Are transaction costs holding back UK equity markets?

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The writer is the founder of Candor Partners

There has been a lot of talk about pension funds being big sellers of UK listed shares, but who do you think has been among the big buyers? They are the listed companies.

Capital returning to investors from our mature listed companies is around £120bn annually, according to AJ Bell research. This capital is returned to investors mainly through dividends and share buybacks. In the UK, AJ Bell predicts buybacks will account for around a third of the total in 2024.

But not all of the benefits of buybacks go to shareholders. Much is lost in transaction costs. If this friction on capital flowing between investors and issuers could be reduced, there would be great benefits for the UK equity market. Changing the disclosure rules could make a significant difference in this regard.

In the case of returning money to shareholders through dividends, there is minimal friction, with shareholders receiving almost all of the money minus negligible fees.

However, share buybacks present a more complex scenario. The friction here affects two groups differently: selling shareholders and remaining shareholders. Explicit costs include execution fees, advisory fees and transaction fees. Implied costs – these arise from the timing and impact of a buyback on the market price of shares – are harder to calculate, but crucial.

When a company buys shares, it essentially buys those shares on behalf of the remaining shareholders. The selling shareholders get the money, and the remaining shareholders get an increase in their ownership of the company.

Most of our issuers repurchase shares in the open market. This means that the selling shareholders are not selling directly to the issuer, but in the market, which introduces a layer of complexity and an opportunity for intermediaries.

Our market rules must balance the interests of both the sellers and the remaining shareholders. In a share buyback, the sellers benefit from an immediate increase in the share price. But remaining shareholders would benefit more from lower initial prices, which would allow more shares to be bought back. The higher initial prices represent the implicit costs borne by the remaining shareholders.

Current disclosure laws that require buyback plans to be announced in advance are meant to promote transparency. But they can inadvertently disadvantage remaining shareholders by raising prices prematurely. Consider the hypothetical scenario where Warren Buffett announced a £1 billion purchase of a UK company – the price would likely rise significantly before he could start buying, thereby increasing the costs of the acquisition – a kind of friction.

While transparency is generally beneficial, excessive transparency of large orders such as buybacks can harm the very investors it is supposed to protect. Allowing companies to delay some disclosures until after the buyback is complete, as their US peers can do, would maintain transparency while protecting remaining shareholders.

This approach might seem less fair to the selling shareholders, but we must remember that all shareholders have a choice to sell or stay. Furthermore, immediate disclosure is much more advantageous to faster-moving intermediaries than to shareholders themselves.

Average redemption execution friction in the UK market is currently immeasurable. But we estimate that the theoretical transaction cost – both explicit and implicit – of an average share buyback in the UK and Europe is around 4.7%.

The potential for real cost reduction can be seen in the outperformance of companies that do share repurchases compared to a basket of their peers that do not. For a basket of UK and European companies, it was 11% in the 12 months to June, according to Morgan Stanley. Some of those gains will be lost to remaining shareholders as shares rise on the buyback announcement.

Just 1% of extra costs add up to £600m of lost returns for our investors every year, and the most powerful part of this is that any reduction in these costs compounds over time. Do the math for our pensions over 30 years for a saving of just 1 per cent, compounding the FTSE 100’s average annual total return of 7.4 per cent.

Small marginal gains are the differences between capital markets that thrive and those that fade. Excessive friction on the transmission of capital through our market has hampered our entire ecosystem.

Reducing these costs on this capital increases yields, which attracts more investors, which narrows valuation discounts, which attracts new issuers to the UK. Capital markets need tending. When they are healthy, the whole country benefits.