Unlocking pension funding and changing mindsets can catalyse the true potential of successful small businesses, says Chris Hulatt, co-founder of Octopus Group
The UK government wants an investment ‘big bang’ to fund the future champions of the economy and ensure UK investors, including pension scheme members, are rewarded for their faith. It wants to turbo-boost our start-up culture, ensuring the best of the best are not sold overseas or generating profits for overseas investors.
UK pension funds are among the biggest investors around, but regulations and conservative thinking often prevent defined contribution (DC) schemes from helping the UK to build back better.
In particular, such schemes are barred from paying the performance fees that venture capital (VC) funds, who provide access to high-growth small businesses, charge. That means reliable funding is not always available and deserving businesses don’t see the investment cash they need to expand their excellent products and services, either here or in overseas markets.
Australia and Canada have no such qualms. Both have limited the barriers to pension funds paying performance fees, rejuvenating the financing options for their small businesses in the process. Millions of pension members who pay monthly contributions are benefiting from higher returns for their pension pots too.
The UK changes proposed are welcome, but they are only one lever and cannot solve the funding issue entirely, especially in the short term.
If high-growth small businesses are to really tap the deep capital they need to scale up, then pension funds need to shift their mindset. They need to be willing and open to invest in these businesses to see the long-term benefits it can bring to their returns, their members and the UK economy.
Real life engagement
Investing in UK small businesses could also improve pension funds’ member engagement. By showcasing the businesses they are backing, pension funds could demonstrate how scheme members are creating real jobs, improving their local communities, backing potential UK unicorns and securing their retirement incomes, all at the same time.
This would be far more relevant – and probably more interesting – to pension members than discussing fixed income or large-cap equity returns. You can imagine having really rich content and material on UK start ups to share with members to show where their money is going.
And if you think the public isn’t ready to consider early-stage businesses as an investment option, think again. At Octopus, we’re seeing the highest level of interest from retail investors in our VCTs than we have at any point in the last 20 years. Pension schemes must see this is an opportunity, particularly at this moment of great change, if we are to help the UK build back better.
Patience is rewarding
Pension schemes may also take a longer view than retail investors, given the often-illiquid nature of VC. Many defined benefit schemes are in run-off mode, but DC schemes are set to grow larger for many years ahead, giving them even more flexibility to be patient.
Likewise, many of their members are early in their journey. But before they commit, they need to understand the sector to ensure they are confident in their investment decisions.
What happens if the big DC schemes do not engage, for regulatory or mindset reasons? The UK is an entrepreneurial country, but new technology means ideas are free to travel and settle anywhere around the world. We could be wishing our future stars away, and that experience could deter the next generation of business builders.
It is also worth remembering that many of these proven companies are working on environmental and social solutions, which could help cement funds’ ESG credentials. Such businesses need not be high risk, if they can prove they are already thriving.
They are close to home, returns are provided in sterling, and the UK has a stable political and legal system. UK businesses do not come with the geopolitical, macroeconomic and currency risks of investing in emerging markets, which pension funds are quite happy to accept.
Getting comfortable with fees and risk
Pension scheme trustees can be forgiven for potentially feeling daunted by the prospect of different fees and risks, if they haven’t invested in VC previously. They needn’t be too apprehensive. By the very nature of performance fees, you are only paying for the delivery of strong performance. Higher fees equal higher returns.
Schemes shouldn’t fear paying for performance if it means they are ultimately delivering strong outcomes for members. For instance, if a VC investment generated a 20% internal rate of return over seven years, net of fees, that would have a very powerful impact on members’ pots.
It would be dangerous for DC pension schemes to engage in a race to the bottom on fees and exclude VC investments purely over cost concerns. Instead, they should be looking at overall expected outcomes, net of fees.
Meanwhile, the potential risks inherent in investing in smaller companies are risks that DC schemes are uniquely well-placed to weather. These schemes are typically made up of large numbers of younger members in their 20s and 30s, who won’t be drawing down their pension for another 30+ years.
DC pensions are perfectly positioned to invest in equally long-term, illiquid asset classes like VC. It would be a real missed opportunity for schemes to not be willing to tolerate some of that investment risk for the rewards on offer.
If I think about my own children, who will likely be DC pension members in years to come, they would rightly be justified in actually demanding that their scheme invests in these kinds of assets.
In 2022 and beyond, if pension trustees can have an open mindset and be alive to the strong entrepreneurial culture in the UK, thinking big need not be quite so scary after all.
The latest digital edition of IPE’s magazine in now available.