Features      

SET and the City The financial community needs to be aware of the opportunities available for wealth creation from science, engineering and technology if it wants to stay competitive in global markets  February 2007

Sir Peter Williams

Gordon Brown is on record as saying “Britain will only have a competitive edge if we develop world leadership in the most technologically intensive and science-based industries and services.”

Superb science and engineering are recognised widely as vital to achieving a modern and competitive economy. But less attention is paid to how technology-based industries can attract finance. In an effort to fill that gap, the Engineering and Technology Board (ETB) set up a group, under my chairmanship, to look at wealth creation from science, engineering and technology (SET). The group was drawn from venture capital, technology businesses, banking and, in our second phase, we were joined by the CBI, EEF and Association of British Insurers ABI, among others.

In our first report, we looked at the policy framework, including tax incentives for investors, of which more later.

We developed some of these ideas on policy in our second report, “SET and the City”, but our major focus was on how financial institutions relate to SET-related businesses in the UK. For achieving a high technology, competitive economy is far too important a task to leave to government. It can do much to encourage and discourage technology businesses and their investors, but the private sector must lead, and that includes sources of finance as well as sources of SET expertise and management.

With a 10-year plan and significant increases, in real terms, in government funding across the whole of SET, the UK has every opportunity to maintain its position as one of the world’s leading nations in scientific research. I hope that a high level of public funding is continued after the announcement of the comprehensive spending review later in 2007.

This scientific renaissance is taking place within an economic context where the UK, along with the US and some other economies, has for a number of years enjoyed stable growth, modest levels of unemployment and stable low interest rates. It is unsurprising against this background that since the turbulence in the financial markets at the end of the 1990s, the major global stock markets have experienced a period of considerable gain and prosperity. Among them, London remains one of the world’s pre-eminent financial centres, perhaps the most important outside the US. The London Stock Exchange as one of the world’s leading exchanges, is facilitating the raising of capital and the trading of securities for companies from 59 countries, and pre-eminent globally in trading in the world and the source of Europe’s largest pool of liquidity. Currently, there are 1,664 main market and 1,500 AIM companies quoted on their markets, collectively worth over £4.4tr and having raised over £20bn in 2005 alone.

Yet a paradox lies at the heart of this otherwise beneficial geographical coincidence of scientific heritage and powerful capital markets. The FTSE 100, the UK’s index of leading shares, contains today at most 16 science, engineering and technology-based companies, including, alongside biopharmaceuticals and engineering, petrochemicals and other industries whose technology is core to their business. The contribution of our much vaunted IT industries to the national economy as a fraction of GDP is less than one 20th of the corresponding figure in the US. It would appear that away from bioscience and the defence and aerospace industry, the UK has lost much of its ability to translate scientific leadership into wealth creation.

The obvious contrast is with the US, where pension funds and university endowments have been keen to fund technology businesses, and have benefited accordingly from the huge returns available. Analysts at Morgan Stanley have looked at what they call “10-baggers”; a business whose stock price has increased by at least 1000% since its initial public offering IPO. Technology businesses loom large in the list of 41 US businesses that have achieved this feat since 1980. Microsoft comes first, naturally, with an increase, as of the end of 2002, of over 35,000%, but the majority of the top 20 are technology businesses. Despite the excesses of the dot-com era, the market value created by technology IPOs in the US increased four-fold between 1994 and 2002.

But there is a further dimension to the UK paradox: the opportunities today for the successful exploitation of scientific knowledge have rarely, if ever, been greater. Our universities have since the 1980s begun to match their research prowess with a greater degree of commercial understanding and awareness. Patents are today as much the outcome of good science as publications. Spin out companies surround the campuses. The UK venture capital industry is the most significant in Europe. All the ingredients are there to achieve the goals articulated above. What we lack, however, despite this note of optimism, is the clear evidence that we can grasp such opportunities and turn them into the industries of the future.

So in what shape are relations between our great financial institutions and SET-related businesses? A survey of technology businesses we organised, with the help of the CBI and the Engineering Employers’ Federation, suggests that there are two distinct groups of technology businesses. One has good relations with the financial community, the other feels much more isolated and ill-served. We need to migrate more of the second group into the first, at every stage from start-up to the FTSE 100. This is a task for both technology businesses and the financial world; government can also play a role. In particular technology businesses and financial institutions need to work much harder at communicating their concerns and needs. Better explanations of R&D spending and innovation more generally can help. The new “Business Review” to be introduced into companies’ reports and accounts (successor to the Operating and Financing Review) will be an important tool for businesses and investors.

Considering different forms of institution in more detail, private equity is a major UK success story. But venture capital, compared especially with the US industry, is still small in scale. We are also concerned that in 2004, US pension funds were a larger source for UK venture capital and private equity than their UK counterparts. This is related to the active role US pension funds play in funding their domestic venture capital industry, in sharp contrast to UK pension funds. For UK venture capital, we do not minimise the difficulties posed by poor returns in the technology sector since 2000, though we are encouraged by recent signs of improvement. UK pension funds, however, continue to be under-resourced, both generally and in relation to managing a venture capital portfolio. Early stage technology businesses clearly need to deliver better performance, but we ask institutions to consider whether they could move prudently to a more US model of funding for venture capital.

For technology SMEs, banks remain the major source of external financing, principally from loans and asset finance, demonstrated amply by surveys from Warwick University and the Cambridge Centre for Business Research. Relations have improved between banks and SMEs generally since their nadir in the early 1990s recession, and technology businesses have shared in that. But we believe the banks could do more to address technology as a sector, recognising its special characteristics and its importance to the UK economy.

The rise of institutional investors in UK equity markets after 1945 coincided with the shrinking of the UK’s industrial base. We are not suggesting a causal relationship, and many factors played a role in this history, but this history strengthens the case for institutional investors to examine carefully their role in financing technology businesses today. We are now strong in fewer industrial sectors than we were two generations ago and despite the current strength of our economy; we believe that we need to build on our scientific and technological strengths to diversify into new markets.
What policy tools could government use to encourage a US-style relationship between the financial world and SET-related investors? Our group has a number of proposals.

First, given the long-term evidence for a funding gap between early stage and venture capital investment in emerging businesses, the government should review with considerable urgency the EIS legislation with a view to simplifying it considerably, in time for the 2007 Budget. It should also consider other measures to address this chronic deficiency in the market.

Second, the government should examine possible taxation incentives for institutional investment in venture capital, particularly by using a technology VCT for institutions by government, tailored to the respective circumstances of pension funds and insurance companies, in time for the 2007 Budget. By a “technology VCT” we mean an incentive, modelled on venture capital trusts for individual investors, but aimed at institutional investors and restricted to technology investments.

Third, we ask for the chancellor to consider supercharged VCTs – with additional income tax reliefs compared with current VCTs but stripped of capital gains additional reliefs, aimed at encouraging charities, either on their own account, or by channelling individuals’ funds, to invest in early stage technology companies, including those partly owned by universities.

Fourth, the government should review the openness of public procurement to early stage and SME technology businesses. Two proposals to be considered are firstly, the UK departmental targets for awarding R&D should be raised to make them far more stretching, with at least 10% of contracts by value being awarded to technology SMEs; secondly, a UK small business administration-style set-aside scheme should be introduced, with 20% of contracts by value going to SMEs; in both cases either directly or through the supplier chain. It is vital that any changes as a result of such a review be introduced with some urgency and that their effectiveness should be demonstrated transparently.

Finally, the government should enhance the activities of the DTI’s Technology Strategy Board and re-examine its relationship to the Council for Science and Technology. We believe that there is a clear case for greatly increased public investment in this sector. I very much support the line of argument on this in the recent report by the CBI and QinetiQ on public procurement.

The private sector can also take independent action. We recommend a number of steps that we believe could help, including:

• We invited the member institutions within the ABI, National Association of Pension Funds and others, while not diminishing their duty of care to their clients, to re-examine their vital central role in the development of the industries of the future, recognising their broader impact on the shape of the UK economy as a whole. Without such recognition, we see little prospect of the private sector matching government’s commitment to the technology sector, an imbalance which will ultimately reflect on national competitiveness.

• We encourage industry groups, trade bodies and government to examine ways of supporting the efforts of the London Stock Exchange in the long-term development of techMARK as a flagship, quoted company community of technologically innovative companies and at the same time encourage non-techMARK member companies to apply to join the community.

• We recommend that the CBI and EEF consider further opportunities to improve the elements of an effective communications programme between technology businesses and institutions within the capital markets, as there is little indication at present of any deep mutual understanding.

Of course all these efforts would fall on deaf ears, and deservedly so, if there were not returns available for investors to reap. But I believe they are available. Dr Mike Tubbs, for example, has looked at the companies that score highly on the DTI R&D scoreboard and their share price performance. He has identified an R&D portfolio of equal investments in 12 of these businesses that increased, in value, overall, by 91% in the period August 2004-November 2006, compared with a 41.2% increase for the FTSE 100. So a screening for R&D may well yield fine returns. It takes hard work and perseverance, but the opportunities are out there. Remember those US pension funds, searching for UK technology VC investments.
............................................................................................................
Sir Peter Williams, former chairman,
The Engineering and Technology Board, tel: +44 (0)20 7240 7333