Reviving UK Capital Markets: The Role of Investment Research

Reviving UK Capital Markets: The Role of Investment Research

By Neil Shah, Director of Research at Edison Group

The UK’s capital markets are struggling. A slump in stock valuations, particularly in tech, a barren IPO market, and the delisting of companies in the UK all highlight the London Stock Exchange (LSE) and the City’s decline. As a result, investors’ interest in the UK capital market is dwindling. This is compounded by the lack of investment research, particularly on small and mid-cap companies, and the availability of investment research, especially for retail investors. In this vicious cycle, neither the market nor investors have the correct resources to thrive.

Rachel Kent’s Investment Research Review provides an opportunity to break this cycle.

Conducted for the UK government, the Investment Research Review would stimulate demand for UK equities and, in turn, uplift the UK’s capital market by improving the quantity and availability of investment research.

Since published, the findings of the review have been endorsed by the government and Chancellor Jeremy Hunt, who indicated the suggestions of the review will be carried out by mid-2024. With the Autumn Statement approaching, all eyes will be on Hunt, who is expected to bring more clarity to the particulars of this policy, including its free structure.

Power of small and mid-cap companies

Small and mid-cap companies are critical to economic growth. They foster innovation and job creation, providing the dynamism that can propel capital markets, including the UK’s. However, without access to sufficient capital, these companies often find themselves stifled and unable to realise their full potential.

The pre-existing challenges for small and mid-cap companies have been worsened by MiFID II regulations, which looked to increase the transparency of costs and improve record-keeping of transactions across virtually every asset and profession within Europe’s financial services industry.

While meant to restore confidence in the industry after 2008, in reality, it has targeted small and mid-cap firms which struggled with the unbundling rules that brought a separation of costs, constraining fund managers’ budgets with limited payment options for third-party research. As a result, far less research has been done on small and mid-cap companies since MiFID II. Instead, funding has gone into the research of well-known equities with greater market capitalisation.

Rachel Kent’s suggestion for the Investment Research Review to eliminate MiFID II’s unbundling regulations would address the disparity in research between small and mid-cap companies versus large-cap companies. In turn, it would offer much-needed flexibility for UK managers to access non-UK research, align with US regulations, distribute resources freely, charge investors for research expenses, and ultimately boost demand for research coverage. While implementing this change may require time, it is a solution that would increase transparency at the fund level for research funding.

Bridging the information gap

To attract investors, there must be a wealth of information available on UK equities, particularly for retail investors who have seen their presence dwindle from 50% of the investment market in the 1950s to a mere 12% today, according to Edison research. One primary reason for this decline is the stark disparity in access to information between retail and institutional investors. This is where Rachel Kent’s Investment Research Review steps in to bridge the information gap, promising to provide a level playing field for all investors.

As seen above, reduced research coverage for small and mid-cap companies is in part, a side effect of MiFID II regulations. This lack of research leaves investors, particularly retail investors, in the dark about the potential of these companies. However, there is a lack of research that is readily available to retail investors – for all companies. This information asymmetry undermines the efficiency of the market and hinders investment in companies that could otherwise flourish.

The Investment Research Review aims to address this by increasing the quantity and accessibility of investment research, particularly for small and mid-cap companies. By doing so, it not only empowers retail investors but also invigorates the entire market ecosystem. This initiative aligns with the UK Government’s goal of expanding access to investor research, thereby promoting inclusivity.

A stark indicator of the issue at hand is the underwhelming performance of recent IPOs on the LSE. Of the 125 IPOs that recently joined the LSE, 103 are trading below their IPO prices, with 69 of them plummeting by 50% or more according to Edison’s calculations. Further, the number of companies issuing an IPO on the LSE since January 2015 has decreased by 22%. Partnered with headline coverage of prominent companies such as Arm and We Soda cancelling its LSE IPO in favour of US exchanges appearing regularly, the lack of confidence in London as a financial centre is clear.

Investment Research Review’s solution

A prominent recommendation from the Investment Research Review is the establishment of an accessible research platform. Almost serving as a ‘Netflix’ for investment research, the platform would balance the supply and demand for equity research – providing investors, particularly retail investors, with company research while giving issuers and research third parties a direct channel to these investors. This serves as a near-term solution designed to create a marketplace between issuers, investors, and research providers while encouraging broader access to research on small and mid-cap companies.

While specific details about the fee structure of this platform are still forthcoming, a substantial portion is anticipated to be subsidised by the government. What remains uncertain is whether large-cap corporations will also contribute to the platform’s funding. Clarity on these aspects is expected in Hunt’s upcoming Autumn Statement. An essential element for the platform’s success which must be accounted for in the fee structure is ensuring it offers free access to all retail investors, minimising barriers to entry. Additionally, the fee structure needs to be carefully designed to facilitate efficient connections between issuers and providers while staying within budget.

The UK’s struggling capital market and decreased retail investor engagement require immediate action. Rachel Kent’s Investment Research Review can play a pivotal role in revitalizing these markets by closing the information gap and empowering all investors, ultimately boosting interest in small and mid-cap companies and rejuvenating the UK investor landscape. It is a promising step towards reinvigorating the City – now to see how the Autumn Statement progresses.