Are transaction costs holding back UK equity markets?

The writer is founder of Candor Partners

There has been much discussion about pensions funds being big sellers of listed UK equities but who do you think has been among the big buyers? It’s the listed companies themselves.

The capital flowing back to investors from our mature listed companies runs at around £120bn annually, according to research from AJ Bell. This capital is returned to investors primarily through dividends and share buybacks. In the UK, AJ Bell estimates buybacks account for roughly a third of the total in 2024.

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

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

Share buybacks, however, present a more complex scenario. The friction here affects two groups differently: selling shareholders and remaining shareholders. Explicit costs include execution commissions, advisory fees, and transaction taxes. Implicit costs — they arise from the timing and impact of a buyback on the market price of stock — are harder to calculate but crucial.

When a company is buying back shares, it is essentially buying those shares on behalf of remaining shareholders. The selling shareholders receive the money, and the remaining shareholders receive an increase in their ownership share of the company.

Most of our issuers repurchase shares on the open market. This means that shareholders who sell, do not sell directly to the issuer, but into the market, which introduces a layer of complexity and an opportunity for intermediaries.

Our market rules need to balance the interests of both selling and remaining shareholders. In a share buyback, sellers benefit from an immediate share price increase. But the remaining shareholders would benefit more from lower initial prices that would allow more shares to be repurchased. Higher initial prices represent the implicit costs borne by the remaining shareholders.

Current disclosure laws that require buyback plans to be announced upfront are intended to promote transparency. But they may inadvertently disadvantage remaining shareholders by driving up prices prematurely. Consider the hypothetical scenario of Warren Buffett announcing a £1bn purchase of a UK company — the price would likely jump significantly before he could begin buying, thereby increasing his purchase costs — a friction of sorts.

While transparency is generally beneficial, excessive transparency on large orders like buybacks can hurt the very investors it should aim to protect. Allowing companies to delay some disclosures until after the buyback’s completion, like peers can do in the US, 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 the choice to sell or remain. Moreover, immediate disclosure is far more advantageous for the faster-moving intermediaries than shareholders themselves.

The average friction on buyback execution across the UK market is currently unmeasured. But I estimate the theoretical transaction cost — both explicit and implicit — of an average share buyback in the UK and Europe is around 4.7 per cent.

The potential for actual costs to be reduced can be seen in the outperformance of companies carrying share buybacks compared with a basket of their peers not doing them. For a basket of UK and European companies, this was 11 per cent over the 12 months to June, according to Morgan Stanley. Part of those gains will have been lost to remaining shareholders as the shares rise on the announcement of the buyback.

Just 1 per cent of additional costs add £600mn of lost returns for our investors each year, and the most powerful part of this is that any reduction in these costs compound over time. Do the maths for our pension pots over 30 years for just a 1 per cent saving by compounding at the FTSE 100’s average annualised total return of 7.4 per cent.

Small marginal gains are the differences between capital markets that prosper and those that fade. Excess friction on the transmission of capital through our market has held back our whole ecosystem.

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