By Joseph Mariathasan February 2024 first published in IPE magazine)

IPE Joseph Mariathasan.

UK equity market

Are the UK’s listed equity markets losing their attractiveness to international investors? Many would respond in the affirmative but disagree on the many reasons why this may be the case. What is clearer though, is that ill thought-out tampering with the regulations and taxation of the UK’s investment markets for immediate gains over decades has led to many long-term unforeseen and generally negative consequences. The most significant of these has been the decline in the size of the natural domestic investor base, both institutional and retail, which is able and willing to invest in UK companies from the early stages to pre-listing rounds and then to IPOs before becoming natural long term investors post listing. This arguably, has led to fewer UK listings and goes hand in hand with a declining importance of the UK listed markets to international investors.

Quick fix tampering by UK governments of both major parties has been prevalent for decades. It has been a quarter of the century since the then UK Chancellor, Gordon Brown tweaked the tax-rules so that pension funds could not reclaim tax paid on UK dividends.

“Government is now reaping a barren harvest, as UK pension funds have forsaken UK listed companies.”

declares Henry Tapper, Chair of AgeWage, arguing that Government should unwind this intervention. But with the now majority closed defined benefit schemes focused on minimising future risks by matching liabilities with bonds, that in itself is unlikely to be significant.

What has happened since the Brown intervention, although not directly attributable to it, is that the UK market has become significantly less important globally.

“When I started my career in 1996, I recall that the UK represented over 10% of the MSCI ACWI.  By the time I started at Railpen in 2011 that number had dropped to 7.5%.  It’s now around 3.6%”

says Craig Heron, director of public markets at Railpen. Moreover, as Edi Truell founder of private equity group Disruptive Capital points out, the UK’s relative performance has been very poor compared to international competitors. –

“The US S&P 500 has returned over 500% in the last 20 years whilst the FTSE 100 has only returned just under 300%. Morningstar data shows that in sterling terms the UK stock market has only returned 72% over the last 10 years compared to 110% from Europe, 103% from Japan and 267% from the US”.

Some of the UK’s poor performance is common to most other markets, due to the US market hegemony points out Heron, but some of it is also due to sector composition –

“the UK has historically had high sector exposure to out of favour sectors like banks and extractive industries and been relatively light in technology”.

As the UK’s global weighting has declined so has its attraction to international investors and UK investors themselves have also followed this trend.

For international investors, it should not matter where a company is listed. If domestic investors forsake a market and as a result, existing companies trade cheaper than their international peers, international investors should arbitrage the price differences away pretty rapidly. What matters is where companies operate, and how internationally diversified they are.

“Whether GSK is headquartered in London or New York does not matter from a pension fund diversity point of view”

says Kerrin Rosenberg, CEO of Cardano UK. He had worked with FTSE in the past to create a multi-nationals index representing a group of genuinely multi-national companies. The idea was that local country exposures could then be obtained through investing in the likes of utility companies, food retailers etc. However, the concept fizzled out due to a lack of demand suggesting that investors still preferred looking at investments through a lens.

Yet there is a serious issue with the UK’s listed markets which does have an impact on the UK economy as a whole and its attractiveness to international investors. This is, as Truell points out, the fact that the UK’s small and midcap sector appears to be in serious decline with

“the number of companies falling by more than 20% over the last five years while the level of market capitalisation has fallen by twice that – a staggering 40%”.

Without a supply of new IPOs by small companies, the pipeline of future growth companies will dry up and as there is normally more of a focus on home markets for mid cap and smaller companies, it has an impact on the UK’s economy as a whole.

The issue is what needs to happen to encourage the growth of UK listings by new companies which would then encourage more international investment. That means encouraging more investment in riskier early-stage UK companies prior to listing. Nicholas Lyons, the former Lord Mayor of the City of London has proposed the creation of a fund to invest in UK risky assets including VC and infrastructure funded by encouraging and possibly legislating the growing DC marketplace to invest 5% of their assets in such a vehicle.

“There’s no question that having a healthy IPO market where private companies can transition into public markets is part as part of a package deal that works very well”

declares Rosenberg. Moreover, argues Truell,

“it absolutely matters where a company is listed”.

The UK has developed a huge specialism in various roles that support companies whether it be professional services like accountants and lawyers or financial advisors. UK listed companies make a huge contribution to the UK through direct and indirect taxes as well as supporting service providers and suppliers. But Andrew Parry, head of investments at JO Hambro Capital Management is wary prescriptive solutions:

“America does not have a prescriptive way, but it has a lot more levers and a lot more opportunities. We can give in to the idea of American exceptionalism or else we can actually begin to think how to actually create innovative thinking in the UK through entrepreneurial behaviour”.

Where the UK underperforms relative to its capabilities, argues Rosenberg, is in some of the funding scientific innovations through venture capital.

“The UK has wonderful universities that produces huge innovations like our role in the COVID vaccines”,

but what the UK does not have in the same way as the US is an active route for commercial partnering with the universities to create the next generations of companies that will ultimately list on the UK stock market.

Whilst corporate DB pension schemes are now unlikely to be a source of risk capital for new companies, there are other potential sources that could perhaps be better utilised alongside the proposals for DC pension schemes. The local authority DB pension schemes are still open. With £400bn or so, a long-term perspective, very much growth orientated with high proportions in both listed and private equity they are classic long term equity investors argues Rosenberg. But he adds,

“When we look at Canada, the Netherlands, Scandinavia and Australia, we see massive pension assets and they are invested in the local economy. So what are we doing wrong?”

The answer appears to be that what the UK lacks are large scale public sector pension funds for professions like nurses, doctors and teachers. Firstly, these funds tend to be open DB, with a genuinely long-term horizon. Secondly, as they are essentially funded by public coffers, they can be more influenced by government directives channelling where the money goes in contrast to corporate DB schemes whose trustees have fiduciary responsibilities to pay pensions, not support the UK economy.

For the UK, Rosenberg’s suggestion of creating more funded pension-schemes for public sector workers could create a powerful domestically oriented investor base that could have a natural home bias encouraging the creation of a bigger pipeline of IPOs benefitting the UK economy and also attracting international investors. As he admits,

“I know it would be painful to get the whole thing up and running but once you’re up and running, you get to a virtuous position where the returns that you’re earning can pay for the pensions”.

The irony of the current situation is that for the UK listed markets to become more attractive to international investors appears to require a larger domestic investor base willing to support new UK companies as they grow in size and in their international footprint to become large enough to attract international investors.

Reproduced with the permission of the author