What explains the variable geography of equity investment?

Investors without an equivalent “home” have different patterns. Overseas investors are particularly London-focused, with 70 per cent of their deals in London-based firms.

In contrast, public organisations – such as the British Business Bank (BBB) – make 70 per cent of their urban deals in the large cities and other cities. This is not surprising: the BBB, headquartered in Sheffield, has a mandate to focus on places receiving less private investment based on the rationale that they are trying to correct for the home bias of London-based investors.

London has by far the largest number of investors of any domestic group of investors. If some of their home bias is a market failure – that London-based investors are ignoring viable investment opportunities in other places – then it would be a factor in explaining the underperformance of places that are being ignored.

London-based investors invest everywhere

The number of investable SMEs in a city influences how many equity deals it receives. As Figure 11 shows, after accounting for the size of a city’s investable firm base, the home bias of London-based investors is much smaller than the home bias of investors based in large cities.

London-based investors do make more deals per investable firm in London (290 deals per 1,000 investable firms) than they make in large cities (182 deals per 1,000 investable SMEs). But they make even more deals per investable firm in Oxbridge (381 per 1,000 investable SMEs) than they do in London.

Overseas investors are more biased towards London than London-based investors. They make twice as many deals per investable firm in London as in large cities (254 versus 124 per 1,000 investable firms).

Large city-based investors tend to invest more in large cities. Due to the small size of the group, their preference for their own cities cannot be measured. But collectively, they are ten times more likely to invest in a large city (79 deals per 1,000 investable SMEs) than they are in London (8 deals per 1,000 investable SMEs).

But the challenge for large cities is that they do not have enough home-based investors for their home bias to translate into higher amounts of investment. As a result, investable firms in large cities rely on outside investors – 89 per cent of the deals in large cities are made by investors based elsewhere, as opposed to 73 per cent in Oxbridge and 57 per cent in London.

London-based investors are not investing in high-value deals in large cities

Home bias should decrease as deal values increase. Larger value deals tend to go to larger and more mature firms. As these businesses attract the attention of a much wider pool of investors and have much larger investments, the location of the investors should become less significant.

In practice the opposite happens for the large cities. As Figure 12 shows, the home bias of London-based investors for bigger deals (above £4 million) increases to twice the rate at which they invest in bigger deals in large cities (126 versus 56 deals per 1,000 investable SMEs). Yet the preference of London-based investors for Oxbridge higher-value deals remains high (238 per 1,000 investable SMEs).

The implication is that large cities do not have enough businesses that can secure higher-value deals. There could be several reasons for this. One explanation may be that more firms in large cities, at the later stages of equity fundraising, relocate to places like London and Oxbridge (or overseas) to expand further. Another explanation may be that firms in large cities are struggling to grow and scale.

While investor proximity clearly influences investment decisions, the evidence suggests that home bias alone cannot explain why the geographies of equity deals and values vary.

Sectors and capital intensity

A key determinant of equity deal value is the sector of the firm receiving the investment. Some sectors are inherently more capital-intensive than others. For example, firms in life sciences can require more R&D spending and have a longer time to commercialise. As a result, SMEs in capital-intensive sectors are more likely to need equity and they are more likely to need larger amounts of equity investment.

If capital-intensive firms are more concentrated in some cities, these cities should have much larger individual deals, which would help explain the larger variation in deal values per investable firm than in deal numbers.

Capital-intensive equity deals have lower values in large cities

Based on the distribution of each sector across deal values, 14 capital-intensive sectors are identified (see details in Box 6). Across all deals in urban areas, deals in capital-intensive sectors account for 13 per cent of deal values below £4 million. This more than doubles to 30 per cent of deals valued above £4 million.

These capital-intensive sectors are not just over-represented in the higher-value deals – their deal values vary more between places than deal values in other sectors.

This again suggests that large cities face a problem in securing the biggest deals, and this appears to be related to the characteristics of their investable firm base.

Oxbridge has a unique advantage in capital-intensive sectors

A much larger share of Oxbridge’s equity deals are in capital-intensive sectors, as shown in Figure 14.

In these places, about 47 per cent of their deals are in capital-intensive sectors, even though investable firms in these sectors account for only 17 per cent of the investable base. These sectors are 2.7 times as represented in equity deals as in the base. In comparison, other places have a much lower share of their investable base in these sectors (7 to 9 per cent) and in equity deals (8 to 13 per cent).

Oxbridge benefits from more capital-intensive sectors in two ways. Not only are the equity deals in these sectors of higher value than in large cities (albeit not as high as London), they also account for a much larger portion of their total deals.

This helps explain why Oxbridge’s performance is so strong. The nature of businesses receiving deals in these cities distinctly differs to those in other parts of the country. This may also be why the home bias of their investors is so strong, if they have specialised, sector-specific knowledge.

By contrast it suggests that the lack of capital-intensive firms is not necessarily a major problem for the large cities. Their issue is with the performance of capital-intensive businesses, not how many there are nor how many deals they can secure.

Turnover and size

Another factor that shapes the value of equity deals is how firms grow and scale.

As a company receiving equity investment grows, it goes through multiple rounds of equity fundraising: from seed fund, to growth fund, to final exit (such as acquisitions by other businesses). The value of the equity deals tends to increase in later rounds of fundraising.

As shown in Figure 15, this pattern is seen in all places (See Box 7 for definitions of stages), but growth through stages varies widely across places.

London has an advantage in firm scaling

From the early stage to exit stage, average deal values in London grow from £3 million to £422 million. In comparison, deals also increase from early to exit stages in large cities. But the increase is from £2 million to £74 million.

So, while deals in London and large cities start with similar values at the early stages, by exit deal values are much larger in London (and Oxbridge) than in large cities.

The ability of firms to scale depends heavily on access to specialised labour markets, management expertise, and networks of professional services such as legal and financial advisors. These agglomeration benefits tend to be strongest in the largest and most specialised innovation clusters. London and Oxbridge appear to provide these advantages more consistently than most large cities, which may help explain why firms located there are more likely to achieve larger later-stage deals.

The scaling challenges in large cities reflect differences in firm performance

As Figure 16 shows, by the growth and exit stages, there are substantial differences between the turnover of equity-receiving firms in different cities. The average turnover for a later-stage equity-backed firm in London is £6.9 million; in Oxbridge, it is £5.5 million in large cities, it is £5.1 million.

This means in later stages, equity backed firms in London and Oxbridge are on average respectively having 34 per cent and 6 per cent more turnover than those in large cities.

Large cities do not have enough firms to compete with London’s scale

Firm growth can be investigated across each of the cities. Figure 17 shows that London, Oxford and Cambridge have a clear advantage in enabling firms to grow and obtain larger equity deals.

From early to late growth and exit, London’s equity-backed firms increase in value 17 times (from £1.3 million to £22.7 million). The average large city increase is close to 11 times (£0.9 million to £9 million) – half of London’s rate.

Across large cities, Liverpool is the strongest performer in terms of value growth. Deals in Liverpool grew from £0.4 million to £22 million. Liverpool’s late-stage firms as a percentage of early-stage firms (16 per cent) was also higher than London (10 per cent).

But only four Liverpool-based firms made it to the late-stage status, because only 25 firms in Liverpool received early-stage equity deals. The same applies in Nottingham – five firms secured late-stage deals with an average value of £13 million from a pool of only 27 early-stage deals.

Scale matters for scaling

Even though some large cities manage to get a higher share of early-stage deals to late-stage deals than London and Oxbridge, they offer less than seven per cent of the early-stage opportunities available in London. Only Manchester has more firms with early-stage deals than Oxbridge.

From the perspective of equity investors, who invest time and money trying to find firms to invest in, this means investing in the large cities is more time-consuming and costly per deal secured when compared to London and Oxbridge. Combined with lower growth prospects for firms in most large cities, the varying geography of equity investment across the country reflects efficient markets for capital rather than market failure.

Improving the equity readiness of the business base is the priority for most cities

These findings call into question the framing of the variation as an “equity gap” market failure. The underperformance of large cities in relation to attracting equity investment is because a smaller share of their small firms are equity-investable, and those that are investable tend to grow less.

Cities that are attracting more equity investment tend to have more equity-investable firms, that are larger and operate in more capital-intensive sectors.

Modelling the impact on total equity investment that a change to the factors identified in the report would have in each large city helps identify the policy priorities for national and local policymakers.

The details of the model are set out in Figure 18.  It estimates the additional equity investment that would be unlocked from the four interventions (methodological details of the models in Box 8). The model and the results are a guide rather than a prediction and are not realistic estimates of policy impacts.

The four interventions are:

• Increase the number of deals per investable firms in underperforming large cities to the urban average (£551 million, 0.5 per cent of the national total equity value).
• Increase the number of equity-investable firms by 10 per cent in large cities (£631 million, 0.6 per cent of the national total equity value).
• Increase the equity deal value ratio between early stage and late growth/exit stages to the urban average (£3.7 billion, 3.4 per cent of the national total equity value)
• Increase the number of equity deals in capital-intensive sectors by 10 per cent (£170 million, 0.2 per cent of the national total equity value)

There are three lessons from Figure 18.

First, improving the performance of the large cities would be significant for the total amount of equity investment in the UK.  Achieving all pathways would result in an increase of £5 billion (4.7 per cent) to the national total of equity investment. Birmingham, Leeds and Manchester would account for £3.2 billion (65 per cent) of this increase.

Second, scaling firms at the rate of the urban average would be the most impactful intervention in most big cities.  This would result in an increase of £3.4 billion to national investment – 73 per cent of the total increase from the four pathways. Realistically, this would be the hardest intervention for policy to address, as so many of the factors that determine the performance and valuation of individual firms are outside the direct control of policymakers.

Third, sectoral change towards more capital-intensive industries would not have a big impact in the big cities. This may be because these industries play a bigger role in explaining the strong performance of equity investment in Oxbridge than the underperformance of the large cities. If so, it would have implications for the role of the “IS-8” in the place component of the Industrial Strategy. Large cities do not have a particularly strong presence or advantage in these sectors, so investing more in the IS-8 does not necessarily go together with investing more in large cities.

Policies to increase equity investment in big cities face trade-offs

These findings present challenges to aspects of the Government’s policy approach that prioritise supply-side measures to increase equity investment for firms in cities outside the Greater South East.

Without improving the quality and quantity of investable firms in these cities, the additional capital may not find suitable firms to invest in. This could result in deals with subpar firms, or the crowding out of deals that would have been made by private investors.

Further complicating the emphasis on increasing the amount of public money available for equity investment is the Government’s other priority, as set out in the Industrial Strategy, of supporting firms in IS8 sectors to grow.

For example, a temptation might be to stipulate that to receive public-backed investment, firms need to be based in a particular city, and operate in a particular IS-8 sector. These sorts of combined requirements would reduce the ability of firms with growth potential to qualify for support, and risk focusing support on inherently weak firms that happen to comply with the checklist.