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Chris Hulatt

This article first appeared in Pensions and Investments.

The UK is one of the best places in the world to set up a business. It’s something we should be proud of and the Government has done a fantastic job in supporting UK enterprise and investing in our entrepreneurial ecosystem.

But when it comes to supporting UK businesses in the early stage and more pressingly, scale-up phases of growth, funding sources are few and far between.

Institutional investment remains relatively untapped as a solution to plugging this funding gap. More should be done to put this capital to work.

UK pension funds in particular, managing £2 trillion of investment, have the potential to both address and benefit from this funding gap. Growth companies are seeking long-term investors, while pension funds are seeking long-term investments.

The UK Government has recognised this potential for some time, with its Patient Capital Review aiming to incentivise pension funds to increase their investment in Venture Capital.

The opportunity should not be overlooked. High Growth Small Businesses (HGSBs) – defined as those with annual growth of above 20 per cent and an annual turnover between £1 million to £20 million – are leading the way in employment, economic growth and productivity across the UK.

These unsung heroes may be relatively small businesses, but their contribution to economic growth is huge. An investment in growth companies is not only an investment in these companies, but in the broader economy.

Octopus’ recent High Growth Small Business Report reveals UK HGSBs created an average of 3,000 jobs every week in 2016. 22% of UK economic growth was created by HGSBs between 2015 and 2016.

Yet in spite of their potential to boost the economy, the funding gap persists. UK companies who outgrow the qualifications for Venture Capital Trusts and Enterprise Investment Schemes find themselves struggling to access capital to reach the next level of growth.

Worryingly, this funding gap is not unique to the UK. It has been prevalent across Europe, with the European Venture Capital market lagging woefully behind the US in previous years. Indeed, while European governments have been looking at incentives to drive institutional investment into Venture, pension funds in the US already play a pivotal role in the development of HGSBs.

Between 2011 – 2015 we saw 5.5 x more Growth Equity raised in the US than in the EU (Invest Europe and National Venture Capital Association 2016 Yearbook.) With the US Venture Capital market at such a mature stage, the investment case for US pension funds has been written for some time. In Europe, the investment case has been in draft form for longer. 

However, developments in European technology are changing the game. European growth companies are increasingly tech focused businesses with the potential to reshape entire sectors. The momentum behind these tech-backed businesses has been driving the investment case. As a result, data from Dealroom.co shows a 5 x increase in capital invested in European growth companies from 2012 to 2016, and there’s been a notable ramp up in deal activity. 

With the European Ventures market coming of age we’ve seen first-hand growing interest from UK pension fund committees in this investment route.

Previously in the UK, some of the biggest barriers for pension funds have been the perceived risk associated with growth companies; limited allocation opportunities and difficulty allocating Venture Capital to a set and restricted allocation pot.

We’ve now reached an inflection point, where a number of factors are coming together to remove these barriers to entry.

Firstly, Venture Capital is often considered a risky investment. For pension funds looking for long-term, stable investments this allocation can be hard to justify. A growth company whose business model is unproven often looks significantly riskier than an established FTSE 100 brand.

Yet, over the last 10 years or so, technology has changed perceptions of where the risk lies, enabling highly-skilled newcomers to transform sectors and challenge the incumbents. Challenger companies such as Secret Escapes, Zoopla and Swoon Editions – which Octopus has backed through its own institutional Funds – have changed the way customers book travel, find new homes and purchase furniture. Secret Escapes, for example, brings luxury, discounted holidays to subscribers at the click of a button. Compare this business with a travel brand with a longer heritage, say Thomas Cook; the risk comparison is no longer black and white in favour of the incumbent.

In many cases, technological developments and the quality of entrepreneurs behind these companies make the challengers look less risky than incumbents. The investment case for tech-related start-ups in particular is becoming hard for pension funds to ignore.

Secondly, in the past, the scale of European Venture Capital funds was generally too small for pension funds to pursue. Administratively the hassle of allocating 10% of capital to a Venture Capital Fund, for example, was off-putting. As European Venture Capital Funds continue to grow in scale there will be more opportunities for pension funds to allocate a meaningful sum.

Lastly, set allocation pots can limit pension funds’ ability to be creative with their investments. Venture Capital does not sit comfortably within set “fixed income” or “equity” allocations. Venture Capital is now on the radar of investment committees who we expect to increasingly rethink and redesign their allocation boundaries to incorporate Venture in future.

The US has proven that pension fund investment in Venture is a win-win. As the European Venture market comes of age, pension funds across Europe should follow the US’ lead.

In the Brexit environment, the UK in particular would be wise to look after its HGSBs. As some of the most productive businesses in the UK, creating an additional 2 months of economic output per year compared to the average UK business, HGSBs will be central to economic growth in a post-Brexit world.

By adding these companies to their investment portfolios, pension funds can ensure HGSBs get the funding they need, while accessing the potential for long-term returns.

For journalists in their professional capacity only. The value of an investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they invest. Personal opinions may change and should not be seen as advice or a recommendation. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: May 2018.