ONS data shows the problem – The latest ONS data for ownership of the UK equity market shows the ongoing reduction in ownership by UK pensions, insurance companies and retail investors.
Depressed by fund flows – This is exacerbated by ongoing withdrawals from UK funds, which amount to £7bn in the current year.
Cheap but cheerless – The UK market looks exceptional value, but remains friendless. This is not surprising given the scale of money exiting. Overseas investors are partially picking up the slack, but this is directed at the more liquid, larger cap names.
Reckless conservatism – The focus on regulation and risk over the past 20 years has been pretty disastrous for the UK economy, tax revenues, level of investment, productivity and the equity market. Change is coming, but needs to be comprehensive to turn the tide. A proactive approach could rapidly change the momentum, which would suck in additional investment and drive improved outcomes for all stakeholders.
ONS data. The ONS has recently updated its data for ownership of the UK equity market. At the end of 2022, the proportion of shares held by overseas investors was 57.7% of market value, with individual investors holding 10.8% and other UK investors 31.5%.
The changing ownership is shown below:
Figure 1: Shrinking UK ownership
Source: Company accounts, Peel Hunt estimates
Below, we show the longer-term trends.
Figure 2: Changing ownership of UK equities
UK equity withdrawals. There have been 29 consecutive months of equity withdrawals from UK-focused funds (amounting to £18bn) as shown below.
Figure 3: UK equity fund withdrawals
Why this matters. There may be a feeling of ‘so what’. However, this really does matter for a number of reasons.
- Drain in natural owners. There has been widespread withdrawal from the UK equity market by pensions and insurance funds due to risk, regulation and conservatism. Wealth managers and charities increasingly run global and balanced portfolios. This means that there are far fewer ‘natural’ holders of UK equities.
- Overseas funds focus on larger companies. Overseas ownership is concentrated on larger companies as they typically focus on more international companies with greater liquidity. It is also important to remember that overseas investors will have relatively few holdings in the UK given that they typically have a pan European or global mandate.
- Reduction in individual investors. Individual investors are particularly important for ownership and liquidity in smaller companies. There used to be a strong equity culture in the UK, but this has steadily diminished.
- Lower retained capital. The change in ownership means that the capital returns from UK companies (in dividends and share buybacks) is increasingly paid to overseas investors, rather than invested or consumed in the UK.
- Growth in passive money. The increase in passive money further exacerbates the trends in terms of reduced active ownership by UK holders.
- Relative value. It is striking that the value of the entire UK market of £2.4tn is similar to the value of Apple. For a global investor, calling the performance of Apple is as important as calling the UK market.
The impact. These trends mean that it is not remotely surprising that the UK market remains friendless, despite the scale of funds returning due to share buybacks and M&A.
The outcome is low valuations, which have made the UK a happy hunting ground for both corporate and financial buyers. There have been 35 offers for UK companies of over £100m market cap in 2023, with a total value of £17bn exiting the market. All of these are in the small & midcap space, over half are being acquired by overseas buyers and a third are in technology and healthcare. This is continuing the de-equitisation trend of the past few years in the small & midcap space, with a reducing number of companies (down >20% in five years), reducing level of market cap (down c.40% in five years) and falling liquidity. Furthermore, the pace is accelerating.
Lack of growth capital. The equity market is a crucial part of the capital markets, providing permanent, growth capital to companies and enabling investors and founders to realise some of the value they have created. The drain of investment over the past few years means that there is a scarcity of funds available to support IPOs (there has only been one of note this year) and to support growth companies that are already listed. Generally, companies that want to raise money need to have shareholders with funds available as there is limited appetite to make a new holding in the portfolio. Furthermore, the cost of capital is materially higher, which raises the bar for investment.
This has material implications for funding the expansion of UK growth companies and the whole ecosystem around them. This matters because they are an important contributor to UK PLC and should be the large companies of tomorrow.
Overseas attraction. Companies are increasingly looking to raise capital in the US given the scale of the investment sector and allure of higher valuations. This is despite the higher cost of raising money and the substantial litigation risk. There is a clear risk that the UK’s growth companies sell too soon in their life-cycle or look to IPO in the US.
There are many reasons for the poor equity market performance in the UK, but a key aspect is the massive reduction in UK ownership by pension funds and insurance companies. This has been driven by changes in taxation and regulation, as well as attitude to risk. The charts below show how fundamental this has been.
Figure 4: Declining ownership of UK equities by pension funds
Figure 5: Declining ownership of UK equities by insurance funds
This shows that pensions and insurance funds owned 46% of the UK equity market in 1997, which has reduced to 4% today. Given the £2.4tn value of the market, that is a massive withdrawal of funding. Furthermore, this has come despite companies pouring £300m of additional pension contributions over the past 20 years. The tragedy of all this is that everyone has lost out:
- UK pension funds have underperformed.
- Companies have had to fund pensions rather than invest in their businesses.
- Pension performance has been lower.
- The UK equity market has materially underperformed global indices.
- UK growth has been slower.
- Tax take has been impacted, ensuring a higher tax burden in the UK, combined with lower funding for public services.
The following chart shows the scale of underperformance over the past decade. The FTSE Midcap has underperformed the S&P 500 by c.250% over this period and the Russell 2000 and MSCI World Smallcap index by c.100% in sterling terms. The S&P 500 has been turbocharged by the Big 7 (Apple, Amazon, Alphabet, Meta, Microsoft Nvidia and Tesla). Although this means that the S&P 500 is not a fair comparator, it also demonstrates the challenge for other markets to compete for airtime with investors.
Figure 6: Scale of underperformance
Source: Company accounts, Peel Hunt estimates
Change is coming
The positive news is that the issues are starting to be recognised. Change is coming through a combination of regulatory change and government initiatives including:
· Consultation to incorporate growth in regulation.
· The Mansion House Compact encouraging pensions to increase ownership of private assets.
· Local Government Pension Schemes being encouraged to invest in private equity.
· Reforms to improve regulatory burden for capital raisings for listed companies and for IPOs.
· Potential retail offer for the government holding in NatWest.
· Investment research review to provide retail investors with equal access to research and greater flexibility for institutions to pay for research.
But more needs to be done
The government is clearly indicating that the period of excessive regard for risk is coming to an end and that growth can benefit all stakeholders. However, this needs to permeate effectively through to a number of parties. For example there is currently little positive incentives for company management, actuaries, consultants and trustees in maintaining defined benefit schemes let alone focusing on growing the assets.
There needs to be a reset of the approach to pension funds in the UK, which would enhance the economy, pension assets and company cash flow. We will explore this in more detail in future reports.
It is notable that Thales has paid an upfront £850m to offload its pension scheme. Thales says it has >7,000 employees in the UK, a supply chain of 21,000 and delivers €1.6bn of economic value to the UK. Clearly the view of management is that removing a £75m per annum cost is good news, but were the actuaries correct in their assessment of the scheme or were they far too cautious in their assumptions. Think of the potential economic value if Thales had actually invested that £850m in the UK. Think of who benefits from offloading this scheme to Rothesay, which is owned by MassMutual, a US insurance company, and GIC, the Singaporean sovereign wealth fund.
The UK has a huge pension fund industry, but it does very little for the UK. This needs to change and the move in interest rates makes this possible. However, a fundamental shift is required to enable companies to take a different approach.
How to resuscitate the UK equity market
We have highlighted the importance of the UK equity market in previous notes in driving economic growth, tax revenue, investment assets and employment. It is a vital source of funding for growing companies, who are the key drivers of economic activity. Thus far there has been good progress on regulatory reform, but little to address the demand side. This is essential to ensure that the equity market can fulfil its function. We see numerous potential areas where the government can have a material impact in a short time-frame.
· Introduce an ISA allowance dedicated to investing directly in companies or funds focused on UK small and midcap companies.
· Combine cash and shares ISAs, so that investors have greater flexibility over their investments.
· Extend the Mansion House compact to include listed small and midcap companies, as well as AIM, and accelerate the timetable.
· Accelerate growth of superfunds to enable a focus on growing assets.
· Broaden the initiative for LGPS to have 10% in private equity to include listed small & midcap companies.
· Introduce graded tax for companies based on certain profit levels, to reduce the negative impact on small companies from the recent increase from 19% to 25%.
· Remove capital gains tax for investing in listed small and midcap companies (similar to gilts).
· Remove stamp duty for transactions in listed small and midcap companies (similar to AIM), to reduce friction and improve liquidity.
· Broaden the inheritance tax exemption beyond AIM to fully listed smaller companies (subject to the same two-year holding period).
· Accelerate supply-side reforms to make being listed more attractive and more flexible.
Access to research
· Introduce research platform to enhance coverage of small & midcap companies.
We need to have a fundamental rethink on the importance of UK capital in driving UK growth. We cannot rely on the goodwill of strangers. For too long our investments have been going into low returning assets or helping to fund overseas companies. Is it any surprise that UK investment lags the other leading economies or that our productivity is so stagnant or that our balance of payments is poor or that our currency has been weakening for a long period. The UK has so much going for it in terms of language, culture, innovation and location. Yet these advantages have been squandered for far too long. It would not take much to turn the tide. The naysayers protest that we should protect pensions at all costs. This totally misses the point that a growing economy has much wider benefits to all in society, including pensioners. The greater risk is to emphasise caution over growth.