Europe is undergoing a crisis of creative confidence. The recent report by Mario Draghi, the former president of the European Central Bank, on Europe’s competitiveness revealed a poor innovation record. He noted that “EU companies spent around €270 billion less on research and development [R&D] than their US counterparts in 2021, largely because we have a static industrial structure dominated by the same companies and technologies as decades ago”.
His solution was to focus on more venture capital (VC) investing in high-risk projects, as a lack of VC has meant start-ups have been more reliant on bank loans, which are unsuited to financing such ventures. He noted that “the core problem in Europe is that new companies with new technologies are not rising in our economy. In fact, there is no EU company with a market capitalisation over €100 billion that has been set up from scratch in the last 50 years. All six US companies with valuations above €1 trillion have been created in that period of time. Innovative companies that want to scale up in Europe are hindered at every stage”.
What can Europe do to fix its innovation crisis?
The key phrase here is scale up. It’s all very well having lots of ideas, but if you can’t turn them into money-making global technology leviathans like the Americans, there’s a problem. Draghi’s hand-wringing has sparked schadenfreude across the English Channel. Analysts have pointed out that the UK innovation and start-up scene seems to be in much better shape. Britain is currently the third-largest venture capital market in the world, behind only the US and China; it has overtaken India to claim this position.
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The UK is also the largest venture capital market in Europe, accounting for more than a third of investment, and UK companies raised £72 billion in total venture capital investment between 2021 and 2023. In 2023 alone, UK start-ups raised $21.3 billion, the third-highest total on record. Britain’s share of global VC investment rose from 3.4% to 5.8% between 2021 and 2023. London continues to be a major hub, driving 70% of total UK VC investment in the last few years.
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Still, it’s not all good news. According to The Times, investment in early-stage firms has fallen to a six-year low. In the three months to September, there were 32 fundraising rounds for start-ups, the lowest number since 2018 and down from 75 in the previous quarter, according to VenturePath, a group of investors who channel capital into early-stage firms. Companies raised only £162 million in the past three months by offering shares to external investors for the first time, also the lowest figure in at least six years.
A more damning critique of the UK’s long-term record of innovation record comes in a joint report by the Tony Blair Institute (TBI) and the centre-right think tank Onward. It points the finger at the City of London: “London was once the world’s largest stock exchange and, today, it ranks sixth... Last year 76 firms delisted from the London Stock Exchange’s (LSE) growth market, Aim... up 62% on the previous year. And... leaders of the UK’s most vibrant companies have publicly stated that they would not consider listing on London’s exchanges. Low liquidity, diminished confidence among investors and a shrinking pool of capital available are compounding the exodus”.
The report went on to say that the implications are severe: not only will our failing capital markets undermine our status as a global financial hub, but they could also “extinguish Britain’s potential to be the home of the next wave of world-leading science and tech companies, hindering its growth prospects for decades”.
Propping up the market
The study’s solutions include closing down Aim and creating a rapid route to listing on the LSE’s Main Market with similar, but time-limited, tax and regulatory benefits; and expanding and enhancing the capacity of the UK’s investment sector. To that end, the UK state should earmark £1 billion of funding to invest in five growth-focused venture funds, crowding in institutional capital to create a generation of UK-based, large-scale growth investors. The report also highlights the need to cut regulatory red tape and governance burdens on asset managers and listed companies.
Those intimately involved in the complex world of funding innovation paint a more nuanced picture. Take Ken Wotton of fund manager Gresham House. His firm is uniquely positioned to understand the link between private and public-market funding of innovation-led companies. Funds range from venture capital trusts (VCTs) and enterprise investment schemes (EIS) to public market strategies for small and mid-cap stocks via the successful Strategic Equity Capital investment trust.
Wotton thinks the financial support system for innovation in the UK has been transformed over the past 15 years, with a burgeoning angel and early-stage VC sector supported by tax breaks such as EIS and VCT schemes. He accepts that the current cyclical funding environment is weak, but the solution, he argues, is not to kill off Aim.
This alternative market might not have “generated amazing returns for investors in aggregate, but has been pretty effective at raising capital for smaller businesses”. The real problem is that the dismal cyclical backdrop means that UK equity valuations are low, and thus few entrepreneurs will plump for the UK if they’ll only get poor valuations via flotations. One concrete example of where the UK outperforms is in the business-software sector, especially in software as a service, or SaaS. Yet Wotton points out that these listed tech businesses are “all trading at massive discounts to the valuations that my private colleagues are putting money into. There are many publicly quoted high-quality SaaS businesses trading at between 1.5 and three times the sales. By contrast, in private markets, you’re putting money into businesses at five times plus”.
What can Britain do?
Unsurprisingly, low valuations for the few UK tech businesses that do list quickly prompt takeover interest. However, that brings up the most acute challenge facing the UK and its innovation sector: Draghi’s point about scaling up. There are plenty of smaller-cap growth stocks in the tech sector with potential and even more that are private. But very few of them remain British for an extended period of time.
That translates to just one pure-play tech firm in the FTSE 100, Sage, which, in turn, results in the main UK equity benchmarks boasting very low exposure to tech growth sectors that global investors are keen on. It’s not that we don’t have the ideas or fast-growing businesses. It’s just that we don’t have the funding available for them to transition from being small caps to becoming global large caps. They succeed and then either go private or are taken over by larger global firms.
One industrial policy expert, Rian Whitton, argues that the British should emulate the French, who have kept hold of many major innovative businesses via a more plutocratic, family-ownership structure of global businesses. Whitton says that, “Fundamentally, wealthy French industrialists... are bigger players at home than their counterparts in Britain”. They retained control as their firms scaled up, keeping ownership in France.
A more modest proposal comes from Wotton at Gresham House. It focuses on giving incentives to business leaders, tomorrow’s Elon Musks or Mark Zuckerbergs. He says the remuneration model for listed UK businesses is a factor deterring entrepreneurs and quality managers from choosing PLC entities as opposed to US businesses or even private equity-backed concerns.
“There needs to be more tolerance of value creation equity schemes (like private equity’s sweet equity schemes) as long as [they are] aligned to long-term shareholder value creation and less reliant on the proxy agencies, such as ISS, which are black boxes on governance and not fit for purpose for scaled-up businesses.”
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