Equity Invested in UK SMEs has increased significantly in recent years
A recent report published by Oliver Wyman and the British Business Bank on the best ways to generate higher returns from pension pots, provides a clear insight into the potential returns from investing in technology and other private companies especially as part of a longer term growth strategy.
With investment in UK Small and Medium Enterprises (SME) increasing significantly over the past three years, the report clearly indicates the higher returns possible from this sector.
The major benefits of investing in private companies with growth potential is highlighted in a joint report by Oliver Wyman, the global management consultancy firm and the British Business Bank, the state-owned economic development bank, entitled The Future of Defined Contribution Pensions Enabling Access to Venture Capital (VC)and Growth Equity (GE)- September 2019.
We look at the key findings of the report below:
- The global VC/GE asset class has outperformed stock markets on average over a sustained period. For example, since 1970, the asset class has delivered an average 18% net return per year compared to 11% for the MSCI World Equity Index. VC/GE investments are illiquid, meaning they need to offer a premium relative to public markets. This premium has averaged 7% points per annum.
- “If sustained over a 40 year pension life, the VC/GE investments would return 12 times more than the listed stock only investments.” The Times Comment Business 01 October 2019.
- Workplace Pension Schemes are growing rapidly; however current allocations to alternative assets such as VC/GE are relatively low, as allocations have traditionally been focused on listed equities and bonds. Given the historical out performance of VC/GE investments, there is significant potential for Pension Schemes to improve outcomes for their members by investing in the asset class.
- VC/GE also provides high exposure to certain sectors (e.g. technology) that are better-represented in private markets and has a relatively low correlation to listed equity markets. This means that allocating to VC/GE would also improve the sector diversification.
- While VC/GE investments are exposed to the same broad macro-economic conditions as publicly listed equities, they may be less affected by short-term swings in investor sentiment that can result in volatility in public markets.
- The UK continues to be the top destination for Venture Capital investment in Europe, attracting around a third of all European VC investment. Additionally, in 2018 small businesses raised equity finance worth £6.7 billion, an 11% increase in investment value compared to 2017.
- Some 90% of all pension savers in the private sector are investing in a Defined Contribution (DC) Scheme.
- In ten years, workplace DC Scheme Assets under Management is expected to reach £1 trillion, more than doubling in size from current levels. Allocating to VC/GE would give access to some of the UK’s fastest growing and most innovative companies (that are not listed on public markets).
- DC Schemes have a higher proportion of younger members, and consequently they tend to have longer time horizons. On this basis, illiquid alternatives, such as VC/GE, fit well in asset allocation strategies and provide an opportunity for DC Scheme members to benefit.
- In the UK and the US, the number of listed companies has declined by 26% since 2005 and by 50% since 1996. The impact on UK stock market capitalisation has been significant: since 1999, it has declined from 190% of GDP to 110%. As diversity declines, DC members are exposed to the increased risk associated with more concentrated investment opportunities.
INVESTMENT IN PRIVATE MARKETS HAS BEEN GROWING RAPIDLY AND IS EXPECTED TO CONTINUE
Assets under Management US$ Trillion
Defined contribution pensions make up approximately 90% of the 18.7m workplace pensions being paid into in 2018. As DC pension payments on retirement directly correlate to investment returns, the UK Government is working with the pensions industry and its regulators to deliver better returns. A key focus is to allow investment into Venture Capital and Growth Equity as alternatives to listed companies. The benefits could be twofold:
- Increased performance of the pension pots producing higher benefits to the pension holders
- Support for the next generation of high growth businesses benefiting the UK economy as a whole.
The current proposal is that defined contribution pensions should pool investments across a wide range of funds that invest in technology and other private growth businesses. It is intended that VC/GE investments would only make up a small share (in the region of 5%) of the overall portfolio of a DC default fund. This should add additional diversity to the portfolio whilst limiting exposure to this high risk illiquid market.
Prior to defined contribution pensions, the majority of schemes were defined benefit (DB). That is the payments received by pensioners are specified according to length of service, salary etc and not the performance of investments in the pension fund.
Managed by professional fund managers, DB pension schemes have traditional allocated on average 24% of investments to liquid and illiquid alternative assets. Much of this investment has been concentrated in high growth areas such as technology, life sciences, and other intellectual-property based business. This includes some of the most innovative business in the UK, some of which are now valued at more than US$1 billion or more.
“Venture Capital and Growth Equity, already a part of DB investment strategies, are assets that drive long term returns and stimulate innovation, jobs and the economy” Ruston Smith, Chairman of Tesco Pension Fund
The benefits for long-term investors of allocating to illiquid alternatives have been illustrated by research recently published by Cambridge Associates. This highlighted that endowments and foundations with a greater allocation to private investments achieved significantly higher returns.
For example, in the past two decades, funds with greater than 15% allocation to private markets achieved a 1.6% point premium in median annualised returns vs. funds allocating only 5% to private markets (8.1% vs. 6.5%). In addition, top decile performers in the Cambridge Associates’ dataset were shown to have steadily increased their allocation to private markets in recent years, pushing well beyond 15% allocations. In many cases, allocations were in excess of 40%. It should be noted that the additional return of illiquid assets is associated with higher risk, particularly in terms of illiquidity and capital loss.
While many workers in their twenties and thirties are customers of these innovative and high-growth companies, they are currently unable to invest their retirement savings in them. These innovative companies are increasingly remaining as private companies, and may therefore provide a source of outperformance for VC/GE investors.
While investment in VC/GE has the potential to generate significantly higher returns over the long term than listed equities, individual VC/GE funds (and, of course, individual company investments) represent a relatively risky investment with a broad range of outcomes. This is because returns in VC/GE are typically driven by a small number of ‘star-performing’ investments.
CSS Partners provides a non-advisory service to high net worth and sophisticated investors who are looking to take advantage of the higher returns possible from technology and other growth private companies. Whilst investing directly into a company is higher risk than investing into a more diverse fund, many investors prefer to retain control over which companies to back as well as the size of each investment. The Enterprise Investment Scheme can also be utilised by investors as a risk management tool when investing directly into UK companies with ambitious growth strategies.
CSS Partners has raised over £175m for entrepreneurial companies since 2001. To learn more about how we enable private investors seeking higher capital growth to invest with confidence in smaller companies click HERE.
Investments offered by CSS Partners are not appropriate for all investors. Our free client service aims to be of benefit to high net worth and sophisticated investors looking to achieve higher returns.
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Any views or opinions expressed in this blog are those of the author alone, except where specifically stated that they are the views of CSS Partners LLP.