From neglect to opportunity: why early-stage UK enterprise is ripe for a comeback

It is no secret that the smaller, entrepreneurial end of the UK market has been unloved for some time – a small cap fund manager we met recently said to us “it’s like trying to sell toxic waste”! We think there is a clear case for an allocation to smaller private and public equities in the UK and that now is as good a time as any to make one. Here we explore the reason for the apparent neglect, and why we believe a shift in sentiment is coming. As an aside, we think there is a strong case for small caps globally, but for the purposes of brevity, and because we feel the case is particularly strong, we will focus on the UK.

Backdrop

The UK has the third-largest Venture Capital (VC) market in the world.¹ The Alternative Investment Market, “AIM”, a sub-market of the London Stock Exchange, is an expression of this. AIM turns 30 years old in its current guise this year and is the most active growth equity market in Europe. More than half (54%) of all growth capital raised in European markets has been through AIM. Indeed, 24% of AIM companies are international, showing that companies outside of the UK find it to be a good place to do business.² The early-stage market is helped by various government incentives, like the Enterprise Investment Scheme (EIS), which provides tax benefits to retail investors.

Combining these factors means the UK tops the table in Europe for Unicorns (tech companies valued >£1bn) and ‘Soonicorns’ (companies believed to become Unicorns in the next 24 months).

Number of Unicorns and Soonicorns by Selected European Countries³

All of that being said, for several years the rhetoric surrounding the UK market has been overwhelmingly negative. This has been driven by low economic growth, increasing tax/regulation, political and economic turbulence since Brexit, as well as institutional and retail investors favouring global stocks such as US high growth companies.⁴ These factors have resulted in nine years of net outflows for the UK.⁵ Valuations have fallen steadily since 2016 against both US and EU peers⁶, leading to a lack of ambition for companies to IPO in the UK. This sentiment has been hardest felt in the UK small-cap market but has spread across the private markets too.

The phenomenon is evidenced by many of the UK’s star companies being taken over by US firms⁷ or listing on US markets, as well as some of the largest UK companies and infrastructure being majority-owned by overseas investors⁸. This trend is concerning, particularly given the UK has the second-largest investor base globally⁹. Indeed, the proportion of domestic institutionally managed capital invested in UK equity has fallen sharply (see the bottom grey area in the charts below). This is due to a combination of factors but the growth of market cap indexing and a weak incentive structure to spur investment in the UK compared to other jurisdictions are two main challenges. It is cheaper for a UK investor – even a tax-exempt entity such as a pension scheme – to transact in US (secondary public or private market) equities. In the UK they are taxed 0.5% Stamp Duty on secondary share transactions – that’s more than a year’s management fees and expenses in many cases.

UK-Based Asset Exposure¹⁰ as a Proportion of:

There are plenty of reasons why a material domestic allocation makes sense for UK savers. Stimulating the domestic economy, developing infrastructure and creating jobs are critical to the UK population. In other words, investing domestically can help to create a virtuous circle. The absence of (or at least, reduced) currency risk can also be a positive.

We observe the rise of firms like Robinhood in the US, and cryptocurrency more broadly, as indications of the risk-taking desire of retail investors. Indeed, 18–24-year-olds in the UK own more cryptocurrency than stocks and shares ISAs!¹¹ So there is clearly a desire to invest, but for all sorts of reasons (outlined above) this has not manifested in allocations to early-stage UK companies.

We believe the UK is well-positioned to become a significantly larger market for small and mid-cap equities using its existing infrastructure, regulatory framework, and the wider ecosystem, such as that built around the AIM market. Below we set out both a strategic and opportunistic rationale.

Strategic rationale

We have identified five key strategic reasons why an allocation to earlier-stage UK growth opportunities stacks up:

Diversification: These companies will definitionally not be in the global passive or ESG tilted equity products that are so pervasive in portfolios nowadays. Many of them provide different, idiosyncratic exposure. This could be due to the value-add nature of the changes being made in the case of private equity, accessing a new technology like quantum computing, or from having a different sector and revenue mix to traditional indices.

Control: There are opportunities to take significant stakes in businesses, both public and private, which inevitably leads to an increased level of control and the potential to contribute views on how the business can position itself for the future. Adding value in this way can contribute meaningfully to return.

System Health: Ultimately, we believe the listed market is weaker without a healthy venture capital and growth equity market. A steady flow of innovative, dynamic, and entrepreneurial companies, fostered through the private and small cap markets, will help to prevent listed markets from becoming stale, which has clearly been happening in the UK for some time. The MSCI UK Index has just 1.1% in Technology yet nearly 11.3% in Energy.¹²

Inefficiency/Return Potential: Putting to one side the depressed valuations for a moment, this part of the market is not well covered by researchers (if at all) and, given the struggles that many managers have faced raising capital, it is not very crowded. There are roughly five sell-side analysts covering each small cap company in the UK compared to more than 20 per large cap company.¹³ This creates a richer opportunity set for managers to extract alpha and means companies are more likely to be open to engagement by these managers. A related point is the managers we speak to see the lack of analyst coverage as another factor that holds UK equity markets back globally, something MiFID II has exacerbated.

Invest in groundbreaking companies in the UK: The UK has some of the leading research institutions globally. Its venture and growth equity ecosystem is developing rapidly (expanded on later in this document) and provides a wide opportunity set to back ground-breaking ideas and research. We include some data below on the Oxford and Cambridge (“OxCam”) region, one of the most innovative globally, with world-leading levels of patents and scientific publications per capita.¹⁴

Opportunistic rationale & catalysts

John Maynard Keynes famously said, “markets can remain irrational longer than you can remain solvent”. With this in mind, what are the catalysts that give us more confidence about the investment case?

Valuation: This phenomenon has been at play for several years and has been described to us as an ‘aberration’ by many of the eclectic fund managers we meet in the UK small cap space. Market-wide multiples are at very low levels but there are also many examples of companies trading at below book value, in some cases with more cash on the balance sheet than their market cap! While the situation may not be this extreme in the private market, there are certainly good pockets of value. Small cap companies tend to do better than large caps with stable or falling inflation too, although we note recent tariffs may change the global inflation dynamic. Working with venture capital managers across the UK, we are also aware of a North versus South valuation gap, with companies outside the South-East available at much lower valuations. This is something we are looking to take advantage of.

Source: Bloomberg. P/E = price-to-earnings ratio. As at 6 March 2025.

Based on end March valuations, using history as a guide, the expected total return of UK small caps over the coming five years is in the region of 15% per annum. The same chart for the S&P 500 has an expected return of around 6%.¹⁵ “Is it different this time”? Probably not.

Source: Montanaro Asset Management, MSCI, Factset. As at end December 2024. TR = total return.

Mansion House Compact: Many large investors in the UK are embarking on a journey to increase their private market exposure. Whilst the pledge does not currently mandate a UK allocation, there is certainly an expectation that these investors make significant allocations to the UK or ultimately will be forced to. A second iteration of the Compact is being discussed, which may focus more on this. Nevertheless, many of the participants we speak to want to allocate a decent portion to the UK regardless.

UK-Wide Initiatives: There are bottlenecks across the UK stifling growth, such as a shortage of laboratory space.¹⁶

Productivity is too concentrated in London and the South-East – the genesis of the “levelling-up” policy announced in 2019. Initiatives like the Northern Powerhouse Partnership, the Midlands Engine and, more broadly, Innovate UK have been created to try and address these.

Growth in University-linked Venture Capital: We observe significant activity in this area. Well-established groups in Oxford and Cambridge, with formal university agreements to foster commercialisation of their IP, are now being followed by new endeavours in the North of England, the Midlands and in London. We are excited by the vibrant ecosystem these aim to provide. Creating specialised areas of excellence is key to their success.

What are the risks?

Procrastination: This is, perhaps surprisingly, our main concern. We hear about asset owners being understandably concerned about the potential changes across the industry vis-a-vis consolidation. Why allocate to a less liquid strategy when you could be impacted by such changes? We posit that we could spend years debating whether industry consolidation is a good thing, or we can take advantage of this opportunity now. It’s a bit like delaying the purchase of a new TV because you might redecorate the living room in 5 years’ time. We don’t mean to trivialise this risk, but the truth is that we think there are ways to manage the risks around, for example, a potential change in the registered nominee investor.

“It’s All Thin Air”: Initiatives like the Northern Powerhouse Partnership are nothing new and require money to be spent by UK taxpayers and (often global) companies in the UK to succeed hence there is a risk this funding never materialises and/or doesn’t attract the talent required. Any momentum needs to be compounded to make a dent in the UK’s productivity deficit and to see a return on this investment in order for the snowball to keep rolling.

Geopolitics: These risks are certainly apparent and could be impactful. However, we think geopolitics is relevant for virtually all investments and is incredibly hard to predict. In our view, it is not necessarily more acute for the investments we discuss here (for example, it could be that domestically focused companies are relative beneficiaries of tariff policies). Nevertheless, additional diversification can help mitigate the risk of the large weight in US equities through global market cap indices and reduce the geopolitical risk related to one country.

Deployment: We have often been asked if there are enough opportunities to deploy into in the UK should pension funds increase their UK holdings. We think this question stems from there being relatively fewer large transactions, with a lot of them being in the infrastructure sector. At the smaller end of the market, we see a significant number of interesting opportunities, and this is the focus of our attention. Very large investors may struggle to build out a meaningful UK allocation in the part of the market we like the most, but there are certainly plenty of larger opportunities too. There is a gap in the market for UK-based growth equity investors, with the vast majority of this capital coming from overseas. Only 18% of UK VC funding follows through to Series C and beyond, this number is 42% in the US and demonstrates the gap UK companies need to fill.¹⁷ That being said, a lot of UK early-stage funding is government-linked through entities like the British Business Bank. Indeed, in the US, pension funds provide 70% of VC investment compared to just 10% in the UK.¹⁸

Culture: Related to the point above is that the UK investment community typically take an “old school” approach to valuation, favouring cashflow and earnings over growth and market positioning. The UK tends to drip feed capital to growth companies where the US will fully explore an idea, accepting a higher risk of loss for a higher/faster return on the winners. This risk adverse culture is limiting the UK’s ability to fund fast growing companies and is one of the reasons sectors like Technology are not well represented in UK indices.

Conclusion

On balance, we believe the investment case for UK small caps, venture capital, and growth private equity is strong. Valuations are attractive, institutional momentum is growing, and government initiatives are supporting ecosystem development. Increasing allocations to these asset classes offers diversification benefits, access to inefficiencies, and the opportunity to support the UK’s economic future.

For UK investors, the additional benefit is clear: investing in domestic growth means seeing capital work at home, driving innovation, productivity, and long-term prosperity. The opportunity is here, and we believe the time is now.