of cannibalisation caused by the presence of too many small players competing in a single market.

As BofA Chief Executive Brian Moynihan aptly puts it, “There are now 6,000 odd banks [in the US], and you’ll find them continuing to consolidate.”

It’s time to ratchet up those wagers on the next banks in line to get hitched. The return of lost confidence from institutional investors is not far off.

Scrollable Gif of Smartkarma Platform
Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Scrollable Gif of Smartkarma Platform
Smartkarma Beyond Europe MiFID II

Beyond Europe: How MiFID II Spurs Regulatory Change Across the Globe

By | General

Financial firms are still grappling with MiFID II, just over a year since the regulation came into force.

What was originally intended to be internal EU regulation has now transcended borders, its impact felt by those who produce and those who consume investment research across global financial markets.

Making sense of this labyrinth of change can be a tall order given how quickly market players have moved to implement their various responses.

In this special blog feature, Smartkarma unveils a range of perspectives drawn from our network of independent Insight Providers to help establish greater clarity of what’s transpiring on the ground – and where.

Price Wars, More Red Tape, and the Search for Differentiation

The initial impact of MiFID II has been to sharply reduce the price paid for research as large banks have led pricing down. Over time, lower prices will lead to lower quality and some houses eventually withdrawing from research.

However, that is a massive step and big banks will be very reluctant to exit. Research is still seen as essential if a broader trading relationship is to be maintained. None of that is particularly good news for independent research. However, the cost structure of independent research is so different for the banks that the pressure is hopefully manageable.

While MiFID II is Europe-focused, we have seen many funds become MiFID II-compliant to simplify their own processes, while some have chosen to follow it to reduce costs. In general, MiFID II has increased bureautic processes, with costs moving from research production to managing research. Hardly a positive outcome.

On the more positive side, we are seeing more enquiries from funds looking for differentiated research. They are typically not index huggers.

– Michael Chambers
New Street Research

US: Mixed Reactions

For buy-side firms domiciled in the US, but with either EU operations or funds catering to those clients, MiFID II is in full effect. Those firms follow the MiFID II guidelines for research consumption.

While the production of reports hasn’t changed, pricing has been dramatically impacted as those firms try to absorb a significant expense (research budgets) that was previously dealt with through soft dollars.

Our EU clients have generally decided to pay for research through hard dollars, and research budgets have been slashed dramatically. Cuts of well over 50 percent have not been uncommon.

Marketing to any prospective EU-based clients has also been impacted, as blast emails and free trials are now unwelcome and raise the anxiety of any recipient not wanting to run afoul of the MiFID II police.

On the other hand, firms based in the US without a foreign footprint have generally not felt the urgency or necessity to adopt these guidelines as of yet. Research is produced, distributed, and paid for as always.

– Joe Jasper
Vermilion Research

Read our commentary on the introduction of temporary no-action reliefs in the US:
The SEC Hands Out MiFID II Lifelines, But US Firms Are on the Clock

Latin America: Not So Dissimilar from the EU

From the buy-side perspective, very large (global and international) asset managers and hedge funds are implementing the directive globally, which impacts the relationship with global and local brokers as providers of research services.

From the sell-side angle, the directive is also being implemented globally by the bulge bracket and other international investment banks.

So increasingly, as within the EU, we see dedicated pricing for research services, and at the margin, a reduction in coverage of smaller and mid-cap corporates especially by the bulge bracket. We perceive a shift of research coverage, especially in mid-caps, of quality and quantity towards locally-focused brokers initially.

With time, as bigger gaps in coverage emerge, independent research providers should take hold in Latin America. Currently in Brazil, there is at least one web-based research platform offering research products to domestic subscriber investors, and the strategy is to take this region-wide.

With regard to IPOs, there does not yet seem to be the regulatory push (as we are seeing in the UK) for independent analysts to participate in the process of due diligence.

– Victor Galliano
Independent Insight Provider

Asia: The Overarching Impact

MiFID II has already started putting pressure on large and mid-tier domestic brokerages across Asia and led quite a few to question their “me too” approach to research coverage. Given the relatively underdeveloped independent research landscape in Asia, it will hopefully nudge more analysts to take the plunge like we did, and provide true unconflicted research. A deeper independent research pool, in turn, will be better for investors and for markets.

– Sumeet Singh
Aequitas Research

China: Walled Up Against MiFID II

MiFID II may not have much of an impact on the Chinese domestic market. The government controls the flow of Chinese funds that want to invest in overseas stocks, and overseas funds that want to invest in China. Only a very small proportion is approved by the authorities.

– Ming LU
Independent Insight Provider

Japan: Succumbing to Free-Market Competition

MiFID II does not apply in Japan and a number of local subsidiaries of foreign fund management firms have changed their direct parent company structure to avoid compliance with the directive. Nevertheless, global and local brokers have responded by offering very low fees for total research access, including Japan equity research.

Irrespective of MiFID II and as a result of client pressure, most fund management houses are moving to paying for all research access from their own P&L, and are bringing Investor Relations introduction and roadshow organisation in-house.

In the ‘brave new world’ that has resulted from the directive’s implementation, the perhaps unintended consequence is that independent research houses in Japan are struggling now to make inroads into already-long ‘approved research provider’ lists at most asset management firms.

To succeed, independent research firms will have to offer a highly differentiated product, keep costs to a bare minimum, and maximise the use of innovative and efficient distribution channels such as Smartkarma.

– Campbell Gunn
TAP Japan Research

Southeast Asia: Dwindling Coverage Seeds New Opportunity

The impact of MiFID II on investment research in Southeast Asia has probably been more marked and more immediate than for the larger markets in North Asia.

Southeast Asia is the first place that large-sized investment banks have cut back their research budgets, reducing the number of analysts on the ground and hence the stock coverage.*

The ability for European fund managers to pay smaller regional brokers has also been diminished, as they are paying for research out of their own pocket, putting pressure on these players. The bottom line is that some good-quality smaller companies have very little coverage and often coverage of large-cap stocks is left to increasingly junior analysts without the experience of longer-term cycles.

This opens the way for high-quality independent analysis of Southeast Asian companies and markets. The corporates themselves are very open to meeting with independent analysts, especially when they can see that the research being written is widely distributed to institutional investors, as with Smartkarma.

– Angus Mackintosh
CrossASEAN Research

*Note by Smartkarma: Maybank Kim Eng is one exception. The investment banking arm of Malaysia’s largest lender has opted to close its Hong Kong and China equity research operations in order to service its near-term vision of becoming a leading Southeast Asian bank by 2020. Regardless, the fact that Maybank had to choose one location over the other demonstrates the resulting trend of streamlining derived from MiFID II’s impact.

Australia: More Transparency, More Intense Competition

In the Australian equity market, the local regulator has not enforced MiFID II on the asset management and brokering industries, but its implementation in other jurisdictions has had spillover effects.

Global funds managers based in Australia have implemented the change in policy and this has led domestic fund managers to follow suit. We predicted this outcome even before the policy became law in Europe.

Asset managers now make cash payments to brokers for research and phone calls. Both parties are required to keep minutes of any analyst meeting, including an assessment of the value created. That inadvertently creates more administrative work.

Commissions paid to brokers have fallen significantly and by around 20 percent across the industry.

The large global brokers are offering their research services to asset managers at a price well below the cost of producing the service and this is squeezing the mid-tier brokers that don’t have large global platforms. For example, an asset manager can pay a global broker around US$30,000 per annum for access to their entire research platform.

Mid-tier brokers without the extensive research offering are being cut as a service provider. Although none of these brokers have exited the Australian market, they are likely to do so over time.

Smaller niche brokers that use research to support small capital market deals have been unaffected and this is likely to continue; they may even see an increase in market share as mid-tier brokers leave the industry.

The market still remains oversupplied with research and is still difficult for independent research providers (IRPs) to penetrate. However, the asset management industry is now focused on paying for what it perceives as quality research. Over time, such demand should create opportunities for IRPs.

– Shane Lee
Macro Strategy Advisors

In Summary

There is little doubt MiFID II has caused quite a stir in financial markets beyond Europe’s borders. Nonetheless, the need for sweeping change also opens a rich seam of opportunity for IRPs and research distribution platforms to step up to the plate.

Three emerging challenges remain unsolved:

  1. The quantity and quality of research coverage continues to dwindle globally.
  2. Increasing bureaucracy is contributing to rising costs for managing research.
  3. Clients value differentiated research more than ever.

All three reinforce Smartkarma’s combined value proposition.

Scrollable Gif of Smartkarma Platform
Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Join For Free

Create your free account to access unlimited Executive Summaries, full research samples, and personalised alerts

Scrollable Gif of Smartkarma Platform
The SEC Hands Out MiFID II Lifelines, But US Firms Are on the Clock

The SEC Hands Out MiFID II Lifelines, But US Firms Are on the Clock

By | General

MiFID II officially entered the global financial services sector about a year ago. But while most are acutely aware of its impact on financial markets domiciled in the European Union, few understand its implications overseas.

Today, the US remains a market of focus.

Saved by Temporary Lifelines

Shortly before MiFID II came into force, US broker-dealers supporting EU investment managers were thought to be severely exposed to regulatory disruption.

The main reason: In receiving separate compensation for research services rendered, broker-dealers would be considered investment advisors under US law. That meant facing more stringent regulatory requirements, including restrictions on certain types of trading with clients they “advised”.

Broker-dealers previously skirted the requirements via an exemption in the law that allowed for research payments to be bundled with client commissions paid for executing trades. Unfortunately, the standalone research payments mandated by MiFID II all but plugged that loophole.

With no timely solution at hand, the US Securities and Exchange Commission (SEC) had to move swiftly to temper MiFID II’s impact or risk a sector-wide fallout. Such pressing circumstances led the SEC to introduce non-permanent no-action reliefs after holding consultations with the EU.

Out-and-out brokers and dealers cheered the news.

They now had a new kind of exemption, albeit a temporary one, that granted them the legal right to render research services to EU investment managers, and to receive payments separately without being penalised.

Investment advisors, too, caught a break with their own version, which permitted them to continue aggregating orders to buy or sell securities, all while receiving varying payments for research from EU clients. This was done on condition they charge clients the same average price for the security and execution costs.

A third no-action relief also helped US money managers operate within the safe harbour, as long as they paid executing broker-dealers for research with client assets through a MiFID II-approved research payment account.

Time to Ask the Hard Questions

The trio of no-action reliefs brought about a welcome respite to the US financial services sector. And to some degree, even enabled market players to act more in accordance with the spirit of MiFID II.

For the SEC, the exemptions bestowed the luxury of time to engage with other regulators, including those in Europe.

“As the staff evaluates possible recommendations, it is invaluable to hear from a diverse group of market participants,” commented SEC Chairman Jay Clayton in a press release. “In particular, it is important to have data and other information about how MiFID II’s research provisions are affecting broker-dealers, investors and small, medium, and large issuers, including whether research availability has been adversely affected.”

Still, that begs the question: How long is too long for a temporary fix?

Alluding to duration, former SEC Commissioner Kara M. Stein has warned that “while a time-limited approach may allow staff to study the impact of MiFID II, taking over 900 days is simply unreasonable.”

This inaction, she adds, may be costly to investors and advantage some market participants over others.

The industry now stands at the crossroads. Market participants can either capitalise on this new regime of provisions to gauge MiFID II’s impact and plan an appropriate response or use the temporary measures as a mere excuse to prolong inaction.

Don’t Discount Market Pressures

Those who go the distance to enact change will actually discover that it’s in their best interest, especially in winning favour from investors.

US asset managers, for example, might eventually be pressured to pay separately for research as clients demand equal treatment and cost transparency, similar to their European counterparts.

According to Smartkarma’s Head of US Business Development Warren Yeh, some have been known to go so far as to absorb the cost of research with a good deal of bravado to prove their incredible level of client accommodation.

Just last year, Vanguard Group pledged to pay for stock research it purchased from banks. A move of this measure from one of the world’s leading money managers would inadvertently place pressure on rivals to follow suit, or risk alienating themselves from clients.

Viewed in this context, free market forces can indeed be a force for change more powerful than any regulatory mandate can ever be.

David(s) vs. Goliath(s)

There is a darker side, however, to such free-market competition: Research providers – the supply side – are now caught in a tussle for market share.

Of late, more independent research upstarts have come into the fray because of increased demand generated by MiFID II.

Big banks have responded by engaging in a price war of attrition. If market participants recall, not long ago JP Morgan made headlines for offering access to basic equity research for as low as US$10,000 per year.

Insight Provider Douglas Kim, who publishes on Smartkarma, views this race to the bottom as a way to further weed out smaller independent research firms and platform operators over the next one to two years.

But price isn’t everything.

“In the end, as in every service industry, it all comes down to focusing on the customer and delivering a great value proposition,” said Kim.

“Whether it be timely, in-depth thematic research, a great long-short call, or helping the client to better understand a new technological concept, independent research providers need to provide great ideas and differentiated research on a consistent basis so that investment managers would find reasons to continue purchasing their research services,” he adds.

Tick Tock, Tick Tock

MiFID II’s strong influence in the US financial services sector is undeniable, and its long-term impact is still very much uncertain.

However, as Wall Street ponders the many ways forward to step out of the shadows of no-action reliefs, one thing remains clear: resistance to change only impedes market competitiveness.

Time is running out.


The original version of this article was published in November 2018 on TabbFORUM.

Subscribe to Our Blog

This is why China urgently needs a trade deal with the US

5 Reasons Why China (Urgently) Needs a Trade Deal With the US

By | General, Special Reports, Trade War

Whether in trade or in politics, US President Donald Trump views this principle of negotiation as a constant: “Leverage: don’t make deals without it.”

Drawn from his book, The Art of the Deal, the aforementioned quote speaks to the source of his confidence in winning a tariff-fuelled trade war with China.

It’s simple, really. China exports more goods to the US than the US does to China, making the world’s second-largest economy more vulnerable to levies.

With both sides now locked in negotiations as the deadline for the 90-day truce closes in, the damage already inflicted on China’s economy might give the US the upper hand.

Here are five economic reasons why China needs to make a trade deal, and make one fast:

1) Consumption-Based Economy: The Dream Is Fading

Chinese President Xi Jinping once remarked, “We will improve systems and mechanisms for stimulating consumer spending, and leverage the fundamental role of consumption in promoting economic growth.”

Lately, his grand vision of making consumption the lifeblood of China’s economy has been dealt a heavy blow.

Between October and December last year, the nation’s consumer confidence index reading came in at 99.4, far lower than the 105.1 figure registered during the same period in 2017. A reading under 100 suggests consumer pessimism.

Not surprising, then, that sales in consumer discretionary categories, such as the auto sector, have faltered. Chinese automaker Geely recorded a 39 percent year-on-year fall in the number of cars sold in December 2018.

Geely-39% Drop in YoY Car Sales Volume-December 2018

2) RRR Cuts: Nothing But a Short-Term Solution

Say for instance, you’re a large bank required by the regulator to maintain a certain fixed capital ratio. Problem is, the rate at which you lend far outpaces your growth rate in deposits, exacerbated by the fact that you have facility loans coming due.

The nation’s economy is facing a slowdown, meaning lending is more critical than ever to stimulating growth. Left with little choice, the central bank lowers the required capital ratio to free up cash so banks like yours can repay the loans and continue lending.

The scenario described above neatly sums up the rationale underpinning The People’s Bank of China’s (PBoC) decision in January 2019 to lower the reserve requirement ratios (RRRs) by a full percentage point.

The move unleashed RMB 1.5 trillion (~US$219 billion) in bank capital across Chinese banks, with roughly half the amount allocated to repaying maturing medium-term loans. That left banks with a diminished lending chest of RMB 800 billion (~US$116 billion) to work with.

RMB800b-(_US$116b) Bank Capital Released from the PBoC’s RRR Cut for Lending-January 2019Is this solution effective? For a while, maybe.

Is it sustainable? Not if the strategy involves eating away at a bank’s finite capital base over the long run.

3) Ballooning Debt: Too Big to Fail

Speaking of stimulus, it’s creating a giant debt problem for China that now stands at more than 250 percent of GDP.

According to Smartkarma’s recent trade war report, “increasing financial leverage in China’s economy is also compromising its ability to withstand future tariff blows.”

More US tariffs will inevitably hurt Chinese manufacturing and consumer sentiment more than it already has, further imperiling economic growth, which could encourage still more stimulus to prop the economy.

Only by reaching a trade deal with the US can China begin to restore lost business and investor confidence. That could open the door to reverse this unsustainable debt spiral.

4) Manufacturing PMI: Under 50

Still unconvinced of China’s increasing economic weakness? Take a hard look at the supply side.

Data from the Official NBS Manufacturing PMI for December 2018 came in at 49.4 (under 50), the first contraction in factory activity since July 2016. Another well-respected gauge, the Caixin China General Manufacturing PMI, posted a 49.7 reading (also under 50).

Official NBS Manufacturing PMI-December 2018Caixin China General Manufacturing PMI-December 2018What happened? “External demand remained subdued due to the trade frictions between China and the US, while domestic demand weakened more notably,” CEBM Group’s Director of Macroeconomic Analysis Zhengsheng Zhong explained in a Reuters interview.

Should these PMI readings continue their downtrend, factory layoffs might ensue. And with it, the rise of possible social upheaval. Time is running out…

5) Property Woes: Too Many Homes, Too Few Buyers

In yet another reflection of growing Chinese economic pessimism, the homebuyers’ confidence index in October 2018 registered its lowest level in nearly two years.

November 2018 data from 67 key cities showed a 0.3 percent month-on-month dip in pre-owned home prices in China, said Diana Choyleva, who publishes on Smartkarma.

“Two of China’s top three leading property developers, Evergrande Real Estate Group and Country Garden Holdings, saw November sales plunges even after cutting prices by nearly a third at some housing projects,” she added.

Unfortunately, China can’t “export” real-estate overcapacity. It needs its economy back on a firm footing to revive consumer sentiment, which, in turn, would help spur fresh demand for property.

Closing Statement

We conclude with a statement drawn from Smartkarma’s special report on the trade war: “The stakes to even the trading field have never been higher.”

For China, that means inking a trade deal with the US as soon as possible so both sides can resume normal trade relations. And in so doing, hopefully lift disruptions to supply chains and export activity.

Get the full story of how this trade war began. Download Smartkarma’s special report: The End of Fair Trade

Subscribe to Our Blog