The Patient Capital Review launched in 2016 focused on the following areas:
- Understanding the availability of long-term finance for growing innovative firms looking to scale up.
- Identifying root causes of the difficulties businesses face in accessing capital, as well as barriers that investors encounter when investing.
- Comparing UK approaches with international best practice.
- Identifying policy changes able to support availability of capital.
An industry panel tasked with proposing ways forward said that while the UK “is, in many respects, a great place to start and grow a business … the lack of patient capital is a significant impediment to UK entrepreneurs’ success”.
Getting start-ups through the scale-up phase was identified as a particular problem: “many UK-based businesses are unable to reach their full potential and either remain “stuck” in a mode of incremental growth, or accept a trade sale as the most convenient exit”.
The review also noted the substantial interest from retail investors in patient capital, but identified the issue of regulatory constraints, particularly in relation to retail investment. Protection of retail investor funds, and ensuring that investments are suitably liquid, are of course important. But “greater opportunity should be given to allow them to share in wealth generation by UK scale-up and science-based start-up businesses.”
Finding the right balance is not easy. A recent consultation carried out by the Financial Conduct Authority looked at what needs to change in order to encourage the investment in early stage businesses. In its Consultation Paper CP18/40, and Discussion Paper DP18/10, the FCA examines the rules affecting fund managers, particularly in relation to funds that are offered to retail investors, and invites comment on how barriers to investment can be overcome.
In our response to the consultation we welcome the planned changes but identify some concerns about whether these will achieve the desired result without other improvements.
Fund management incentive structures
Authorised funds typically invest in readily realisable assets with a focus on income and or short term capital returns. Quite naturally, management fees and carry arrangements in authorised funds are often geared to incentivise investment firms to produce profits in the relatively short term. Management fees may be lower than venture capital management fees, reflecting less active involvement in the portfolio from the investment firm, and the manager might expect to profit from a combination of management fees and carry or performance fees, paid on an ongoing basis from income and capital returns from a moving portfolio.
In contrast, with arrangements in early stage venture capital, funds may operate with a much tighter belt. Patient capital can require more intensive fund manager interaction with its portfolio companies, and often the management fees may be set at a higher level, to reflect running costs. A substantial proportion of the management firm’s profits might be expected to come from carry or performance fees on exit. This fee gearing should actively incentivise VC fund managers to take a patient view themselves.
Unless the investment firm adjusts its fee structure, one potential issue with an authorised fund increasing its portfolio to include a greater proportion of non-readily realisable assets is the effect this could have on the retail investor’s income returns, as the income-producing half of the portfolio could end up bearing the weight of the management fees. In addition, a manager who is primarily incentivised to profit from immediate income and capital returns may be unlikely to manage its portfolio “patiently”.
Therefore there could be drawbacks in relaxing the rules on authorised funds investing in illiquid assets, particularly where the investments are in early stage businesses, without taking into account the manager incentivisation arrangements that accompany that relaxation. A key objective of the government’s Patient Capital Review is to promote long term investment in growing businesses, with benefits for employment and productivity, as well as the development of promising new technology.
While authorised funds may well increase investment in VC funds or directly into early stage businesses, achieving their managers’ desire to maintain those investments over the long term may be challenging. In order to achieve the short term returns necessary to their own business, managers may find themselves incentivised to focus on income-producing businesses rather than true patient capital, push for early exits, “spread-bet” by investing in a large number of growing businesses, then taking a “crash and burn” approach, selecting a small number of those achieving the best performance over the first one or two years, or take a riskier approach to valuations.
Any of these approaches could have the effect of not supporting a proportion of the smaller companies initially selected, potentially pushing some of those companies out of business, with a consequent loss of jobs, and/or sacrifice of promising technology and growth potential.
This may be contrasted with the approach taken by venture capital funds. These generally aim to grow a select number of portfolio companies over a longer period of time, and adopt measures consistent with this aim. Board level practical support if often provided alongside a medium to long term approach to funding.
The manager of an authorised fund invested into a venture capital fund may also be inclined to encourage the VC fund to carry “dead weight” (ie, not exit companies which are income-producing but are not likely to achieve substantial growth). Although this is not in and of itself negative – supporting “low flyers” is as important as supporting the potential unicorns – this could cause tension either where an authorised fund invested in a venture capital fund exerts pressure on the latter to carry dead weight, or where authorised and venture capital funds are co-invested in these companies.
The potential for adverse consequences we identify above might be particularly acute in certain sectors, such as life sciences and technology, where a quick return is highly unlikely and the capital needs to be very patient.
We suggest that one approach to avoid unintended adverse consequences might be to require that if authorised funds are offered relaxations around investor protections such as liquidity, this is conditional on confirmation by the firm that its fee structure is appropriate to promoting patient capital objectives, and/or to require the firm to provide specific explanations and risk warnings to retail investors about its fee structure.
You can read our consultation response for a more detailed analysis of these proposals.