In January the government published a green paper on “Building our Industrial Strategy”. The report lays out 10 pillars consisting of wide reaching measures with implications for the whole economy. In my previous post I pulled out the proposals which I think are most relevant to the UK early stage tech sector.
In this post I wanted to discuss in more detail the report’s reasons behind those measures, some of which I agree with, some of which I don’t.
The macro problem: low productivity
The strategy is principally concerned with improving the productivity of the UK workforce.
It reports that despite strong GDP growth since 2010 (second only to the United States among advanced economies), and the lowest un-employment rate for 11 years, real wages have struggled to recover from the decline during the 2008 recession.
The paper points to the ‘productivity gap’ between the UK and its ‘competitors’ as the major cause of this stagnation in real incomes. Whilst the UK had started to close the gap in terms of output per worker (middle chart, below) with France, Germany, and to some extent the US, much of this progress was reversed during the recession.
More importantly, the UK remains far behind all three countries in terms of productivity per hour worked. As the right hand chart below shows, workers in the US, France and Germany produce as much in 4 days as UK workers do in 5.
As well as improving overall productivity, the strategy aims to correct stark regional disparities. As the chart below shows, productivity in London is now 72% higher than the national average with all other UK regions except the South East having productivity below the national average.
According to the paper, this is more pronounced than it is for our neighbours, although it is difficult to compare apples with apples given the differing geographies of different countries.
So what does this have to do with tech start-ups and investors?
Well the report rightly highlights technology innovation by early stage businesses as an important driver of productivity improvement and it specifies two main barriers holding this innovation back.
1. Insufficient access to R&D funding.
2. Lack of support for ‘scale-up’ businesses.
As I explain below, the report makes a good case for the first, but I’m not so sure about the second.
Access to R&D funding
The green paper concludes that there is a need for increased government R&D funding, highlighting a correlation between government support and business investment in R&D (BERD) as shown in the chart below.
The UK invests 1.7% of GDP in public and private R&D which is below the OECD average of 2.4% and far behind leading backers of innovation (e.g. South Korea, Israel, Japan, Sweden, Finland and Denmark).
This is a function of lower government spending but also a below average ratio of private to public investment.
The report also emphasises that whilst the UK has a strong record of early stage research, we are relatively weak at turning those innovations into commercial successes.
The UK has 3 of the world’s top 10 universities and 12 of the top 100 and it has the “most productive science base of the G7 countries”. However, the report claims that we have a long standing weakness in translating research into commercial outcomes and have “too often pioneered discovery without realising the commercial benefits”.
This may be partly due to the way we distribute funding across the different stages of R&D. Whilst our distribution is not hugely out of line compared to other European countries, we have a striking skew towards early stage research (basic and applied research rather than experimental development) compared to innovative countries such as Israel and many Asian countries. Notably China spends 80–90% of its R&D funding on later stage experimental developments compared to 30–40% for the UK (see below).
You can read about the proposed measures to boost R&D in my previous post.
Support for ‘scale-ups’
The paper highlights that whilst the UK has done a great job of creating a world class start-up environment, it has done less well at fostering those start-ups to reach ‘scale’.
The UK ranks 3rd for business start-ups but only 13th for scale-ups according to OECD research, and whilst 2015 was a record year with 5.4 million small businesses in the UK, a “lower proportion of UK start-ups grow into standalone businesses than in the US”.
According to the paper “some observers say we have an under-supply of late stage venture capital compared to the US” and this is presented as the main cause of our ‘scale-up’ under performance.
However, the report provides no evidence to support this, and as a ‘scale-up’ investor myself I haven’t seen any evidence of it in the market. Of course, it depends on how you define ‘scale-up’, but in the £2–15m range that we invest at Smedvig Capital, its doesn’t feel like there is a shortage of capital.
According to Beauhurst (a data provider) there are 76 funds who can invest up to £25m in equity finance in the UK, there are 112 that can provide up to £15m, and 247 than can provide up to £5m. So that’s somewhere between 76 and 247 funds chasing roughly 200 deals per year (I acknowledge there is a certain amount of ‘chicken and egg’ in this relationship).
Yes, the UK is far behind the US in terms of scale-up successes but I am not sure that this is down to a lack of funding. I don’t have any strong evidence to say what the underlying cause is, but let us not forget that the UK is a fundamentally smaller market than the US (which is 5–10x bigger in most cases). For UK businesses to reach anywhere near the scale of similar US competitors they either need to go to the US or to multiple other markets. Given the challenges of entering new markets this must make it harder for UK businesses to reach ‘scale’.
Some of the current and proposed work by the Department of International Trade (including expansion of export finance) may well help with this by making it easier for UK businesses to scale internationally.
The paper also suggests that fund management incentives weaken long-term decision making in Europe as “funds are expected to deliver short term returns versus industry benchmarks”. At Smedvig Capital, we are lucky to have a very flexible mandate and we certainly see that many successful investments take longer than the 3–5 years that many companies are forced to aim for (our average hold period is 7 years).
The report also singles out lower levels of fixed capital investment for UK listed firms compared to other OECD countries as a possible symptom of short term incentives in public markets holding back long term investment (we have been in the lowest 10 per cent for 16 of the last 21 years).
If you have a view on this topic, the government has launched its business scale-up inquiry and is looking for feedback by May 3rd.
You can read about the proposed measures to help UK businesses scale-up in my previous post.
Conclusion — good proposals, not sure about the reasons
Whilst I definitely support the measures laid out by the report, I’m not sure I fully agree with all of the reasons behind them. In particular, I haven’t seen any evidence of a lack of ‘scale-up’ finance in the UK.