Why smaller hedge funds could be most impacted by new EU rules on research

With MiFID II, sweeping European regulations changing the face of brokerage research, bearing down, market participants are acting “like a deer in headlights,” according to one brokerage executive. Another report notes that the most numerous segment of the research consuming demographic is planning to simply forgo paying for research altogether. But could the US Securities and Exchange Commission provide large international banks, brokerage firms, and asset managers relief?

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The largest segment of the research consuming audience, smaller hedge funds, plans to do without research

Sweeping regulation that forbids institutional brokerage firms from “bundling” free research and other consulting services in a higher trade execution transaction cost is approaching like an oncoming train rounding a curve with a car stuck on the tracks. The practice, which is illegal in certain regulatory regimes for retail-focused derivatives asset managers, is set to take effect January 3. Anyone doing business in Europe will be required to conform to pay for research separately and how it is consumed. The regulations should not come as a surprise, as they have been under consideration since April 2004.

The biggest consumers of large brokerage research are hedge funds, and within this group, nearly 75% are smaller firms. Rather than play the research game, many hedge funds, particularly the smaller players, are eschewing brokerage research altogether rather than pay up to $455,000 per year, as Barclays is currently asking for their research.

“I’m not going to consume sell-side research for the foreseeable future,” Theron de Ris of London-based  Eschler Asset Management told Bloomberg. “It’s not going to change my world if they stop coming,” he said, while nonetheless categorizing the research as “quite useful.”

“Quite useful” is a relative term. Even with JPMorgan coming in with the low bid to date of $10,000 for a skinny bundle of stock research, the real measure of “quite useful” is likely to be determined by how many hedge funds are willing to pay for the service.

On that score, a simple understanding of business models might indicate that demand might be expected to be weak.

Smaller hedge funds operate on tight margins with little room for a research budget

The business model for most hedge funds isn’t spectacular, particularly at the end of the business with the largest number of funds.

Citigroup estimated hedge funds need from $224 million to $250 million of assets under management to break even on their business model – although we had some big questions on that study. Smaller hedge funds have been most dramatically impacted by fee pressure of late, which reduces their net income. This can be seen in part through the mortality rate. 82.3% of the 7,000 hedge fund closures since 2009 have been firms with less than $100 million under management, according to Eurekahedge.

“The numbers I’ve heard in terms of what’s going to be paid looks completely impossible for smaller managers,” Lightfield Capital founder Samuel Gruen, who manages $20 million from London, was quoted as saying. The smaller firms that don’t have the budget to employ a research staff and might need bank research the most are most likely to do without, which is forcing new fund managers to “rethink the investment process.” Gruen has stopped using outside research while even larger firms, such as the $2.3 billion Tyrus Capital, are making plans on what research they can “scrap.”

With both large and small firms looking like “deer in headlights,” according to Cowen Inc. President Jeffrey Solomon, a savior could be on the way: the SEC.

That observation is echoed by Jeff Sprecher, CEO of Intercontinental Exchange Inc., which operates both a derivatives and stock exchange. “We’re going on sales calls and cold calling people to talk about these things, and they look at us like we have three eyes,” he was quoted as saying.

Bloomberg is reporting that large banks are lobbying the SEC to provide relief and delay the implementation, with the expectation that the agency will act now that it has Jay Clayton installed as Chair of the stock market regulator.

On the positive side, (at least in terms of equity bottom down focused) smaller hedge funds tend to look at smaller caps. Large caps have far more brokerage research than smaller companies, so in some ways it could even out.