Patient capital review: Are fund managers hindering the UK’s scale-ups?

The UK ranks third in the OECD for business start-ups, with 350,000 new businesses created in 2014.

But a new Patient Capital Review, launched by the Treasury, hopes to address why those firms are failing to attract scale-up capital. When it comes to the number of scale-up businesses based in the country, the UK only ranks 13th in the OECD, despite being home to one of the world’s most dominant financial centres.

The review, announced in November, is part of the Government’s Industrial Strategy to increase productivity and drive growth as the UK prepares to leave the EU. A consultation will be launched, with final recommendations ahead of the Autumn Budget 2017. An industry panel, including Neil Woodford, Legal & General chief executive Nigel Green and Miton’s Gervais William, has been assembled and the Treasury is in early discussions with the investment industry. It will be chaired by Damon Buffini, former head of private equity house Permira.

Prime Minister Theresa May says the review will examine how firms can “break down the obstacles to getting long-term investment into innovative firms”.

Woodford lays blame on the risk-averse asset management industry. “There is an appetite in the saving community. The problem is the bit in the middle: the advisers and the fund managers do not have the mindset to invest,” Woodford told a House of Lords select committee on science and technology.

Speaking to the committee in March, Woodford said he created the Woodford Patient Capital trust in response to market research that showed retail investors want to invest in early-stage businesses. Since its launch in April 2015, the fund has reached £752.98m market cap. Four of its 10 largest holdings are unquoted: Oxford Nanopore, Immunocore A, Proton Partners International and Oxford Sciences Innovation.

“It is the failure of the fund management industry – the capital allocation industry, if you like – to embrace the long-term patient capital approach that is required for success in this sector,” Woodford said.

But he reckons the Government can incentivise more capital to flow from savers into early-stage companies through targeted fiscal incentives, such as inheritance tax incentives. “Targeting them at a specific type of investment would catalyse my industry to create the products that would capture that flow. The FCA’s focus on liquidity and resistance to ‘hard-to-value’ securities is also a problem,” he says.
Computer chip firm Arm was the one UK scale-up from the science sector on track to enter the FTSE before its sale to Japan’s SoftBank shortly after Brexit, Woodford told the committee.

Jackie Hunter, chief executive of artificial intelligence business BenevolentBio, who also addressed the committee, listed Solexa and Heptares Therapeutics as other high profile British businesses that were sold to foreign buyers. The former was bought by US company Illumina for $600m in 2006, while the latter was acquired by Japanese company Sosei in 2015 in a $400m deal. Series A and Series B funding is much less in the UK than the US, Hunter argues.

The AIC has already released its initial comments on the review, including a Patient Capital Isa proposal. The Investment Association says it will publish its consultation in response to that document and expects it to dovetail with some points raised in its Productivity Action Plan, released last year, which examined short-termism in the industry.

The greatest opportunity to mobilise additional sources of finance for investment in patient capital lies in changing the perspective of IFAs, the AIC says in its initial comments document. It estimates they allocate 1 per cent of client assets to investment companies, which chief executive Ian Sayers argues are perfectly set up for patient capital, allowing liquidity regardless of the underlying assets.

“Everything you would traditionally think of in the patient capital arena, which is small start-up businesses, growing private companies, we would throw into that infrastructure, it is very difficult to incorporate into an open-ended structure.”

A regulatory focus on specific product recommendations, rather than creating a balanced portfolio, is holding IFAs back from recommending products in alternative asset classes, the AIC submission on the Patient Capital Review says. It notes that the Wealth Manager Association private investor indices recommend holdings between 7.5 per cent and 17.5 per cent allocated to hedge funds and alternatives, depending on a client’s risk appetite.

“In the absence of any form of tax incentive, the money will go into what people already know and are familiar with, so within Isas that would be cash or mainstream equity funds. How much of that directly or indirectly gets into what we would call patient capital… I think we can confidentially say it would be less than half a per cent,” Sayers says. He reckons around 20 per cent of members by assets would be allo­cated to what could be termed patient capital.

Responding to concerns that the Isa landscape is already complicated enough, Sayers says he envisions a Patient Capital Isa that would be a top-up to the existing allowance, which would make it available only to investors with more than £20,000 annually to invest, under new limits for the 2017 tax year.

Mark Brownridge, director general  of the Enterprise Investment Scheme Association (EISA), says defining what patient capital means was one of their first questions when they met with the Treasury to discuss the review at the end of March.

The US aside, he says other countries are keen to replicate the success of UK schemes like the EIS, with China, Canada, France and Malta among the countries from which the association has fielded queries.

But Brownridge admits there are gaps in the funding cycle. “We see a lot of companies start up in the UK and it goes quite well, and then it gets to a cut-off point where they don’t know what to do next. They can try to get some more funding, and they go on through that, but often they don’t find any funding, so we perhaps lose them to the US or China.

“There’s a gap that needs filling and I think that’s where the Patient Capital Review is coming from.”

Woodford, whose trust invests after the seed stage, suggests that the gap for UK start-ups is for scale-up capital. Often after firms have accessed EIS or VCT finance, although he notes those avenues are important for early-stage firms and creating businesses.

The Patient Capital trust invests in early stage companies – pre-revenue and pre-profit – and early growth companies, which have overcome earlier risks and are attempting to penetrate target markets.

A Government report on closing the gap between UK and US scale-up companies by 2025 described them as businesses with 20 per cent annualised growth over at least a three-year period.

Clash of interests
Conflicting interests between the Treasury and the FCA are part of the problem, says Kealan Doyle, chief executive of Symvan Capital, an EIS and SEIS investment manager primarily focused on tech. The Treasury wants to encourage investors into high growth companies, but the regulator “would like very much if a retail investor never lost money again on an investment”. Doyle says this means many wealth managers avoid growth sectors in favour of other products.

Awareness also needs to be addressed, says Hugi Clarke, director at Foresight Group, an EIS, VCT and private equity investment manager. “While the products are unquestionably high risk, and often higher risk than many investors are used to or equipped for, for some investors there is a place for these investments as part of a broad and balanced portfolio.”

Fraud detection software company Alaric Systems, which the company supported over 11 years through multiple rounds of funding, and MPL Systems, which Foresight has held since 1999, are among holdings Clarke would describe as patient capital success stories. The former sold to US-based NCR Corporation for $84m, but the latter remains a UK business.

Currently 30,000 investors take advantage of the tax advantages of EISs and SEISs, but there are 4.9m higher-rate taxpayers. Clarke says EIS investments represent a 98 per cent tax break for investors who employ the 30 per cent income tax relief, combined with 40 per cent IHT relief and 28 per cent CGT deferral.

“There is always more that could be done, but EISs are already the most tax advantaged investment it’s possible to make.”

Depending on the outcome of Brexit negotiations, UK start-ups could be cut off from the European Investment Fund, which had supported 27,7000 SMEs in the country by the end of 2015. But there is potential to address EU State Aid rules following the UK’s exit from the EU. A lot of EISA members say the strict rules introduced in 2015 have restricted them from investing in good businesses, Brownbridge says.

“For example, you can’t invest through EISs in a business that has been trading for more than seven years,” he explains. “Our point of view is that there shouldn’t be a time limit on when a company decides to scale up.” This is particularly true for some sectors, such as life sciences, Brownbridge adds, which can have a long gestation period.

Patient Capital Review

Announced by the Prime Minister in November, the HM Treasury-led review will identify barriers to access to long-term finance for growing firms. The terms of reference set out that the review will:

  • Consider the availability of long-term finance for growing innovative firms looking to scale up
  • Identify the long-term root causes affecting the availability of long-term finance for growing innovative firms, including any barriers that investors may face in providing long-term finance
  • Review international best practices to inform recommendations for the UK market
  • Consider the role of market practice and market norms in facilitating investment in long-term finance
  • Assess what changes in Government policy, if any, are needed to support the expansion of long-term capital for growing innovative firms