When a UK biotech firm starts to show promise, they set sail across the Atlantic. Investors can’t blame them.

Why UK small-cap biotech shares are going extinct

As a UK-based financial commentator, there is long-running joke about the UK’s FTSE 100. The premier index is often referred to as a ‘dinosaur’ index, filled with oil majors, miners, and banks with no real technological innovation. Indeed, this seems to be a factor in ARM’s reluctance to dual list in the UK, with Refinitiv data showing that only 2% of FTSE 100 companies are in the tech sector.

Accordingly, UK investors have two main choices when investing for growth; either head for the NASDAQ, which usually comes with currency conversion fees, or buy shares in the UK-based small caps.

However, the UK is simply not structured for high-risk biotechs to get growth off the ground.

UK small-cap tech stocks incentives

At present, the best investing incentive for private investors in high-risk early-growth stage companies is the Enterprise Investment Scheme. Among other incentives, it offers income tax relief, tax-free growth, capital gains deferral advantages, loss relief, and EIS-qualifying shares held to death are also exempt from inheritance tax. Knowledge-intensive companies also benefit from additional tax incentives for investors.

However, similar schemes exist across Europe and the US, so there while EIS provides strong incentives for retail investors, it isn’t enough reason for a start-up tech firm to begin business in the UK. Instead, many flee to the US where the start-up culture has carefully propagated.

Arguably, the UK has serious overregulation, and as a result, far too few investment managers prepared to invest in UK start-up tech, particularly biotechs.

Avacta CEO Alastair Smith

Indeed, Avacta CEO Alastair Smith, in a recent piece for the Times, lamented that ‘in the past four years 11 UK biotechs have chosen to make their initial public offering in the US.’ Smith cites the ‘retail distribution review’ and MiFID II as ‘oppressive pieces of regulation’ that have put ‘smaller investment banks off high-risk stocks.’ And while these are important points, this is not the whole picture.

What’s actually happening is this: the UK is exceptional at the ‘R’ (research) but awful at the ‘D’ (development). The problem is that institutional UK investment is prepared to fund small-cap research, but sell out before these companies get too large, as they are not prepared to commit funding required to get through the development stage.

Partially, this is structural. I won’t use the ‘B’ word (though it is a factor), but regardless, the UK has a unique situation in that it is both filled with multiple world-leading universities, which spin-off excellent new scientific opportunities, but also has a dearth of wet labs needed to scale up.

For perspective, overseas pensions funds are more heavily invested into UK biotechs than the entire value UK pensions industry. Consider the Ontario Teacher Pensions Plan, which commonly invests in risky ventures for exceptional returns; our pensions managers simply do not have the freedom or inclination to follow their example.

GSK Chair Jonathan Symonds

GSK Chair Jonathan Symonds has previously argued that the UK needs to focus on ‘scale-up’ capital — the development stage where Phase II trials are run at great expense. Currently, the most promising UK biotechs are simply bought out by American firms, leaving shareholders happy with sizeable returns, which might have been far higher had the correct domestic financing been available.

And this attitude is reflected in the psychology of the small-cap market; US investors will commonly wait years for returns, while UK investors are happy to sell off the family silver for a quick return.

R&D tax credits

And arguably, this is because the UK tax ecosystem is going to get worse for the initial growth stage.

Chancellor Hunt’s misinformed proposed scale-back of the R&D tax credits system is already being compounded by the fact that some companies are not even applying for the credits as HMRC can strip them of their qualifying status, years after having their application approved.

The government is planning on merging the two separate R&D tax credit schemes to address concerns of fraud and misuse. At present, SMEs can claim about a third of their R&D costs, compared to a 13% for large businesses, and both are set to move to circa 20% under the unified scheme. As a caveat, this is a very oversimplified statement.

In a recent consultation document, the government recognised the reform ‘creates challenges for some R&D-intensive small and medium-sized enterprises and those in the life sciences sector in particular’ and recognises that there is ‘merit to the case for further support.’ But far from creating a science superpower atmosphere, it simply sends a message that smaller companies should seek institutional support abroad.

The government does want to increase public R&D public spending to £22 billion per year by 2024-25, with much of this spending going to biotech firms. But with institutional investment already not prepared to provide ‘scale-up’ capital, this is currently pie-in-the-sky thinking. And worse, a combination of public spending and tax incentives should see the eventual returns stay in the UK, but this isn’t happening.

And this wider system is reflected in the valuations of some promising — but not yet certain — FTSE AIM biotechs. Researched investors sometimes look at the breakthrough RNS and wonder why the share price hasn’t shot up. The answer is that the UK market is hostile to growth, and their long-term profits are going across the pond.

On 17 January, Avacta told investors that the company was moving towards ‘chemotherapy without side effects.’ While trials are still in the early stages, the share price has barely moved.

And when the likes of Avacta, hVIVO, Hemogenyx, ReNeuron, and Polarean Imaging — with their various, multi-faceted investment cases — are either sold off to US private equity or go off to seek NASDAQ listings, UK investors can’t blame them.

This article has been prepared for information purposes only by Charles Archer. It does not constitute advice, and no party accepts any liability for either accuracy or for investing decisions made using the information provided.

Further, it is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

Charles Archer is an experienced financial writer specialising in monetary law. With a background in stock market and private equity analysis, he’s worked for many years as a freelance investment author,...

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