Bridging the funding gap for UK small quoted companies

With economic growth stalling and a steady flow of headlines about British companies opting to list in the US, it wasn’t a surprise when the Chancellor paved the way for a new UK ISA (Individual Savings Account) in the Spring Budget to help boost growth and reinvigorate the UK’s public equity markets.

Funding for start-ups and scale-ups, and the attractiveness of the London Stock Exchange as a venue for listing, have received significant policymaker attention in recent times. But less attention has been given to what happens to companies after they complete an Initial Public Offering (IPO) – to the supply of capital to small and mid-sized listed companies.

Despite a long record of healthy investment returns, structural changes have led to a decline in capital moving into the UK smaller companies sector. Action is needed to reverse this trend, to ensure that small and mid-sized companies can help drive the economy forward in the future. 

Why do UK smaller companies matter?

Listed smaller companies matter to the UK economy.  Their success is more closely aligned to the success of the UK economy as a whole, given they derive a significantly greater share of their earnings in the UK than the FTSE All-Share index as a whole. 

Around 45% of the revenues of the smallest 10% of UK listed companies¹ is from the UK, compared to around 23% of UK derived revenue for companies making up the FTSE All-Share Index. 

The small cap² sector also has four times more technology businesses than the FTSE All-Share index as a whole.  UK smaller companies are also big UK employers – the sector has nearly double the exposure to the retail and leisure sectors – and it shouldn’t be forgotten that a significant number of today’s FTSE-100 index companies started as small, listed companies that grew supported by capital provided by UK investors. Historically, UK smaller companies have been a dynamic force in the UK economy, producing strong long-term returns for investors. 

Why are smaller UK companies suffering?

Despite strong performance over decades, in recent years the smaller companies sector has experienced a dearth of new capital, partly due to key structural changes in both the UK economy and the retail and institutional investor landscape. 

First, in line with several other developed economies, the number of new companies coming to the market to list has declined significantly as companies look to remain private for longer, or for good.  Given that most companies looking to IPO are small or mid-cap companies, this has particularly hit the supply of companies to the sector.

Since the recent peak in 2005 when 387 smaller companies undertook an IPO, this number has dwindled to just 10 in 2023². The long-term UK average for all companies since 1987 is 134 per year – in 2023 the total was just 26².

Second, for much of the last decade (apart from post-pandemic recapitalisations), the quantity of funds raised on the UK’s equity markets for IPOs or for existing listed businesses has been consistently below historic averages.

As a result of the fall in IPOs and continued exits through de-listings (removal from the stock exchange) and takeovers (principally private equity and overseas corporate buyers), the UK has seen a continued reduction in the number of businesses listed on the London Stock Exchange³.

Third, when we combine the amount of new investments with withdrawals, we see that retail investors have been reducing their money in the UK Smaller Companies sector for 16 of the last 20 years⁴.

Fourth, institutional investment has also been in decline as defined benefit (DB) pension funds have sought to reduce risk and diversify their investment strategies: Investments have shifted away from equities into fixed income such that, since 2008, the UK equity percentage of UK defined benefit pension schemes has fallen from 25.8% to 1.4%⁵.

The transition to direct contribution (DC) pensions does present an opportunity to attract long-term capital from schemes. However, the cultural and regulatory focus on cost within DC, rather than value, has increasingly driven many pension trustees to access equities through global indexes rather than active investment strategies, again to the disadvantage of smaller companies.

The combination of all these factors has created an almost perfect storm for small and mid-sized company funding.

Can the new UK ISA be part of the solution?

The announcement in the Spring Budget that the government plans to introduce a UK ISA was welcomed by professionals and savers alike. As an addition to the existing ISA allowance, the UK ISA represents a further £5,000 tax-free savings opportunity for UK investors, while also potentially benefiting UK companies.

Currently in a consultation period until 6^th June 2024, the government is seeking views on the investments that can be included within the UK ISA and how it will run. If the investment is directed to UK small and mid-cap companies – either directly in shares or via investment funds – this could be an attractive way to help solve the problem.  For example, if just 200,000 ISA investors allocated an additional £5,000 to the UK smaller companies’ sector, the £1bn of extra funding would represent a sector record for the last 20 years.

The UK has an enviable track record of developing innovative growth companies. But support is needed across almost the full spectrum of equity provision to ensure not only that growth companies want to list in the UK; but that once they are listed, they can continue their growth story.