Written evidence submitted by HM Treasury
State of the VC market
The UK is home to the leading Venture Capital (VC) market in Europe. According to British Business Bank analysis of Pitchbook data in 2021, total UK VC investment in 2020 amounted to £11.9 billion, more than France and Germany combined. However, the UK market lacks the scale and maturity of the US market, and there are opportunities for pools of VC capital to be deeper.
The British Business Bank’s Small Business Finance Markets report, published in February 2022, showed that record levels of investment were made in the first three quarters of 2021; £14.0bn of investment was recorded. This exceeds the £8.7bn invested in 2020, and is a 130% increase on the £6.1bn invested over the same quarters in 2020. There was also strong growth in deal volumes which, at 1,811, were 20% up on the equivalent period in 2020.
Beauhurst have published information relating to the first quarter of 2022, which suggests that £8.79b was invested into private UK companies during the quarter (another record). There has been no change in deal volume from Q1 last year, but a 58% increase in deal value.
While UK equity investment is at a record high, there remain relative gaps in UK firms’ ability to access finance, notably for deep tech firms and scaling businesses. The Patient Capital Review found that there is a ‘patient capital gap’ between the UK and the US. This ‘gap’ was driven by the quantum of capital invested per firm (particularly at later funding rounds) rather than the number of firms receiving investment. Fewer UK firms receive follow-on funding than US counterparts, and the ability of firms to scale up is limited by the average size of VC deals. The gap was most acute at the later stage VC markets, for businesses seeking £10-50m.
Government is taking action to address this ‘gap’ and supporting a thriving UK VC investment ecosystem through a range of policies and programmes targeted at supporting innovative firms to access capital through the VC markets (see below). All of this means that we are closing the gap between UK and US VC equity: VC investment into UK companies has more than doubled since 2015. This is a higher increase in VC investment than the US (which grew by 141%), though US investment as a proportion of GDP is around 1.4x that of the UK.
Existing policies, interventions or programmes to support the VC market
The government has a number of existing policies, interventions and programmes in place to support the UK VC market, spanning a range of different levers (fiscal and non-fiscal).
The Government provides three tax-advantaged venture capital schemes; the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS) and the Venture Capital Trusts (VCTs). These schemes are designed to tackle market failures of information asymmetry which are broadly agreed to be most pronounced in companies at an early stage of development, small business within the broader ‘SME’ grouping and innovative companies that are often associated with higher levels of risk and/or intangible assets.
This information asymmetry leads to a lack of investor appetite to provide growth capital to SMEs for two reasons:
- The costs of researching info are similar for small and large businesses. Investors therefore tend to prefer larger deals involving larger businesses where the transaction costs are a smaller proportion of the investment made.
- Businesses often do not have a track record, or sufficient performance measurement data, available to investors when they are assessing individual high growth SMEs. This makes investors more risk averse and can result in higher levels of return being required or lower levels of investment being committed.
The venture capital schemes address this market failure by providing a range of tax reliefs to alter the risk return balances, thereby incentivising investors to back higher-risk, early-stage companies facing the biggest challenges in accessing growth capital. The reliefs are world leading in their generosity, and the schemes are popular and well-established with stakeholders. In 2020-21, the latest year for statistics, over £2.5bn was raised through the schemes.
In line with wider policy on tax reliefs, the government keeps the schemes under review in order to ensure they continue to meet their policy objectives in a way that is fair and effective.
The government most directly supports the UK VC markets through its targeted spending interventions to support businesses access finance, largely through interventions and programmes delivered through the British Business Bank. The British Business Bank is a government-owned economic development bank that aims ‘to drive sustainable growth and prosperity across the UK, and to enable the transition to a net zero economy, by improving access to finance for smaller businesses.’
The Bank runs a number of programmes designed to support businesses access equity finance including through the venture capital markets:
- British Patient Capital – a £2.5bn programme that invests as a cornerstone Limited Partner into later-stage VC funds, with co-investment capability.
- Future Fund: Breakthrough – a fund that co-invests alongside private investors into UK-based companies working in capital and R&D intensive areas (such as quantum, AI, life sciences and clean tech).
- Managed Funds – a programme investing in a series of private sector fund of funds of scale, designed to crowd in new investment into the funds of funds market.
- Enterprise Capital Funds – a programme supporting funds targeted at earlier-stage VC, designed to develop new VC fund management talent and increase the supply of fund managers in the UK.
- Regional Funds – a series of regionally-focused funds that work with local fund managers to provide a mixture of debt and equity finance, designed to reduce regional imbalances in the availability of finance.
- Regional Angels – a programme designed to help reduce imbalances in access to early-stage equity finance through the development of clusters of business angels across the UK.
The Bank also conducts and supports research into the state of the equity markets on a regular basis, as well as standalone research projects in its capacity as government’s centre of expertise for SME finance. Yearly publications include an Equity Tracker published in June, a Small Business Finance Markets report in February which includes commentary on VC and wider equity markets, and annual research on trends in UK VC returns.
The government indirectly supports the success of the UK VC industry through its support for the pipeline of innovative businesses that may go on to raise venture capital, and the UK innovation ecosystem as a whole. The government supports business-driven innovation as part of its wider public R&D investment (which will reach £20 billion by 2024-25). As part of this, core funding for Innovate UK, the nation’s innovation agency, will reach £970m by 2024-25.
Innovate UK supports UK businesses to develop their innovation efforts by:
- Providing direct financial support, primarily via competition-based grants and innovation loans.
- Running the Knowledge Transfer Network, which facilitates networking and connections to academic experts, other businesses, and investors.
- Running the EDGE program, which complements Innovate UK grant funding with intensive, specialist-led support for such ambitious businesses.
- Operating the Catapult Network, which consists of 9 centres, each with a technological speciality. These provide businesses with access to specialist expertise and facilities, enabling them to test, demonstrate and improve their ideas.
The financial support on offer from Innovate UK, complementary to the work of the British Business Bank, aims to fill “funding gaps” that innovative businesses typically face when growing, for example at the seed stage. The health of the pre-seed and seed funding environment is important to the wider innovation ecosystem, as it provides the pipeline for later stage investment. Innovate UK helps businesses of all sizes, across all sectors, access finance for innovation, via their own competition-based grants and loans, or by facilitating follow-on meetings with investors. The programmes they deliver create £7 of economic benefit for every £1 of public investment, crowding in private spending.
The government has also committed £800m to the establishment of the Advance Research and Innovation Agency (ARIA), which will operate with a “high-risk, high-reward" mandate in the pursuit of transformation science and technology. ARIA will use a range of innovative approaches to funding research, which is likely to include the ability to run prizes; take equity stakes; and issue small grants rapidly without lengthy open competitions. The agency will therefore complement the work of UKRI and Innovate UK as another source of public R&D funding that supports the wider innovation ecosystem.
Venture Capital Trusts (referenced above) are a type of investment company and are listed. The UK funds regime also offers a Registered Venture Capital Fund (RVECA) label.
More broadly, VC funds – particularly smaller funds – tend to be established as limited partnerships or private fund limited partnerships (LP funds). Structurally, LP funds are closed-ended vehicles and are not listed. From a regulatory standpoint, LP funds are classified as alternative investment funds (AIFs) and are unauthorised (i.e. the funds themselves do not need to be submitted for approval before being launched). However, the managers of LP funds are regulated by the Financial Conduct Authority (FCA) under the UK legislation that implemented the Alternative Investment Fund Managers Directive (AIFMD). UK LP funds are not accessible to retail investors in general. Similarly, AIFs such as VC funds which are domiciled overseas and which use the UK’s National Private Placement Regime are limited to marketing to UK professional investors and to those, such as high net worth and sophisticated investors, who can be exempted from the regulatory restrictions on financial promotions subject to certain conditions.
The government is currently undertaking a review of the UK funds regime, covering tax and relevant areas of regulation. As part of this, a 2021 ‘call for input’ sought views on potential changes that would enhance the UK as a location for LP funds, given the key role LP funds play in facilitating investor access to alternative investment opportunities such as venture capital.
As noted in the government’s formal response to the call for input, published on 10 February 2022, the government has recently reviewed legislation on limited partnerships and intends to introduce measures that will increase the level of transparency around the ownership and activities of LP fund structures. The government will give further consideration to the non-tax issues that were identified (for example that ‘English’ LP funds cannot elect to have separate legal personality, and that the system for legally transferring fund interests could be modernised) before taking forward any specific reforms. The government will also keep under review the points made in relation to tax barriers.
That response, which also addresses the other areas covered by the call for input, is available to view here.
In addition, the government has worked with industry and regulators to ensure that investors have a range of options for investment in long-term assets, such as VC. The Long-Term Asset Fund (LTAF) is a new fund structure to assist investors, such as defined contribution (DC) pension schemes, to invest in long-term illiquid assets, and the FCA rules for the structure came into effect in November 2021.
Future policy proposals
The government keeps all policies under review and considers carefully the case for further policies that align with broader government priorities and objectives. Interventions to support the innovation ecosystem and the effective function of the VC markets are no exception.
Unlocking additional sources of capital for UK VC
The government has a longstanding commitment to help unlock new sources of capital for investment into productive parts of the economy, including UK VC. This will benefit the UK economy by helping to reduce finance gaps while also enabling investors to access the opportunities that investment in asset classes like VC can afford.
Facilitating investment from UK institutional investors into long-term, productive assets, is an important part of this. The Prime Minister and the Chancellor have called for an Investment Big Bang to unlock the hundreds of billions of pounds held by UK institutional investors and use it to drive the UK’s economic recovery from the Covid 19 pandemic. The Government has taken significant action to remove obstacles and costs to making long-term, illiquid investments in the UK, and is doing everything possible – short of mandating more investment in these areas as some have advocated – to encourage a change in mindset and behaviour among institutional investors.
The government has worked extensively with industry to identify the opportunities and barriers to increasing pension and insurance scheme investment into illiquid assets. In 2018, HM Treasury led the Pensions Investment Taskforce to understand the potential of DC pension schemes as investors. In 2019, supported by the government, Oliver Wyman and the British Business Bank published a joint report on ‘The Future of Defined Contribution Pensions’, a feasibility study exploring a blueprint for pooled investment in patient capital. In 2020, the government and regulators convened the ‘Productive Finance Working Group’, chaired by the Economic Secretary to the Treasury, the Chief Executive of the Financial Conduct Authority, and the Governor of the Bank of England. This industry-led group looks at practical solutions for barriers to investment in long-term assets such as venture capital, to ensure that investors can access the opportunities that long-term assets afford, while also supporting growth and innovation. In September 2021, the Group published recommendations, the implementation of which is ongoing.
Where appropriate, the government has taken action to reduce or remove barriers to institutional investors accessing long-term investments. For example, the Department for Work and Pensions has consulted on various proposals to facilitate pension scheme access to illiquid assets, including reforms to the cap on fees that DC schemes can charge to remove well-designed performance fees from scope, as well as accelerating the consolidation of the pension sector, and encouraging transparency and a focus on net value over low cost investment strategies.
We remain open to addressing further barriers where they are identified.
Choosing which assets to invest in to secure the best outcomes remains a matter for pension fund trustees, and other custodians of institutional capital. We believe all institutional investors should be considering how they can take advantage of the changes and support the Government has established over the last 5 years.
The government also continues to consider the role of retail investment in VC. The FCA intend to launch a consultation in 2022 on whether to enable a broader range of retail consumers to access Long-Term Asset Funds – a type of fund which supports investment in long-term illiquid assets, such as VC.
Ensuring that the UK has the right talent – both investment talent, and specialist science & tech talent to found and build innovative firms – is important in creating the environment for successful VC investment.
Our Higher Education sector is world-leading - 4 of the world’s top 10 universities are in the UK and the UK compares well internationally on tertiary education with c50% of adults educated to tertiary level.
The Chancellor recently announced that the government is doubling the available scholarships for AI and Data Science Master’s conversion courses with a £23 million investment aimed particularly at under-represented groups in the tech sector.
This spring, we committed £117m to create 1000 new PhDs through Centres for Doctoral Training, with the investment further leveraging industry and university funding. This builds on the existing £100 million commitment delivering 1000 PhDs through 16 AI Centres for Doctoral Training at universities across the country.
Outside of the education system, the government is taking action to ensure that investment and fund management talent is encouraged. The British Business Bank’s aforementioned Enterprise Capital Funds programme is backing the next generation of fund managers by combining public and private money for investment into early-stage businesses through funds managed by new or emerging fund managers. The Bank incentivises private investors to invest in first-time managers, who are often considered to be riskier bets than established managers, through a subsidised enhanced profit mechanism, and the scheme has been successful in cornerstoning over 36 funds since inception.
Attracting international talent is another important component in building the innovation ecosystem. The government is committed to ensuring the UK remains the location of choice for top talent and innovative businesses from across the world, and is introducing attractive and competitive visa offers, both new and reformed, to achieve this.
In May 2021 we introduced an improved visa for Global Talent to attract talent in academia, research, and digital technologies. In April 2022 we launched the Global Business Mobility route to streamline several existing offers and make it easier for overseas businesses to transfer staff to the UK. In May 2022 we introduced a new visa for High Potential Individuals for those who have recently graduated from a non-UK university ranked in the global top 50.
In August 2022 the government will launch a new offer for scale-ups to help these fast-growing businesses bring in the talent they need to grow and drive innovation. In 2022 we will launch a Global Talent Network to attract talent from across the globe in Science and Technology, with an initial focus on the San Francisco Bay area, Boston, and Bengaluru. In autumn 2022 we will introduce a reformed Innovator visa, to make it easier for those with the skills and experience to found, and invest in, innovative businesses in the UK. This complements an existing offer for start-ups and replaces the now closed Tier 1 Investor visa.
Effectiveness of policies in meeting wider UK government priorities
There are well-known disparities in businesses’ ability to access equity finance in different regions of the UK. Analysis by the British Business Bank for their Regions and Nations 2021 report showed that London, the South East, the North West and the East of England account for 86% of equity deals despite hosting just 55% of businesses, and evidenced the fact that uneven distribution of growth finance is driven more by the location of investors than a lack of high-growth-potential businesses.
That is why several of the government’s policies focus on developing the depth of equity markets outside of London, to help the country ‘level up’. The British Business Bank has an explicit objective to identify and help to reduce regional imbalances in access to finance for smaller businesses across the UK. Several of its programmes contribute towards delivering against this objective. The Regional Angels programme commits funds alongside regionally-based business angels to support businesses to raise early-stage equity rounds. In addition, the Bank currently operates three regional investment funds – the Northern Powerhouse Investment Fund (NPIF), Midlands Engine Investment Fund (MEIF) and Cornwall and Isles of Scilly Investment Fund (CIOSIF). These funds work with local fund managers to provide a mixture of debt and equity finance to SMEs in these regions. Since they launched, the Bank has invested over £430m into NPIF, MEIF and CIoSIF regions, crowding in over £500m in additional private sector co-investment and supporting over 1,800 SMEs. At Spending Review 2021, the government announced an expansion of the Bank’s regional investment funds into the North East and South West of England. It will also provide funding for the Bank to set up new regional funds in Scotland (£150m) and Wales (£130m) and to build on its existing programmes in Northern Ireland (£70m), working closely with the devolved administrations.
It is clear that these programmes are contributing to the effectiveness of the British Business Bank in supporting businesses outside of London to access finance; the Bank’s 2021 Equity Tracker found that the concentration of deals undertaken in London by British Business Bank supported funds has reduced sharply over the last couple of years, from 68% in 2016 to 42% in 2020.
The government is also supporting the growth of a healthy pipeline of investable businesses in more areas of the country. The Levelling Up White Paper outlined the ambition to increase public R&D investment outside the Greater South East by at least a third over the Spending Review period and at least 40% by 2030, with that additional government funding seeking to leverage at least twice as much private sector investment over the long-term to stimulate innovation and productivity growth. In addition, the UK Government will target £100m of investment in three new Innovation Accelerators, private-public-academic partnerships which will aim to replicate the Stanford-Silicon Valley and MIT-Greater Boston models of clustering research excellence and its direct adoption by allied industries. These pilots will be centred on Greater Manchester, the West Midlands and Glasgow City-Region.
The British Business Bank also has an explicit objective to help address climate change and support the UK’s transition to a net zero economy. It recently published a report, “Smaller businesses and the transition to net zero”, which explored the contribution SMEs could make to wider net zero objectives if they all made changes to reduce their carbon footprint.
VC markets are an important source of finance for some of the UK’s most innovative businesses, and can be the only finance option for science and technology-focused firms whose success depends on high-risk new technologies. Therefore the full programme of policies in support of the UK VC market indirectly contribute to the government’s objective for the UK to become a science superpower.
A number of British Business Bank programmes focus directly or indirectly on ensuring that the UK VC markets can provide finance for the most exciting science and technology start-ups and scale-ups in the UK.
Recognising the importance of the life sciences sector to the UK economy, the Life Sciences Investment Programme combines £200m of public investment with private capital (including an £800m commitment from UAE sovereign wealth fund Mubadala) to boost the supply of finance to this high-growth, innovative sector. The programme aims to ensure the continued competitiveness of the UK’s world-leading Life Sciences sector and support the development a UK-based Life Sciences investment ecosystem.
The Future Fund: Breakthrough programme is specifically aimed at increasing the supply of growth-stage venture capital to UK based companies working in capital and R&D intensive areas (such as quantum, AI, life sciences and clean tech). The objective of the programme is to address the growth-stage equity finance gap faced by innovative, R&D-intensive UK companies operating in breakthrough technology sectors. Future Fund: Breakthrough will increase the size of funding rounds that these companies are able to raise, by providing public investment alongside the private sector. Future Fund: Breakthrough has already supported a number of businesses, including Ultraleap and Quell Therapeutics.