Unintended Consequences: The Big Are Getting Bigger

by | Oct 29, 2019

As regulations ramp up, so does the barrier for entry that stands in front of small and midsized asset managers. Many asset managers have already transformed their business models to comply with MiFID II. One of those changes is a move towards paying for research services from profit and loss (P&L) rather than using client money when consuming research, advisory and corporate access services from the sell side.

This change is creating yet another unintended consequence, by increasing the cost to operate by making it difficult for smaller asset managers to remain competitive versus their larger peers.

MiFID II regulations have put new requirements on the use of client money which in practice can be onerous and restrictive, especially when it comes to meeting with companies. Investment managers have always placed high value on meeting a company arranged by the sell side as part of the investment due diligence. Limiting the use of client money has left buy-side firms with no choice but to pay from P&L.

This development has liberated certain investment managers from disclosing how they use client money to support investment decisions.

Larger asset managers can afford to do this given their economies of scale and fees earned while smaller asset managers, more reliant on outsourcing services, are finding it increasingly difficult to maintain a margin of profitability. 

For smaller asset managers, this change in regulation has challenged their operating model, making them more dependent on outsourcing to the sell side to keeping their internal resources and costs lower. Absorbing additional costs has caused drastic change and a challenge as asset managers now have to reassess the value of their research commission budget and reallocate dollars to a variety of internal costs. Building up in-house research capabilities and a dedicated corporate access team is one of a few ways investment managers are defending against these changes. While this is not ideal by any stretch for the industry, it’s even more burdensome for small and midsized managers. 

As a result, it’s creating an uneven playing field that could have far-reaching consequences that start with reduced competition and ultimately lead to consolidation. With consolidation becoming more prevalent across the investment management industry, smaller buy-side firms are seeking partners to help consume these inherited costs.

For example, Franklin Templeton Investments, with $717 billion in assets under management (AUM) in 2018, acquired Benefit Street Partners last year, which had $26 million in AUM. According to a report in February this year by Sandler O’Neill, there was a record-high 253 merger and acquisition (M&A) transactions with asset management firms in 2018.

Coincidentally, Sandler O’Neill and Piper Jaffray announced a merger agreement this summer. These M&A deals have helped firms relieve pressures from compliance costs, diminished transaction fees, and margin compression.

Meanwhile, as the buy side brings services in-house, it’s reducing the overall fees paid to their sell-side providers. As such, the sell side is going through its own transformation, cutting staff and small and midsized asset managers, left to make a decision; they can either add staffing to fill the holes left in the research gaps or team up with other firms that have the scale and capabilities to help support their needs.

Perhaps the landscape would be different if the U.S. Securities and Exchange Commission (SEC) had collaborated with European regulation officials on the implementation of MiFID II. We’re now months away from the expiration of the SEC’s no-action assurances, which means U.S.-based firms will have to fully comply with Europe’s research rules. Increasing the cost to operate and making it difficult for smaller asset managers to remain competitive is another unintended consequence of regulatory reform.

I suspect we will see more change and consolidation in the years to come as the viability of smaller firms to remain independent is thoroughly tested and the barrier for entry and profitability doesn’t appear to be getting easier anytime soon. More important is choice, liquidity and access to services for the everyday investor. Instead, we are seeing less as the big continue to get bigger. 

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