How to reverse the rapidly shrinking UK small & midcap market

• Pace of M&A – There have been 27 potential transactions of >£100m announced YTD, with 18 from financial buyers and 17 from overseas. Of these, 30% have been in Technology and Healthcare, key sectors that the government wants to encourage!
• Not refilling the hopper – There has been minimal IPO activity for the last two years.
• FTSE SmallCap most affected – The index is seeing a steady decline in the number of constituents (-10% YTD) and market capitalisation (‑20%). We also look at the dramatic change in index composition and implications for index funds and costs.

Action required – The pace of decline is relentless and is likely to continue unless effective action is taken quickly. We are currently in a doom loop, where valuations are low, liquidity is reducing, investors are seeing withdrawals and there is little desire to IPO. If this continues, the UK could lose a crucial part of its financial ecosystem. Regulatory reform should help, but it is the demand side that requires serious attention.

Where are the funds coming from? We have discussed in previous notes the changing composition of ownership of UK companies, with pension funds substantially reducing their exposure over the last 25 years (overseas ownership is c.56% vs 31% in 1998), as well as many funds (eg charities) moving to a balanced portfolio with a global perspective. In addition, wealth managers have moved portfolios to a similar structure, and platforms (such as Hargreaves Lansdown and AJ Bell) have enabled retail investors to broaden their portfolios. All of this is great in terms of accessing a wider range of investments and spreading risk; however, it is fundamentally undermining the smaller company segments of the UK equity market.

The following table shows the massive change in the ownership of the UK market as insurance companies and pension funds have been withdrawing from equities, which has been replaced by overseas ownership. Market cap and liquidity constraints mean that overseas investors predominately target larger companies (ie FTSE 100 and the upper level of the FTSE250). This means the available pool of capital for smaller companies is shrinking.

FIGURE 1: Changing ownership of UK equities

• Source: ONS

The latest ONS data is from 2020, but it is more than likely that these trends have continued. It is also notable that there has been a marked reduction in individuals’ ownership of the UK market, which reflects a move into other assets and global portfolios.

What can be done? The good news is that the seemingly inexorable decline can be reversed relatively easily, and the UK can return to having a preeminent small and midcap market, where being listed is an aspiration and the market fulfils its primary function of providing capital to growing companies, acting as an effective marketplace and driving wealth creation. Central to this is increasing demand, which would drive a virtuous circle of higher investment, improved valuations and increased liquidity. It would also attract additional inward investment from overseas. There are a number of levers, a combination of which would transform the UK small and midcap market. 

• ISAs – Introduce an ISA allowance dedicated to investing directly in companies or funds dedicated to UK small and midcap companies. It is perverse that investors receive a tax break, which is then invested overseas.
• ISAs – Combine cash and shares ISAs, so that investors have greater ability to adapt their investments according to their requirements, rather than being locked into a single investment strategy. 
• CGT – Remove CGT for investing in listed small and midcap companies (similar to gilts).
  
• Corporation tax – Introduce graded tax for companies based on certain profit levels, to reduce the negative impact on smaller companies from the recent increase from 19% to 25%. This could be focused on listed companies, to reflect the importance of the equity market to wider society.
• SIPPs – Mandate a proportion to be invested in UK-listed assets in return for the associated tax benefits.
• IHT – Broaden the inheritance tax exemption from AIM to fully listed smaller companies, with a similar two-year holding period.
• Pensions – Extend the Mansion House compact to include small and midcap companies as well as AIM, and accelerate the timetable.
• Stamp duty – Remove stamp duty for transactions in listed small and midcap companies (similar to AIM), to reduce friction and improve liquidity. We estimate the total tax take on this to be only £10m, so there would be considerable benefit for a very low cost.
• Local Government Pension Schemes (LGPS) – Broaden the initiative to increase exposure to growth assets by widening the mandate to go to 10% in private equity, to include small and midcap listed companies. Also, the requirement should be for these funds to be explicitly targeted at UK investments. 
• Superpensions – Scale matters in pensions, as it gives purchasing power, cost advantages and greater ability to manage risk across a broad portfolio. The benefits can be material to the domestic economy. A good example is the growth of AustralianSuper, the largest pension fund in the region, which outperforms UK pensions and has a higher weighting in listed companies.

A combination of these proposals would turbo charge the UK equity market, encourage economic growth and enhance tax revenues, as well as making the UK a more attractive market for inward investment. It is essential that measures are put in place in the short term to ensure that the current malaise does not worsen. The good news is that most of these can be enacted quickly and the impact should be felt rapidly. The enhancement to economic growth and the overall market would ensure a net contribution to tax. 

When we are discussing small and midcap companies, we mean all businesses outside the FTSE 100. However, there may be merit to incorporating a market cap cut-off (eg £1bn) to enable greater targeting of the key problem area. 

M&A – an inexorable trend

We show below the list of companies leaving / potentially leaving the market announced since the start of 2023. 

FIGURE 2: Bid activity 2023 YTD (>£100m equity value)

Source: Company announcements.  * Note – Peel Hunt is restricted on these companies

Key points to note are:

• Index – There have been 11 bids for companies in the FTSE SmallCap and 11 in AIM, with two in the FTSE 250 and one in the Fledgling Index. 
• Sector – There have been five bids in the technology sector, with four in retail and three each in Healthcare, Media and Real Estate. There have been two in Financials, Leisure and Support Services, with one each in Food, Funds and Transport.
• Acquiror – There have been 18 financial buyers and nine corporate.
• Value – The total equity value of the bids amounts to £15bn, of which £13bn relates to financial buyers. 
• Location – Ten of the acquirors are based in the UK and 17 overseas.
• Month – There were seven approaches in April, with five each in September and October. The following chart shows the value and volume split by month. 

FIGURE 3: Bid activity by month

Source: Company announcements

FTSE Smallcap in focus

Index composition. It may seem obvious to those that know. However, many investors that subscribe to a FTSE Smallcap tracker fund are probably not aware that 48% of the constituents and 53% of the market cap is actually represented by funds. The large number of companies departing and the increase in funds mean that the split is now broadly even between funds and companies.

The de-equitisation trend is striking, as shown below:

This shows that over the last five years, there has been a 28% reduction in the number of companies in the index, from 160 to 115. Over the same period, the market capitalisation of the companies has reduced by c.50%, reflecting a number of larger constituents being acquired, and lower valuations. Even within the 115 companies, there are actually a number of quasi-funds (11 REITs and seven funds). If these were excluded as well, then the number of companies drops to 97, or only 43% of the total number of constituents. 

This is reflected by the greater concentration of companies in lower market cap bands, as shown below:

FIGURE 5: FTSE SmallCap ex Investment Trusts by market cap bands

Source: Bloomberg

This shows a 47% reduction in the number of companies with a market cap of >£250m, which materially reduces the available market cap for investors. 

In 2023 to date there have been 11 completed or proposed takeovers (hence the pro forma numbers above), which equates to a 10% reduction in the current year alone. It is no exaggeration to say that the sector faces an existential threat as it moves rapidly from being populated by companies to populated by funds.

Below we show a brief explanation of the eligibility criteria for the FTSE SmallCap. The index includes:

• Companies in the FTSE All-Share that are not large enough to be in the FTSE 350. The FTSE All-Share aims to represent >98% of market capitalisation of all companies eligible for inclusion. 
• Those with a minimum free float of 10% if UK incorporated, and 25% if non-UK incorporated.
• Annual liquidity tests in June.
• Companies in the Fledgling index are eligible for inclusion in the All-Share if they are >0.2% of the full market cap of the FTSE SmallCap at quarterly reviews, assuming they pass the liquidity test. As a result, companies with a market cap of >£105m are eligible for inclusion in the All-Share at present. Currently there are only five companies that qualify, of which four are funds. This continues the trend towards funds dominating the FTSE Smallcap.
• Companies are excluded if they fall below 0.1% of the full market cap of the FTSE SmallCap.

The full ground rules for the index can be found here, with the liquidity tests here.

Why does this matter?
The impact from the reduction in the number of companies and available market cap is significant for a number of reasons, as it results in:

• Lower choice for investors
• Reduced liquidity
• Declining market cap, leading to lower allocation from larger funds
• Lower interest from international investors
• Tracker funds investing more in funds than companies
• Declining professional ecosystem around the companies (lawyers, financial advisors, PR, analysts, etc)
• A marked reduction in companies that could become the large companies of tomorrow.

Tracker funds 

We suspect that many investors in UK small and midcap tracker funds assume that they are investing in growth companies with a focus on the UK. However, this is no longer the case, given the shift in the composition of the FTSE SmallCap towards funds.

For example, the L&G UK Smaller Companies Index Fund has a 56% weighting to Financials, with nine of its top 10 holdings being funds. Only one of the top ten invests in UK companies as its principal strategy, and even this fund is heavily weighted to the FTSE 100. This is a c.£360m fund that purports to invest in UK Smaller companies, but actually has a large proportion invested in a wide range of funds.

It is a similar story in the FTSE 250 – again, fund holders may assume that they are investing in midcap companies. For example, the £1.4bn HSBC FTSE 250 Index Fund is highlighted by Hargreaves Lansdown for retail investors. This fund reflects the composition of the FTSE 250, which means that 33% of the constituents and c.30% of the assets are in funds. This is a similar scenario for ETFs, such as the £740m Blackrock iShares FTSE 250 ETF.

The following table shows how the composition of the FTSE 250 has changed over the last five years.

FIGURE 6: Sharp reduction in companies in the FTSE 250 (by number and market cap)

Source: Bloomberg