TokePortal.com’s own content: 28.08.2023

Author: Bálint Márton Temesvári

The Newly Established Fintech Fund

The state-initiated UK FinTech Growth Fund aims to finance British fintech companies in the growth phase (Series B, C, D, or pre-IPO) to help them become world-class global organizations. This means supporting startups that already have a well-functioning business model, a developed and market-tested product, and a stable customer base. The fund’s £1 billion capital is provided by large institutional investors like Barclays, NatWest, Mastercard, the London Stock Exchange, and the investment bank Peel Hunt. The fund is expected to make between 4 and 8 investments annually, each ranging from £10 million to £100 million. The investments will only acquire minority stakes in the funded companies, and the financial instruments received in exchange for the financing will always be shares or equity-linked assets. The first investment is expected to be realized in the last quarter of 2023.

 

Background of the UK FinTech Growth Fund

The creation of the fund was one of the recommendations from the Kalifa Review, a 2021 study by the former CEO of Worldpay Group, Ron Kalifa, on the state and development possibilities of the UK fintech sector. The study describes that it is very difficult for fintech companies to transition from the startup phase to the scale-up or growth phase because they immediately need to compete with already globally operating larger companies and fintechs from other countries. Competing in such an environment requires rapidly developing fintech products suitable for multiple markets, which in turn requires a large amount of funding quickly. Despite the availability of the necessary capital at the national economic level in the UK, the money mostly flowed into foreign, already mature tech companies, even though investments in these fintechs would have grown by £2 billion annually according to the 2020 Growth Capital Report. As a result, British fintechs that managed to secure funding mostly did so from foreign investors, and the average 27-fold returns between 2010 and 2019 were mostly realized by foreign investors. Most fintech companies, however, either became acquisition targets for larger foreign companies or foreign owners gained majority control before the original owners could realize their growth plans. To ensure domestic financing, the FinTech Growth Fund was established, with the principle that its central players and capital holders should be large institutional investors, coordinated by professional organizations.

The Other Cogs in the Machine

The study states that the £1 billion fund can fill only 10% of the financing gap for British scale-up fintechs. To fill the remaining 90%, much more private equity investment needs to be channeled, which requires making institutional and small investors as interested as possible in investing in growth-phase fintechs. One way to do this is by offering tax incentives to investors. For institutional investors, British SMEs and larger companies alike could receive corporate tax relief on a portion of their R&D expenses. However, the problem was that large institutional investors could not include R&D costs if the R&D activities were outsourced to profit-oriented subcontractors. As a result, the tax relief did not encourage the creation of R&D projects in partnership between large institutional players in the financial sector and fintech companies. Partly based on the Khalifa Review’s recommendations, the legislator extended the range of allowable costs to subcontractor R&D expenses from April 2023 and increased the amount of the tax relief.

In a previous article, we wrote about how the British government can incentivize small investors to invest in early-phase startups through SEIS and EIS income tax relief by assuming a significant part of the investment risk. From a fintech perspective, these programs have been effective in getting companies to the growth phase. In 2018 alone, British fintech startups received £150 million through EIS. According to the authors, extending the scope of SEIS and EIS could further increase the number of fintechs reaching the growth phase. In response to this recommendation, the British government extended the EIS program, which was set to expire in 2025, increased the maximum funding that can be raised per startup within SEIS from £150,000 to £250,000, raised the maximum gross asset value limit from £200,000 to £350,000, thus including more startups in the fundable range, and doubled the maximum annual investment that angel investors can make in startups participating in SEIS from £100,000 to £200,000.

Beyond tax relief, the institutional investors highlighted in the Khalifa Review were defined contribution pension plans (DC pension plans) as an untapped source of funding. At the time of the study, the market liquidity criteria and the so-called Charge Cap, which capped fund management costs at a low level for investors in DC plans, restricted illiquid investments in growth-phase fintechs and other startups. The problem with the Charge Cap was that the fund management costs capped at 0.75% of the nominal value included the performance fee of fund managers, which did not allow for adequate performance incentives for fund managers in illiquid portfolios requiring significant initial costs and active management. According to the authors, allowing illiquid investments could support startups and ensure that higher returns provide sufficient funds for people saving for retirement, as with the current returns and savings rates, many people would not have enough reserves for their retirement years. After a series of consultations in the second half of 2022, the British government accepted the argument that the long investment horizon of pension investments made it not significant if it took 5-10 years to exit individual assets, and the daily determination of the market value of investments was feasible. As a result, the government decided to support illiquid investments, with the first step being the removal of fund managers’ performance fees from the Charge Cap in 2023.

What Can We Learn from This in Hungary?

The fund focusing on the British fintech sector and the surrounding additional investment incentive measures provide guidance on how the Hungarian state can support the creation of startups and their development into global-sized entities from a financing perspective. The goal is for more startups to be launched in Hungary and for them to secure necessary funding in each financing cycle at a higher rate than currently. The above describes support the recommendations made by McKinsey in January 2023 for developing the Hungarian startup ecosystem:

Encourage the creation of private equity funds financing startups similar to the FinTech Growth Fund with state involvement and leadership by an independent professional organization. According to McKinsey’s recommendation, the state could also provide funding through a fund-of-funds structure, investing in a fund from the budget along with other private equity investors, which in turn would invest in proven successful venture capital funds. The state can complement financing through private equity funds with state support for research in strategically important sectors.

The government should motivate investors to invest in startups through tax incentives. Small investors could be effectively encouraged to finance startups through personal income tax relief and institutional investors through corporate tax relief. In terms of taxation, startups could also be directly supported by reducing the contribution payments on employee wages, thereby reducing their need for external financing.

It may also be worthwhile to encourage and create the framework for a small portion of pension savings to play a role in financing innovative startups.

The most important lesson from the British example is that the state must recognize that supporting the startup ecosystem is in the national economy’s interest, and state investment will pay off in the future. Otherwise, why would the British do it?