Sticker Shock: Small Hedge Funds Seen Ditching I-Banking Research Under MiFID

For the past several months we"ve discussed many theories about how the new MiFID II rules in Europe might drastically change the investment banking research business model.  For those who haven"t followed this narrative, MiFID II is a new set of regulations in Europe that requires investment banks to charge separately for research as opposed to just lumping it into an asset manager"s trading fees. 

Here are a couple of our thoughts/predictions:

1. Investment banks will find that there just might be a very large bid/ask spread between what they think their research is worth and what their clients are willing to pay for it.


2. Exorbitant research fees will create even higher barriers to entry for upstart hedge funds and cause existing small funds to ditch research vendors altogether.


3. Large asset managers will be forced to cut back their research vendors leaving smaller, independent research shops doomed.

So far, it looks like 2 out of 3 of our predictions have come true. 

Just last week our first prediciton seemingly came true when Deutsche Bank announced plans to slash the price of their fixed income research in half due to a "lack of demand" (see: Deutsche Bank Forced To Slash Fixed-Income Research Price By Half On Lackluster Demand). 

Now, as Bloomberg points out today, small hedge funds are seen ditching pricey research packages because they simply can"t afford it.

“The numbers I’ve heard in terms of what’s going to be paid looks completely impossible for smaller managers,” said Samuel Gruen, who started Lightfield Capital last year and whose his firm manages $20 million from London. The rules will force people to “rethink the investment process when launching a hedge fund.”

Theron de Ris, who oversees less than $10 million at Eschler Asset Management, said he plans to stop getting outside research altogether because of the new rules.

“I’m not going to consume sell-side research for the foreseeable future,” said de Ris, Eschler’s London-based managing partner. “It’s not going to change my world if they stop coming.”

Of course, in the end, MiFID II’s new research rules only serve to reinforce the advantages that larger and wealthier asset managers have always had over smaller funds.  Since 2009, over 80% of hedge fund failures have come from small funds with under $100 million in capital to manage and that"s likely to only get worse.

Meanwhile, even Tony Chedraoui, founder of Tyrus Capital which has $2.3 billion in AUM, tells Bloomberg that his firm is evaluating what research is essential and what it can safely “scrap.”  All of which means that prediction number 3, on our list above, is well on it"s way to coming to fruition.

Spot The Conflict(s): This Strip-Club Operator Pays Sidoti $40,000 A Year To Cover It's Stock

We"ve spent a lot of time of late discussing Europe"s new MiFID II regulations that will go into effect in January 2018 and require investment banks to charge institutional clients separately for trading commissions and research.  As we"ve noted (here and here), initial offer prices are coming in relatively high at around $450,000 per bank...all of which led us to the following conclusions:

Of course, the logical takeaway from these exorbitant offering prices, if they hold, is that institutional clients will ultimately be forced to consolidate their vendors...translation, so long to the small independent research shops.  Meanwhile, investment banks will be forced to control costs by trying to focus on writing reports that people actually read (vs. the 1% hit rate they have today).  All of which means that those shrinking analysts pools are about to completely collapse.

Alas, it seems that we may have been a bit premature in our prediction of an early demise for independent research shops, at least if Sidoti and Rick"s Caberet has anything to say about it.  In light of the new regulations that will undoubtedly disadvantage his research firm, Peter Sidoti has embraced a whole new, fundamental-transformed research business model that he hopes will save his business...charging the companies he covers for research about themselves.  More from Bloomberg:

With the future of equity research looking shakier than ever, one boutique U.S. firm is betting its turnaround on getting paid by a different customer: the company being covered.

As analyst budgets get slashed amid new regulations designed to reduce conflicts of interest, Peter Sidoti hopes that laying those conflicts out in the open with company-sponsored research can bolster his small-cap focused firm, Sidoti & Co. “The wheels came off” Sidoti’s trading-pays-for-research model about a year ago amid shrinking fees and the rise of passive investing, he said. Bring in new rules requiring direct payment for research, “and all hell breaks loose.”

Three companies -- a strip-club operator, a pet products company and a chipmaker -- pay Sidoti $40,000 a year for coverage by the firm’s 25 analysts. Ultimately, he sees one-third of the stocks his firm covers, now around 300, being paying customers. The sweet spot for research sponsored by companies is those with a market capitalization of under $300 million and which have one or no analysts covering them, Sidoti, the founder and CEO of the firm, said in an interview in New York.

Wouldn"t it be ironic if new regulations specifically designed to eliminate banking conflicts actually resulted in an even more conflict-ridden business model?

But, at least Rick"s CEO is happy with his coverage...

Adult entertainment and sports bar company RCI Hospitality Holdings Inc., which pays for Sidoti’s services, said that it is challenging for smaller companies to get quality, independent analyst coverage. “We believe Sidoti has contributed to our overall effort to increase the understanding of our business and financial model,” Eric Langan, RCI’s Chief Executive Officer, said in an email. The company, which operates the Bombshells bar chain, has seen its stock gain 92 percent since Sidoti started coverage. Pet-products company OurPet’s Co. and chipmaker Ixys Corp., which are also paying customers of Sidoti, didn’t respond to multiple requests for comments.

Sidoti defends it"s rather controversial business model by comparing it to Moody"s and S&P which employee similar funding strategies...unfortunately, the weaknesses in those funding strategies were exposed for all the world to see during the mortgage crisis.

“We think equity research is heading the same way as debt research,” Sidoti said, drawing a comparison with how debt-rating companies like Moody’s Investors Service and S&P Global Ratings are paid by issuers to produce reports. While this model has also been fraught with conflicts and controversy, especially in the aftermath of the financial crisis, Sidoti sees a new opportunity for the sponsored-research model arising from the European Union’s MiFID II rules.

While we jest, at least the conflicts in Sidoti"s business model are overt and open for the world to see...unlike the current model which pretends to be "independent" but secretly favors the perpetual advisory fee generating companies they cover and give preferential treatment to their favorite hedge funds.

Finally, since we know that you really only clicked on this post to see a larger picture of the teaser image, here you go...Happy Friday.