The chancellor’s mansion house speech 2023

Let’s start with the latter. Doing away with MiFID II research rules is a right step. The rule, which essentially required companies to pay for research rather than get it for free as part of a relationship, has gutted research departments across Europe and left many smaller firms severely under-researched. The EU itself has recognised that this particular clause has not been successful and considers ways to review it as well. Moving first on this would allow London to spearhead some change in reviewing overregulation and would probably not cause a clash with the EU. We could see more jobs for analysts and better coverage for smaller firms, allowing for higher valuations. There are going to be losers, of course. Mid and small cap funds thrive in investing in under-researched companies. But increasing market coverage and information for the markets is always a good thing.

Simplifying a prospectus is a more mixed bag. On the one hand, reducing the regulatory burden for listing would help smaller companies achieve that goal and raise capital from the markets. On the other, the move itself would do little to improve London’s reputation as a global finance capital. Larger companies have few problems meeting the costs for listing. What they care more about is valuation. Higher valuations can be achieved better where there’s bigger market breadth and less investor concern. On average, between 2006 and 2016, UK stocks traded at roughly 20% discount versus their US peers. This number has doubled in the seven years post the referendum, at 44%. After 2021 the average P/E for a US stock is nearly double that of that for a UK stock. This is the reason why ARM, a Cambridge-based tech company bought by Softbank and taken private a few years ago, decided to be re-floated in the US instead of the LSE. 

Finally, we need to discuss the idea of increasing the share of pension funds in the private equity market. Its intent is to increase funding for smaller non-listed UK companies, allowing them, and the economy, to grow.

The intention is noble, but implementation comes with significant challenges.

The first and foremost is whether Venture Capital vehicles will be able to meet the strict requirements posed by pension funds. Assuming that this hurdle is cleared, one needs to consider the wider Private Equity landscape.

A decade of ultra-low cost of capital signalled the rise of Private Equity investing. Many companies even opted to remain private, rather than raise money through an Initial Public Offering.  

Venture capitalists and private equities adhered to the so-called “Power Law”. They needn’t get every investment right. They had to get a few of them right, and those few would result in big payoffs covering the losses from other failed ventures. The system worked, as long as money was cheap. It allowed private investors to spread the money Venture capital and private equity could spread the wealth and build company valuations up, with small risks, all the way until a company was listed in the stock market.

However, the resurgence of global inflation, as a result of tectonic geopolitical shifts, upended this cost/benefit calculation. As the cost of money rose, so did the opportunity cost for those funds. At the same time, their own capital is drying up. Pension funds, and other big organisations who could not find a yield in bonds, would expand to equities and private equity. However, as the risks rise, and bond yields with them, they are now beginning to trim their exposures. The risk/return calculus changes as private equities and venture capital firms can now not spread the money as much, which means that the probability of severe capital losses mounts. As a result, they would be less able to invest in as many new companies, and they would try to get more value out of their current exposures.  This causes an additional valuation problem. Without new money flowing into companies, valuations will happen based on earnings. Those who have not earned enough to justify, usually high, valuations, may be now faced with severe valuation contraction. Pitchbook, a news outlet for private equity companies, said in February that “private equity returns are a major threat to pension plans’ ability to pay retirees in 2023”.

It is in this environment that the Government proposed an increase of pension shares into private equity. The plan would help some smaller UK firms to be sure, and some off-shore ones as it doesn’t prescribe use of funds only for British firms. But it comes at a very challenging time for the Private Equity industry.