Are we making progress in unlocking pension fund investment for biotech?
A core mission of the BIA is to improve the funding environment for UK life sciences companies, which in large part means seeking as-yet untapped sources of finance. British pension funds are one such source, as they currently invest little in venture capital. With £2.2 trillion under management, even a small fraction of these funds could make an enormous difference to the start-ups and scale-ups in innovative industries like the life sciences.
We’ve been talking about this opportunity for many years and it has been a major focus of our policy work since the 2017 Patient Capital Review. So with the Conservative Party committing to it in their manifesto, and a new report recently out from the British Business Bank looking at the potential of pension funds to invest in illiquid assets, it's a good moment to take stock of how far we have come, and ask what more needs to be done.
Background
In the Patient Capital Review, the Government formally recognised a long-known problem in the UK’s economy and committed to do something about it. The report said that there is a chronic lack of long-term finance available for early-stage and scaling companies in the UK, and that the life sciences sector is particularly afflicted. The BIA submitted views to the review, including highlighting the potential of the UK’s pension funds to help solve this problem. The Government launched a raft of welcome measures to start to increase capital supply and committed to continue to look at the thorny challenge of unlocking pension funds.
In autumn 2018, the Government announced it would convene a working group of some of the UK’s biggest defined contribution pension schemes to explore options for pooled investment in venture capital (VC) and growth equity (GE). The British Business Bank would lead the work, with representatives from Aviva, HSBC, L&G, NEST, The People’s Pension, and Tesco Pension Fund and the steering committee. The new document published by the Bank reports on that work, this is what is says...
The future of DC pensions: enabling access to venture capital and growth equity
The report focusses on defined contribution (DC) pension schemes because they are the growing segment of the pensions market following the introduction of auto enrolment. 90% of active savers outside the public sector are saving in DC schemes and funds under management are expected to grow to over £1 trillion by 2029. Moreover, as savers in these schemes are typically younger, they are more suited to the long-term investment horizons of VC and GE.
The report’s aim is to make the case for pension funds investing in VC and GE. It is very much intended to push behaviour change in the industry by setting out the returns that can be generated, identifying the barriers to DC schemes investing in such illiquid and potentially risky assets, and producing the solutions and options available to DC schemes.
The case for investment
The first task in producing behaviour change is creating the incentive. For those responsible for DC schemes, the incentive is better returns on investment that will grow savers’ pension pots. Low interest rates of the past decade and schemes’ preference for investing in bonds and “safe”, blue-chip companies have resulted in slow value growth for UK savers.
The report analysed multiple data sources going back to 1970 to determine that investments in VC/GE deliver returns seven percentage points higher on average than those in global listed equities. That means a 22-year old could see a 7-12% increase in retirement savings. This makes a compelling case for investment in VC and GE assets.
However, the report notes that there is a lack of firm data on the returns of VC and GE funds and recommends that the British Business Bank and others work to improve the data to provide more evidence. (The Bank has taken its first step in doing this by publishing a comparison of UK and US VC returns, showing that the UK actually slightly outperformed the US during the 2002-2011 period studied, despite the common perception to the contrary.)
The barriers
Institutional investors, especially pension funds, often point to regulations that they claim prevent them from investing in illiquid assets like VC. The Patient Capital Review identified these and there have been many positive steps taken by regulators and others to remove them or clarify that they are not an impediment. The main ones are:
- the cost of investing in this asset class, which is an expensive thing to do due to the expertise and due diligence required. Not only are DC schemes wary of high fees because of the competitive marketplace for pension providers, but they are also subject to the Government-imposed “charge cap”, intended to stop auto-enrolled employees being charged more than 0.75% on their savings. The effect of this is to exclude the costly business of VC/GE investing, where fees are typically 2% plus additional fees of 20%s – called “the carry” – when the investment does well. The report says that these high fees may in some circumstances be balanced by low fees in schemes’ other investments, but also encourages fund managers to develop more flexible and innovative fee structures to enable DC funds to invest in them. In this way, the report is hoping the market will address the fee barrier. The Government appears unlikely to remove the charge cap itself but is exploring more flexibility to how it is calculated (which the BIA has fed into).
- accessing the diversification and expertise required to mitigate the risk of investing in VC/GE. A collective investment vehicle allowing schemes to pool their allocations to VC/GE would be required, and those schemes involved in producing the report stated a preference for one to be provided by existing investment managers rather than created by the schemes themselves, due to the high start-up costs. So, essentially, they are hoping that this report will incentivise someone already in the market to design the perfect vehicle. The other question here is the legal structure of that vehicle. Although the Financial Conduct Authority (FCA) has been consulting on changes to fund structures to enable greater investment in illiquid assets, the report concludes that the existing structures of Investment Trusts and an open-ended unlisted fund could both work.
- the liquidity risk created by assets that can’t be sold quickly to meet the redemption requests of pension savers, who have the right to withdrawal their money at any time. VC and GE assets are hard to sell quickly, and the seller won’t get a good price. However, as it is intended that schemes allocate only a small proportion (~5%) of their total funds to illiquid assets, the report concludes that liquidity can be managed at the scheme level. Furthermore, the FCA has already proposed clarifications to make it clear that this is allowed within existing rules, as there was some doubt within the pensions industry.
The report also explores and solves three other potential barriers: ensuring fund withdrawals by one scheme won’t negatively impact others; how daily pricing requirements could be met; and addressing the poor performance all venture capital investments see in their early period that could put off schemes from being the first movers.
The report’s recommendations
Having made the case for investment and addressed the barriers. The report makes recommendations for all stakeholders, including trade bodies like the BIA, to help unlock DC schemes’ investment for VC and GE:
- Information: The British Business Bank, supported by the BVCA and venture capital and growth equity funds, will continue to work to improve the quality and availability of industry-level data on historic returns of the asset class;
- Education: As data improves, investment consultants, data and analysis providers and trade bodies can better educate DC scheme trustees on the value and nature of venture capital and growth equity funds;
- Regulation: Prioritise regulatory changes to facilitate venture capital and growth equity investments;
- Industry change: DC schemes can use their scale for good to create pooled investment vehicles and develop reduced fees with DC-centric structures.
The next steps for the pensions industry
The purpose of the British Business Bank’s report is to act as a catalyst by making public all the key considerations for establishing a collective investment vehicle, in the hope that a provider in the market can produce it. We’ve spoken to some that are trying, but they are still searching for the sweet spot that has the business case to entice pension schemes.
The regulatory hurdles appear to mostly have been debunked or removed, although no-doubt there will be nuances for some. The FCA has published its new rules for fund structures and the Investment Association’s proposal for a new “Long-Term Asset Fund” structure appears to be finding favour, meaning there are multiple types of vehicles to be tested in the market, to see which are most attractive to pensions.
The next step for government
With a General Election now called, the next steps will be dictated by the new Government’s priorities. However, encouraging pension funds to invest in more productive parts of the economy should have broad cross-party support, so we could see progress regardless of the new administration’s shape and colour.
The Conservatives have committed to “unlock long-term capital in pension funds” in their manifesto, which it is great to see following our campaigning on the issue.
Conservative ministers have been keen to say that they cannot tell pension funds what to invest in. But in the Queen’s Speech, it said it would bring forward legislation to ensure pension schemes provide more information to savers to give them more control over their investment decisions. This could lead more people to question the investment returns and social benefits their savings are delivering, and to therefore look elsewhere for providers offering investments in growth sectors and those seen to have environmental, social and governance value. This is a growing trend in personal investments. The legislative agenda set out in the Queen’s Speech is now on hold pending the General Election, but the policies could resurface after the election, including if the Tories do not get back in.
The Government also has control over the British Business Bank, which could be a catalytic cornerstone investor in any new collective investment vehicle for pensions. The Bank is also a key player in the education of pension funds by providing relevant and trustworthy data on the real returns that VC and GE can deliver. However, its focus is currently spread across all sectors and it arguably could be more targeted to sectors where there is a greater case for government intervention, such as addressing the life sciences funding gap identified in the Patient Capital Review.
The next steps for the BIA
The BIA has long highlighted the need for pension funds to allocate some of their funds to the UK’s emerging and high-growth companies. We have been a cheerleader for the work stemming from the Patient Capital Review in 2017 and sought to bring stakeholders together, and raise the profile of biotech specifically within a government agenda that is broadly sector agnostic. We will continue to do this, working collaboratively with the British Business Bank, the British Venture Capital and Private Equity Association (BVCA) and others. In particular, we believe the British Business Bank can play a key role in addressing market failures as part of the Government’s Industrial Strategy, for which they may need additional resource.
We firmly believe that people should have choices about how and in what they invest, and, in particular, they should have opportunities to invest in exciting sectors that deliver benefits to them and the causes that they believe in, be it environmental, health, or foreign development, for example. This was the driving force behind the Citizens’ Innovation Fund, which we developed in 2013. The pensions reform legislation provides a new opportunity to put information into the public’s hands so that they can make these decisions and the BIA will be taking part in the public and parliamentary debate on how this can be achieved. We hope that the pension fund industry will act themselves to ensure they are investing wisely to deliver the returns needed for people’s retirement, but stronger measures may be required to compel them to consider this, much like they do for the Environmental, Social and Governance (ESG) criteria. The French “Solidarity Investment Fund” is also an interesting model to look at.
To complement this, we will be launching a newsletter for generalist investors to raise their awareness of the momentum and opportunity building in the UK biotech sector, and publishing a guide to investing in biotech, which will help generalist investors, pension fund trustees and the wider public understand the sector, including its risks and opportunities.
