Research and development: An investment thesis for UK recovery
By Steve Phillips, CFO, and Somil Goyal, Investment Lead, at GovGrant – The UK has a rich history of scientific discovery and research. Of the top 100 prescription medicines used around the world today, about 25 per cent were discovered in the UK. The country also has recognised expertise in sectors like AI and machine learning developing around leading universities.
But despite the UK’s strengths, Research & Development (R&D) spending lags many peers and draws attention to the opportunity to invest smarter and benefit from the economic recovery. Government support, eg, through R&D tax credits, is a timely lever to help drive higher returns.
The economic benefits of R&D can be sizeable and persistent. For example, every pound spent on medical research delivers an annual return of about 25 pence, forever. These benefits flow through the economy, and so the government policy is to support R&D. But businesses benefit too, for example the UK government’s Innovation Report estimated that firms that consistently invest in R&D are 13 per cent more productive.
So the opportunity is for investors to leverage this as part of their investment thesis. Currently, the UK only invests the equivalent of just 1.7 percent of GDP on R&D – well below the OECD average of just over 2.3 per cent. The British government has set a target of 2.4 percent by 2027. But even then, the UK would still fall short of leading nations Israel (4.9 per cent), South Korea (4.3 per cent) and even the US (2.7 per cent). The UK needs to set its sights higher to deliver more economic benefit.
It was therefore encouraging to see the 2021 Budget set out various commitments to address long-term recovery needs, including a review of R&D tax relief. The Chancellor’s pledge to review the R&D tax relief schemes is a positive step towards ensuring the UK is globally competitive, especially in the context of the new 130 per cent ‘super deduction’ introduced in March’s Budget that is aimed at encouraging investment spending on certain forms of R&D. This could well turbocharge innovation in the UK.
However, what separates the UK from leading spenders of R&D is the penetration of venture capital. Israel and the US have highly developed venture capital segments, which in turn drives a proliferation of hungry start-ups. The innovation by these companies leads to outsized returns for the investors. The UK is some way behind, and has also faced competition from other European hubs, including Paris, Berlin and Stockholm, the latter having created some the biggest names in European tech of recent years, including Spotify and Klarna.
But the UK is scaling up. UK tech companies attracted a record USD15 billion in funding in 2020, including USD500 million for fintech group Revolut and USD84 million for DNA sequencing specialist Oxford Nanopore. These are businesses in R&D intensive industries that now have more money to spend. As the UK VC sector gets bigger, it is also getting broader with more funds and accelerators for seed investment and earlier stage businesses.
What the UK still lacks, however, is a more concerted approach to R&D and using the available incentives. There were about 60,000 claims for GBP5.3 billion of R&D tax credit in the 2018/19 tax year. But most claims are concentrated in just three sectors: manufacturing; professional, scientific & technical; and information & communication.
Companies can focus more on R&D. But the government can also invest more, and VCs can do more to access funding. Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes give an indication of what could be done with a little joined-up thinking. Those fund structures raise capital (from mainly retail investors) for investment in qualifying businesses, supplying companies with capital while benefiting the investors with tax relief on invested capital and their returns.
Why shouldn’t there be funds that target advantages inherent in R&D focused companies and industries? Or vehicles that seek to unlock the benefits of intellectual property schemes such as Patent Box? The tax benefits could make for attractive returns for investors while driving capital into innovation.
There is, at the very least, the potential for VCs and investment managers to take a more portfolio-wide view to R&D and tax incentives. The driver for accessing tax credits tends to be the finance department of the company, rather than the sponsor. With more knowledge at the investment management level, there can be greater best practice sharing.
More than that, a clearer focus on R&D tax credits and other incentives can make R&D an integral part of the value creation playbook across the portfolio. Cash generated in this way can increase overall cash flows to pay down debt or pay dividends. It can also increase company value by boosting profit margins and paving the way for innovations or patents that deliver higher valuation multiples. Viewed in this way, R&D tax credits are less of an accounting mechanism and more of an operational tool that creates real value.
Businesses also need to think more broadly about R&D. Too many companies believe that investment in innovation is about ground-breaking inventions or finding a cure for cancer. However, a new product, service or process could amount to R&D. So could new business practices or marketing concepts. Even investment in internal research, training or hiring of external knowledge and expertise.
Among our clients, we helped the largest tomato grower in the Midlands to access R&D tax credit activities like tracking and testing different pest control techniques. Many members of staff were indirectly enabling R&D by monitoring processes and collecting data and so they could claim a proportion of their salaries too.
Many companies, from pharma and tech to agriculture and retail, are always improving processes and services. The benefits they get from R&D tax credits can give them more capital to invest throughout the business. They also flow through to the investors, boosting their returns and giving them more capital to invest in other innovative companies.
The UK’s recovery and future competitiveness will be driven by start-ups and SMEs funded by private capital and using supportive government policies. And their success will rely on innovation. R&D is the fuel that lights the fire.