In 2021, Canadian Pension Plan Investments invested $300m in UK scaleup Octopus Energy. That one deal was larger than the total investment by UK pension funds into UK startups in all of 2022.
Investors and politicians have long said that the nation’s pension funds should be doing more to back venture capital and innovative companies, both to diversify their holdings and potentially boost returns to let regular Brits benefit from the upside. UK pension funds manage the world’s second-largest pool of retirement savings, a massive $3.6trn pot; for comparison, UK tech raised £24bn in 2022.
In April, a key regulatory hurdle that kept pensions from investing was rolled back by the UK’s innovation-friendly government. In its Spring Budget, the government also said it would develop a road map to “encourage” pension fund investment into startups and VCs.
VC firms are understandably keen for pension funds to do more.
“Meaningful investment from pension funds and insurers would be transformational, particularly for the later-stage ecosystem,” says Tom Wehmeier, a partner at VC firm Atomico.
So will pension funds finally take the plunge?
Not so easy
Pension funds have traditionally had good excuses for not investing in venture: they couldn’t.
That was because of a fee cap introduced in 2014 as “an end to rip-off pension charges”; private asset managers usually charge around 2% in management fees (plus performance fees), and pension funds could legally pay only up to 0.75%.
That issue has now “largely” been addressed, according to Chris Elphick, senior VC manager at the British Private Equity and Venture Capital Association. The budget changed the rules that govern pension funds to exclude performance fees from the fee cap calculation if they meet certain criteria.
But other issues remain, such as challenges of quarterly reporting for many pension schemes, according to Elphick. He explains that returns in the venture industry usually follow a J-curve — losses in the early years followed by returns much later. But a large deficit in the early years could begin to weigh heavily on quarterly reports, particularly for smaller pension funds.
Then there is the problem of fragmentation among UK pension funds. There are over 5,000 defined benefit (DB) schemes (those that pay a set retirement income) with an average size of £330m. Of the 27k different defined contribution (DC) schemes (those that pay based on the amount contributed), all but 1,300 have fewer than 12 members.
“They are very fragmented and don't have the scale to invest more diversely. So, they have become very risk-averse,” according to the Tony Blair Institute’s Jeegar Kakkad, who recently co-authored a report on the topic.
The average size of a DC scheme in UK at the moment is £53m, according to Kakkad, which means that by themselves they lack the size to effectively invest in diverse classes of assets, including venture capital. Typically, institutional LPs contribute between $5m and $50m to a fund.
Investors say that a lack of experience in private markets and risk aversion are other factors holding pension funds back.
“The perceived risk and illiquidity can be daunting [for pension funds], and while it’s essential that this [risk] is balanced across portfolios, there also needs to be a better understanding that risk is prevalent in the private, public and bond markets,” says Wehmeier.
Nordic and North American pensions as a model
North America, the Nordics and Australia have seen pensions become big backers of innovation, and investors say they can be a model for UK pension funds looking to dip their toes into venture.
In 2020, Nordic pension funds invested close to $200m in European venture capital, while UK pension funds invested $30m.
Wehmeier says that the Nordics are leading Europe and show benefits for pensioners as well in the form of good returns. “For instance, Sweden’s AP6, a fund solely focused on investments in unlisted companies, provides a great example to follow and is currently growing at a 15% CAGR,” he says.
Elphick argues that much of this difference can be explained by the differing architecture of those funds.
“Pension funds in these jurisdictions [North America, the Nordics and Australia] have the expertise and flexibility to invest in a range of assets such as private capital and are also allowed to invest globally to find the best returns,” he says.
What’s next
The Financial Times recently reported that chancellor Jeremy Hunt will use a speech in July to outline plans to bring more pension fund capital into the tech landscape.
The government has been in consultation with the industry on how best to invite investments from pension funds through the Long-term Investment For Technology and Science mechanism, more commonly known as LIFTS. The initiative is currently seeking proposals for new investment vehicles to attract pension investment to science and tech investment with an initial commitment from the government of up to £250m.
Proposals from the government include co-investments with British Patient Capital, the state-owned British Business Bank’s venture capital arm, to leverage its investment capabilities in this sector. Other options include the setting up of new investment vehicles in addition to the BPC. The government is expected to announce next steps in November, according to a document released in March.
The opposition Labour Party are keen to not be left behind. It's said it's considering a 5% mandatory contribution by DC funds into a £50bn growth fund for fast-growing companies if it's voted to power.
According to industry experts, the mandatory contribution — Labour has acknowledged that it may not have to come to that — could complicate things.
But there are also risks with mobilising more capital from pensions, investors say.
Tim Mills, managing partner at early-stage VC firm ACF Investors, says that forcing pension funds to invest in an asset class they are uncomfortable with may not be a good idea.
“Forcing a series of entities to invest in an asset class they are not comfortable with, without thinking about them having the capability to manage those investments well and without building that capability, is not ideal. It's not likely to lead to a good outcome in the long term."
Wehmeier of Atomico agrees. “There’s a risk mandatory contributions could have a detrimental impact if capital is deployed without the appropriate skill set behind it,” he says.
Rather than mandating pensions investor, Wehmeier says that incentives are a better way to move more pension capital into venture.
