Science and TechnologyWritten evidence submitted by Katie Potts, Herald Investment Management Ltd

1. What are the difficulties of funding the commercialisation of research, and how can they be overcome?

From Herald’s perspective the UK is one of the most attractive markets in which to invest, with a strong regulatory framework, and low valuations particularly relative to bonds in spite of having to fund the cost of the welfare state, and relatively high salaries. There is also a reasonably high level of innovation and entrepreneurial spirit in the UK, particularly compared to Continental Europe, if not Israel and the US. There seems to be a greater sense of inferiority that overseas markets have greater attractions than is justified from the micro perspective of investing globally in smaller TMT stocks. We are proud that we have made long term returns, without Government subsidies, well ahead of all the wider indices in early stage investments. Nevertheless, we have been on the defensive, as we ourselves have directly been victims of the pension funds selling Herald shares, and they have gradually been replaced by private investors, who are regrettably less stable. Furthermore we have had to defend our overweight position in the UK to certain investors in Herald’s funds in spite of the evident solid long term returns.

It has been our stock in trade at Herald to provide early stage (ie pre-profits) capital, mainly at IPO and follow on secondary offerings in the quoted market through Herald Investment Trust plc. Historically we have co-invested with other investors, and taken stakes up to 10% of the issued share capital. In the current environment IPOs are unattractive for two reasons (a)There are insufficient co-investors to raise the needed capital (b)There are too many cheap stocks in the secondary market (which we want to protect against predators), which have less risk. Furthermore, at Herald’s venture meetings I have repeatedly said “I can’t get my mind round investing £2 million in a pre revenue company on a valuation of £10 million, when I can buy companies in the quoted market that are already profitable and growing on similar valuations.”

It is only with healthy secondary market valuations that IPOs are attractive, and thereby justifies the risk of venture investing early stage. There is a disincentive to attempt to commercialise research if follow-on funding is uncertain or expensive.

(i) Shortage of capital

Equity Shortage

There is much media discussion about the difficulties small companies have in raising bank debt. Bank debt has never been available for early stage technology companies, and furthermore it is an inappropriate form of funding for companies pre profits. The current environment shows an absence of equity. This is reflected in the virtually closed market for quoted IPOs since 2007, and a similarly meagre venture pool. Unfortunately the bubble of IPOs when the TMT sector was too fashionable, led to poor returns, which has led investors to perceive the sector as risky. AIM had a similar but less pronounced bubble and bust. There has also been a shortage of major successes in the UK versus the US. This has led US investors to have greater confidence and therefore US technology companies have had a lower cost of capital. However, even in the US the number of US IPOs in the last decade is 80% lower than in the1980s or 1990s, with investors in US IPOs having equally inadequate returns. It is frustrating to have watched the bubble of investor interest into emerging Asia, even from UK based investors. As global investors we find the lack of established regulation, and the lack of IP in markets such as China a pretty unattractive investment proposition, and despair to see limited UK resources going there, and not to lower risk propositions in the UK. In Continental Europe there are very few emerging technology companies, and closed public equity markets.

Why the shortage of equity investment in the UK?

However, there is an even greater issue, which has led to the shortage of equity. It is the evaporation of pension fund and insurance company asset allocation into UK equities, and an even greater reduction in the exposure to smaller companies. These institutions were professional long-term stable investors, with good corporate governance skills who controlled executive remuneration etc. It is a tragic and devastating unintended consequence of the abolition of ACT relief, combined with the rising liabilities for defined benefit pension schemes as life expectancy has grown, and investment returns have diminished. The accounting requirement to disclose these liabilities with valuation methodologies which discourages equity investing has been the final death knell, which has led to the disappearance of institutional investors on the registers of our investee companies. In addition, historically fund flows into UK equities were to some extent guaranteed as pension trustees had positive cash inflows, and believed that sterling liabilities should be matched by predominantly sterling assets. It was also in their members’ interests to have a strong UK economy, so there should be an allocation to small companies which will provide growth to the economy, and there is strong historical evidence that small companies over the long term do outperform large companies: For example the Numis Smaller Companies Index (previously HGSC Index) has returned 404.8%% over since 31/12/1994, versus 255.3% for the FTSE 100. On an even longer term basis over the 57 years from the start of 1955 to the end of 2011 the Numis Smaller Companies Index, representing the bottom 10% of UK companies by market capitalisation, has generated a total return of around £3 million for each £1,000 originally invested (dividends reinvested), while the overall market (FTSE All-Share) has given a total return of approximately £0.6 million for each £1,000 originally invested. The return from smaller companies over this period has therefore been five times greater than the market overall. Annualised returns over this period are 15.1% for the NSCI, and 11.9% for the All-Share. This does not feature in Trustees’ consideration today, and allocation seems determined by actuaries and accountants and not fund managers, and the pressure for consistent short term returns. Furthermore, defined contribution schemes means that companies care less about maximizing performance, and more about minimizing risk. It seems to me to be a frightening mistake which we shall come to rue.

I stress I am more despondent about the funding environment for UK technology companies than at any stage in my career, which now spans nearly thirty years, and believe there is a bigger problem than realised. (I am despondent as a taxpayer. As an investor having some money when others don’t has its attractions, but at times I fear we have a watering can in a desert!).

To me the obvious simple solution is to require pension funds, in order to maintain their existing favourable tax treatment, to allocate at least say 1–2% of total assets to equity investment in small private and public UK companies. This could be extended to European small companies if EU rules require. The definition of small company should be £0 million to c£500 million in valuation, and care needs to be taken in defining UK—eg % of employees. In practice this investment should phased over a reasonable time period. This would allow professional investors to make commercial judgments and investments at no cost to the taxpayer.

As a matter of urgency Government needs to encourage greater equity ownership, especially by long-term high-quality investors such as pension funds.

(ii) Shortage of commercial management

It is evident that the cluster of successful companies in northern and southern California, to take the most extreme example, has occurred because there has been a succession of fast growing companies, which has taught a succession of management teams about how to scale a business. There is no such UK training ground. It is depressing how few first generation businesses have become large companies in the UK compared to the US. A radical suggestion would be to make private investors pay income tax rates on realised gains on assets that are held for less than three years, and lower the CGT rate from 28% on assets held for longer than 10 years and/or at least index the book cost in line with inflation. (NB At current rates of inflation CGT rates of 28% are in real terms higher than income tax for long term investments.) In addition pensions could be charged a gains tax on profits realized within five years. This would encourage longer term ownership, and help develop a generation of management that can scale a business.

In 2002 we were approached by the Russell Group to consider managing a fund to invest in technology transfer out of university laboratories. We were flattered to be considered, and undertook an extensive process to consider the viability of such funds. This included meetings with successful universities overseas (Colombia, Harvard, Massachusetts Institute of Technology, New York and Stanford in the United States and Technion in Israel. Our conclusion was that money alone could not solve the problem. Commercial management was equally necessary. Academics can underestimate the skills associated with developing, producing, marketing and selling. We also observed how effectively Columbia, for example, had commercialized IP through royalties. It is an obvious way to reduce the business risk if you can leverage an existing corporate structure and sales force to launch a new product. However, it is a challenge in the UK because there is a shortage of large companies who could be incentivized to commercialise products. We were impressed by the commercial approach at Technion which is reflected in a remarkably successful technology sector in Israel in relation to the size of the economy. In contrast the UK universities seemed far less commercially aware or astute. I suspect that efforts made over the last few years mean that UK universities have improved. Overall, regrettably we came to the conclusion that we, at Herald, had inadequate resources to take on the challenge.

(iii) Shortage of skills for the development and marketing phase

Every day we meet companies who complain about the difficulty of recruiting qualified UK schooled staff. Often we hear that immigrant labour is better qualified with a better work ethic, and overseas offices are often opened for skills not just cost (eg Poland and India). From the micro perspective of a TMT fund manager the education policy has been daft in not offering more places, and incentivizing students, to study disciplines where there are skill shortages. Maybe statistics published for employment rates a year after graduation for each course from each University should be more proactively analysed and published, and places be expanded where there are high recruitment rates, and reduced or closed where there are poor employment rates. In addition there is a shortage of large UK companies to undertake graduate training. For example GEC/Marconi was a great training ground, but no more.

In a knowledge world there is a mismatch between rising remuneration where there are skill shortages, and simultaneously rising unemployment. There is a similar disconnect in the corporate world where cash rich companies cannot invest cash to grow. Innovation is not a function of money but ideas. Small companies can be more innovative and productive than large ones, but they are cash limited. It is an investment challenge to invest in ideas, where no reliable discounted cash flow projection can be modelled. Economists are disappointed by subdued capital expenditure, but in the knowledge based TMT sector in which we invest R&D is more relevant than capital expenditure. Manufacturing for so many volume products is now in the Far East, with lower cost labour.

There is no shortage of creativity and IP generation in the UK. It has been said that the indisciplined UK culture, whilst bad for productivity, has been good for stimulating creativity.

2. Are there specific science and engineering sectors where it is particularly difficult to commercialise research? Are there common difficulties and common solutions across sectors?

Technology offering solutions to a large addressable market are more commercially viable, albeit certain niches can be less competitive. Clearly products where there is a long development and design-in cycle require more capital, and hence makes capital less available.

3. What, if any, examples are there of UK-based research having to be transferred outside the UK for commercialisation? Why did this occur?

We have been frustrated by the plethora of takeovers in the quoted market, at valuations that might have constituted a premium to the stock market valuation, but were disappointing in terms of invested capital, and our expectations. In particular it is frustrating to have invested at a risky pre profit, and sometimes pre revenue early stage, and to have seen the company through to cash flow profitability only to see the less risky upside taken, generally, by US corporate and private equity houses. The UK financial sector has very limited expertise in the technology sector, and is particularly poor at ascribing value to progress other than profitability.

4. What evidence is there that Government and Technology Strategy Board initiatives to date have improved the commercialisation of research?

From my perspective invisible. I have been in the technology investment industry since the mid 1980s. If initiatives have been helpful they have been more than offset by the evaporation of capital looking to invest in early stage and smaller companies equity.

5. What impact will the Government’s innovation, research and growth strategies have on bridging the valley of death?

From my perspective the Government would see better returns from nurturing 50 -100 man companies who have a greater chance of doubling and doubling again. Too much resource has been focused early stage only for them to gobbled up by overseas buyers.

6. Should the UK seek to encourage more private equity investment (including venture capital and angel investment) into science and engineering sectors and if so, how can this be achieved?

Private equity in City parlance relates to leveraged buyouts of established companies with positive EBITDA (cash flow), whereas venture capital is providing capital to start-ups and early stage companies that have not reached profitability. Now that pension funds are taxed on dividends, but not interest there is a fiscal incentive for companies to own corporate debt rather than equity. This combined with low nominal interest rates, and low public equity valuations has been a stimulus to private equity. There is zero need for Government to encourage private equity. On the whole they have short term time horizons. Cynically the parallel is a property developer who covers up the cracks, and sells on at a profit. Long term ownership like that of home ownership, is more desirable for businesses. In fact there is a case for making interest costs a non tax deductible expense to level the playing field with equity ownership. The short term shock to leveraged sectors such as property and private equity would be too traumatic, and have knock on negative effects on the fragile banks, but maybe tax deductibililty could be removed on all but loans secured on tangible assets. In contrast the Government must encourage venture investing, which is vital for the emergence of new businesses, added value job creation and exports.

The outside world has a tendency to see the City as homogeneous in attitudes and practices. Within the financial sector there are very evident divergences. We our long term in our approach we endeavour to invest in companies that will be making sustainably higher profits on a five to ten year view, and are supportive to that end. We cynically view so many short term investors as psychologists ie they endeavour to work out what other people will pay more for tomorrow than they do today.

Building successful businesses takes time. Pension funds and insurance companies have appropriate long term funds and professional managers. Angel investing is difficult and expensive to attract, and does not have sufficient depth for follow on funding.

At Herald we have managed two venture partnerships. After twelve years the IRR on the first fund (on unsubsidised investment) was a modest 3.6% per annum. This fund was launched in September 1999, and the return does exceed the total return on the UK equity market over that time frame, and according to BVCA data makes the fund respectably top decile. However, frankly, it has been an inadequate return on effort, and insufficient to get investors enthused about reinvesting. Idealistically I know that the economy needs venture investment, and I feel that we are well placed with our skill set and knowledge of the global sector through the quoted markets to be relatively proficient, and have useful experience. However, experience makes me realize that it takes many years to establish a sustainable business, and many of the stresses have been associated with inadequate capital, and the struggle to raise follow on funding. My judgment is that this makes it too risky to embark on early stage investing without sufficiently deep pockets to see an investment through to profitability, because external follow on funding may either not be available, or too expensive in terms of dilution. Equally it is uneconomic to have committed capital idle for up to 10 years when the final round might be needed. If the health of the market improved as described previously with better funded smaller quoted companies market, then this problem would be addressed. Candidly I would be unable to raise a fund of sufficient scale without this improvement. Idealistically I should like to raise a further fund, but selfishly I do not want the distraction or the stress, and cannot honestly present a case to potential investors with the same belief that I have in the potential performance of our quoted funds.

7. What other types of investment or support should the Government develop?

At Herald we have considered raising a VCT but have resisted the temptation. Why? The market is limited in scale, and the tax subsidy is devoured by the cumbersome expensive structure, and the high cost of marketing to retail investors. Furthermore, the time horizon is short, the availability of capital for follow on funding uncertain, and the size restrictions too dangerous. Hence my preference for encouraging the deeper pockets of pension funds who have long term money to fund the follow on investment required. In addition it would make investing more appealing to angels if they have knowledge that there would be a competitive market for follow on funding at higher prices. In other words I think existing VCT and EIS incentives would be more attractive, and yield a better return for the tax payer if the follow on market improved.

23 April 2012

 

Prepared 12th March 2013