Outsourcing provider CRISIL Global Research and Analytics made dire predictions of the impact of MiFID II’s unbundling provisions on the profitability of European and US asset managers, arguing that operating profits could decline by 17% to 29%. The harsh numbers are the result of aggressive assumptions which we believe are unfounded.
CRISIL’s report, “Asset Managers face profitability pressures: The implications of Europe’s research unbundling for Asset Managers” is centered on a pro-forma analysis of ten large active European managers and an unspecified number of US managers.
The analysis attempts to first calculate the research spending of the asset managers by estimating the equity trading activity (assets x turnover x percentage of equity assets). The paper uses a commission rate of 12 bps, which assumes that most of the trading is high-touch bundled trades. This underweights execution-only trading, in our view inflating the imputed research costs which are assumed to be 50% of commissions. Strangely, CRISIL uses a 10 bps commission rate assumption for its analysis of US asset managers, even though US commissions are cents per share, not basis points.
CRISIL comes up with a base case estimate of €1.8 billion of research spending for its ten European asset managers. It then assumes that asset managers will pay for 80% of their research costs under its base case scenario. CRISIL provides no explanation for assuming that the majority of research will be paid from the P&L, other than that a few firms have chosen this funding route.
The pro-forma analysis then deducts the assumed new research costs from operating profit, and concludes that operating profits will drop 16.8% under its assumptions. CRISIL also provides a ‘bear’ scenario where profits drop 29%.
The paper applies similar assumptions (including a willingness to pay 80% of research costs from the P&L) to an unspecified number of US asset managers and derives a 9% to 16% drop in US asset manager profits. The lower numbers are primarily the result of assuming an average commission rate of 10bps for US firms rather than 12 bps for European firms.
CRISIL Global Research & Analytics (GR&A) is the outsourcing component of CRISIL, which includes Irevna (a KPO firm acquired in 2005) and Coalition (a consulting firm focused on the investment banking industry acquired in 2012). CRISIL, majority controlled by S&P Global, says it is the world’s largest provider of equity and credit research services.
CRISIL is hoping to expand its outsourcing business with asset managers who find it cheaper to outsource research rather than pay for external research. Its pro-forma may therefore be more an example of wishful thinking than an industry forecast. The direction of travel is for asset managers to fund research payments with client commissions, as permitted under MiFID II. This is by no means a foregone conclusion in Europe (merely our view) but it is virtually certain that US asset managers will not pay for 80% of their research costs out their P&L, unless the US Congress suddenly wakes up and decides to repeal Section 28(e) of the Securities Exchange Act of 1934.
IHS Markit and Expand estimated that the top 400 global asset management companies will spend more than $1 billion in 2017 to adopt systems and processes for MiFID II compliance, including systems to implement new research procurement rules. According to asset management consulting firm Casey Quirk, global asset management industry profits are in excess of $100 billion. If overall MiFID II compliance costs represent approximately 1% of industry profits, CRISIL’s estimates seem extravagant at best.