Commentary: Pension funds hold the key to unlocking investment in growth companies

The U.K. is one of the best places in the world to set up a business. The government has done a fantastic job in supporting U.K. enterprise and investing in the country's entrepreneurial ecosystem.

But when it comes to supporting U.K. businesses early on and, more pressingly, during growth phases, 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.

U.K. pension funds in particular, managing £2 trillion ($2.74 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 U.K. government has recognized this potential for some time, with its "Patient Capital Review," aiming to provide incentives for pension funds to increase investment in venture capital.

Strong opportunity

The opportunity should not be overlooked. High-growth small businesses — defined as those with annual growth of more than 20% and an annual turnover of £1 million to £20 million — are leading the way in employment, economic growth and productivity across the U.K.

These unsung economic heroes might 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 found such companies in the U.K. created an average of 3,000 jobs every week in 2016. In 2015 and 2016, 22% of U.K. economic growth was created by HGSBs.

Yet in spite of their potential to boost the economy, the funding gap persists. U.K. companies that outgrow the qualifications for investment by venture capital trusts and enterprise investment schemes find themselves struggling to access capital to reach the next level of growth.

Not limited to U.K.

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

From 2011 to 2015 we saw 5.5 times more growth equity raised in the U.S. than in the European Union, according to data from the 2016 Invest Europe yearbook and the 2016 National Venture Capital Association yearbook. With the U.S. venture capital market at such a mature stage, the investment case for U.S. 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 increasingly are 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 show a five times 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 venture capital market coming of age we've seen first-hand growing interest from U.K. pension fund committees in this investment route.

Previously in the U.K., 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 narrowly defined allocations.

Barriers are falling

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 past 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 favor of the incumbent.

In many cases, technological developments and the quality of entrepreneurs behind these companies make the challengers look less risky than the incumbents. The investment case for tech-related startups 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, narrow allocation descriptions 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 that we expect to increasingly rethink and redesign their allocation boundaries to incorporate venture in future.

Eye toward Brexit

The U.S. has proven pension fund investment in venture capital is a win-win. As the European venture market comes of age, pension funds across Europe should follow the U.S.' lead.

In the Brexit environment, the U.K. in particular would be wise to look after its high-growth small businesses. As some of the most productive businesses in the U.K., creating an additional two months of economic output per year compared to the average U.K. 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.

Chris Hulatt is co-founder of Octopus Group, London. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.