UK startups turn to Silicon Valley to fill gaps in risk-averse pension funds

Matthew Scullion says the turning point for the British software company he founded came when it secured backing from two US venture capital firms.

In 2018, Scale Venture Partners and Sapphire Venture led a funding round for Matillion, then a seven-year-old startup headquartered in Manchester.

British investors put in a small amount, but Scullion believes the injection of Silicon Valley money and know-how helped propel Matillion into the ranks of a select group of British unicorns – privately held companies valued at more than $1 billion.

“[The US venture capital firms] “They want me to build the biggest company I can and work until the day I die,” the 45-year-old entrepreneur explained.

But for City executives, business leaders and investors seeking a radical reboot of Britain’s capital markets to reverse years of declining listings and turn startups into global leaders, Scullion’s experience highlights many of the challenges they face.

Rebooting UK capital markets

This is the second in a two-part series examining efforts to revive London’s stock market and reform its risk-averse pension system.

Part 1: A club of entrepreneurs plotting a revival of London

That includes persuading wary domestic pension funds to back start-ups and developing more investment funds with the knowledge, track record and ambition to help entrepreneurs build their businesses.

With the final days of the campaign dominated by the gambling scandal, the future of the pensions sector and how to grow a world-class company received little attention, but it is on the agenda for both the Conservatives and Labour.

Last year, Chancellor of the Exchequer Jeremy Hunt set out plans to boost pension returns and investment in British companies. The so-called Mansion House reforms included plans to strengthen pension funds by merging smaller ones, as well as an overhaul of the local government system.

The Labour Party, which is polled to be favourite to win the July 4 general election, has promised to overhaul the pensions sector but has yet to provide details.

But calls to force pension funds to invest more in British companies, public and private, have drawn fierce criticism, with opponents arguing that it could hit pensioners’ retirement benefits by narrowing the investment choice available to funds.

“We will invest wherever we can get the best results,” said Andy Briggs, chief executive of FTSE 100 Phoenix Group, Britain’s largest long-term savings and retirement provider. He added that he supports encouraging investment in the UK but “does not support any form of coercion on the UK”.

For Sir Jonathan Symons, chairman of FTSE 100 pharmaceutical company GSK, increasing investment in fast-growing private companies is a prize worth fighting for.

Having worked in the pharmaceutical industry for more than 40 years, Simons has seen firsthand the obstacles that startups founded at the nation’s universities face when trying to scale up.

“The UK has a fantastic life sciences industry and one of the largest pools of capital in the world, but they are parallel worlds,” Symons said, expressing concern that future retirees would be deprived of the economic benefits of British innovation.

“We must support British innovation with British capital,” he added. “Our desire is for the UK to see a wide range of individuals, businesses, regions and universities benefiting from and participating in the success of British science and innovation.”

Fred Cohen, co-founder of Monograph Capital, a venture capital firm that backs biotech companies on both sides of the Atlantic, has seen promising British companies get snapped up by overseas buyers.

In 2022, Myrobio, a Monograph-backed therapeutics company spun out of Oxford University, was sold to US pharmaceutical company Gilead Sciences for around $405 million.

Monograph’s portfolio also includes Aviadbio, a gene therapy group founded at King’s College London, and Maxeon Therapeutics, which is developing antibody drugs at the University of Cambridge.

“The quality of UK science is on par with that of Boston or San Francisco, but its ability to translate that into biotech products and equity value creation lags significantly,” Cohen argued.

A government-commissioned report last year recommended tackling one of the causes of the problem by adopting standard market terms to speed up spin-out negotiations and prevent universities from holding too much stock in companies, making it difficult to incentivize management.

But Cohen said the UK also suffers from a shortage of “real risk capital” and “there aren’t many managers who are comfortable taking on the risks required to put that capital to work.” He added that “there is a lot of capital in the City of London, but it tends to be concentrated in low-risk, low-return asset classes like UK government bonds.”

Low-risk government bonds have long been the mainstay of British pension funds’ assets, but a series of changes in accounting rules, tax rules and regulations over the past two decades have led managers to cut allocations to equities.

Accounting standards introduced in 2000 require companies to calculate the surplus or deficit of their defined benefit pension plans annually and disclose the deficit as a financial liability in their accounts.

In response, companies rushed to phase out defined-benefit pension plans that promised payouts tied to employees’ salaries, and pension plans shifted money from stocks to less volatile bonds in an effort to avoid sudden swings in potential shortfalls.

British pension funds will have 26% of their assets invested in equities at the end of 2023, down from 46% a decade ago, according to the Thinking Ahead Institute, with a much smaller share of that earmarked for UK shares.

For those trying to lay the foundations for a revival of Britain’s capital markets, making London a more attractive destination for initial public offerings is a key yardstick for success.

Without that, “the only viable route” for investors wanting to exit private British companies would be either an overseas IPO or a sale to a foreign buyer, according to Michael Tolley, co-founder of consultancy Ondra Partners.

But proponents of the reforms argue that increasing pension funds’ risk tolerance is essential to the broader recovery, helping to boost returns for retirees and generate domestic funding for start-ups.

Taavet Hinrichs, co-founder of London Stock Exchange-listed fintech company Wise, is one to make this argument.

“If we discourage or limit UK pension funds from investing in these asset classes, they will become less competitive,” said Hinrichs, who left Wise to set up Plural, which backs European start-ups. “We need to find incentives to encourage pension funds to invest in private assets.”

Investors in U.S. venture growth funds are primarily domestic pension funds and endowments, he added.

While there has been little focus on these issues in the election campaign, Phoenix’s Briggs said the government would ultimately have to consider how the pensions industry could better serve retirees.

More than 80% of Brits have not saved enough to maintain their standard of living in retirement, according to a 2022 Phoenix report, a problem that has become more pressing over the past 20 years or so as more businesses have adopted defined contribution pension models, ultimately placing the risk around the size of their retirement savings on employees.

Briggs said any reform of the pension system should have two focuses: raising savings rates by expanding auto-enrolment and putting money into private assets, a broad area including private equity, infrastructure and venture capital.

This is consistent with the view of John Graham, chairman and CEO of the Canada Pension Plan Investment Board, one of the world’s largest private wealth investors with about C$630 billion (US$460 billion) in assets.

“Private equity has been the single largest driver of returns for our portfolio,” Graham said. “I don’t think there’s any extra risk. What you’re giving up is liquidity. Private markets work well when you pool assets over a long-term time horizon.”

Australian and Canadian pension funds have much higher allocations to equities and private assets than their U.K. counterparts, which boosts returns. Over the past decade, the size of the U.K. pension industry as a whole grew 2.9% a year, compared with 4.2% in Canada and 6.8% in Australia, according to the Thinking Ahead Institute.

Like calls to encourage pension funds to move money into UK assets, any move to increase allocations to private assets will also be controversial, especially as rising interest rates raise questions about the sustainability of returns.

The Bank of England has warned that significant risks are building up in some private assets such as private equity, and regulators have also raised concerns that private assets are being held at overvalued levels on investors’ balance sheets.

At the same time, investing in private assets is more costly than allocating to bond or equity strategies that track indexes.

Stephen Batchelor, a partner at HG Capital, a British buyout firm specialising in the software industry, argued that pension funds need flexibility to invest in areas that offer higher returns after fees.

Without it, he said, “there is a risk that the pension system will be run on a buy-cheap-get-cheap principle, which will ultimately hurt UK pensioners the most.”

Increasing capital flows into private assets, including start-ups, is a central tenet of the Mansion House reforms, which also include an agreement between the UK’s 11 largest DC pension providers to target allocating 5% of their default funds to unlisted assets by 2030, up to £50 billion.

But in a sign of how heated the debate over the pensions industry’s future has become, pension providers stopped short of promising to increase investment in British companies, both public and private.

Opinion polls are predicting the first Labour government since 2010, but some City leaders argue its policy agenda remains too modest.

“We need to be bolder,” said Peter Harrison, chief executive of FTSE 100 asset manager Schroders, arguing for stronger automatic enrolment into pension schemes, tax credits to encourage investment and full pooling of local government schemes. “That would really shift the game in favour of British investment.”

Like Scullion, Harrison is a member of the Capital Markets Industry Taskforce, a group of 10 business leaders set up in 2022 to advocate for fundamental reform of the capital markets. For the entrepreneur from Altrincham, near Manchester, his main objective is clear.

“It doesn’t matter how well you develop the public offering markets,” Scullion said, “but it’s all for naught if there are no companies going public in the first place. The most important thing we have to do, of course, is learn how to build impact companies.”