Depiction of The European growth problem and what to do about it

The European growth problem and what to do about it



European growth is insufficient to improve lives in the ways that citizens would like. We use the UK as a case study to assess the scale of the growth problem, underlying causes, official responses and what else might be done to improve the situation. We suggest that capital market reforms can both provide funding for Europe’s great ideas and allay prudential concerns.

The European growth problem and what to do about it

On 15 January 2025, the Financial Times reported research indicating that recent productivity growth is not enough to sustain improvements in living standards in most large advanced economies.1 In Germany, productivity growth in 2012–23 was on average 0.7% per annum, while the rate now required to sustain improvements in living standards is 1.4% (or 100% more). The discrepancy in the EU’s other large economies is far worse. In France, Italy and Spain, productivity growth has been 0.2–0.3% while the required rate is now 0.9–1.4%. This is a serious policy problem requiring strong action. We use the UK as a case study to describe and explore the issues and attempt to identify what to do about them.

The funding gap

The UK has many innovative, forward-looking companies and universities that generate a large number of smart ideas:2 Oxford and Cambridge University alone produced more than 350 spinouts between 2011–24.3 In 2023, £8bn was invested into UK venture-backed businesses,4 and the country is the third largest venture capital market in the world, after the US and China .5 Despite this, growing and productive enterprises face a significant funding gap when looking to attract new investment.6

A major issue is access to private equity—a crucial driver of growth for young firms. In 2020, the ScaleUp Institute, Innovate Finance and Deloitte estimated this funding gap to be £15bn annually in the UK (£7.5bn of which was cyclical and attributable to the impact of Covid-19).7 The funding gap is felt most acutely at later-stage rounds of funding,8 meaning businesses are less likely to scale-up effectively.9 Additionally, a growing proportion of large UK deals involve foreign investment.10 A Dealroom report found that for every pound UK ventures receive, 42p is invested by US firms.11

Costs of the dearth of local investors

The growing role of foreign investment in UK venture capital suggests that domestic savers are missing out on opportunities to finance future ‘unicorns’12 and benefit from the associated financial returns. Furthermore, British businesses raising funding internationally are more likely to choose or be obliged to relocate their operations abroad, at the expense of domestic jobs and investment.13 Choosing the US can be rational as it is a single large market for testing products, benefits from its single language status and has low regulatory and legal fragmentation. This leads to lower domestic productivity growth than if firms remained in Britain and contributed to the economy through research and development, employment opportunities, and tax. This matters because scale ups14 are highly productive, generating £1.4trn in turnover—equivalent to 55% of the output of all UK SMEs 15, ‘despite [scaleups] making up just 0.6% of the UK business population’.16

Reports from Deloitte17 and the British Private Equity & Venture Capital Association18 suggest that redirecting ‘patient’ capital held by British pension funds could be important for firms seeking scale-up investment.

The Mansion House proposals

UK Chancellor Rachel Reeves, in her Mansion House speech, announced policies aimed at improving pension returns while fuelling economic growth.19

The Chancellor proposed that ‘through consolidation of the Defined Contribution pension market and Local Government Pension Schemes (LGPS) into megafunds’, around £80bn could be ‘unlocked’ for investment in ‘private equity, including exciting growth businesses’. This aims to replicate the ‘megafunds’ seen in Australia and Canada.20

The proposals also introduce a larger role for the British Business Bank (BBB) and changes to the UK Infrastructure Bank (UKIB), which will now operate as the National Wealth Fund and take an active role in the government’s industrial strategy with incremental funding of £7.3bn. UKIB will prioritise certain ‘foundational’ investments.21

Will the Mansion House proposals work as intended?

The creation of ‘megafunds’ could lead to cost savings and more diverse capital allocation by pension schemes.22 This could include investing directly in infrastructure projects23 and more investment in other less liquid assets. As a result, this could reduce the scaleup funding gap faced by growing businesses.

The situation, however, is not straightforward. Against the argument that larger funds can invest in higher risk assets that typically require substantial sums from individual investors is the ability of small pension funds to invest in such assets through easily available intermediary funds. Moreover, as regards cost savings, Oxera’s own research finds that diseconomies of scale can be a feature of asset management.24 Also, an FCA consultation on a Value for Money framework for defined contribution (DC) pensions aims to shift focus from short-term costs to long-term value.25

Equally, some circumstances may support the Mansion House proposal for megafunds. The high costs of venture capital 26 are a barrier to pension funds increasing their exposure to it, despite the high risk-adjusted potential returns on offer.27 Perhaps these costs are more likely to be acceptable in a very large fund which also has a large volume of low cost investments. Moreover, research suggests that investment in venture capital has the potential to deliver ‘very high’ returns,28  which of course means that risk is also very high. Even if small schemes can access venture capital exposures through intermediary funds, it must still be the case that megafunds can achieve greater diversity in such exposures. This is important for risk management and for making growth investments acceptable to powerful authorities with risk and prudential obligations such as The Pensions Regulator and the PRA.

Again, though, large hurdles stand in the way of the reforms delivering substantial results. In addition to the investment flexibility already available to small funds and the evidence on diseconomies of scale, increasing investment in private markets poses other challenges for pension funds.

First, pension funds must consider liquidity requirements. Less liquid assets are less readily convertible into cash, which pension funds need to meet their obligations. Thus, the limited exit opportunities (predominantly through secondary sale or public listing) associated with private equity investments and the lengthy time horizon for realising returns from direct investment in infrastructure are problematic. The Bank of England suggests trustees and pension managers can meet short-term cash needs through new contributions and sale of liquid assets, and that funds could invest in illiquid underlying assets through liquid structures, such as listed investment companies or the recently created Long Term Asset Fund (LTAF). 29

A second issue is pricing. Venture capital and other forms of private equity are priced much less frequently than listed securities. In practice, investments are often held at cost or the price of the latest funding round, meaning values could be ‘stale’. This makes regularly updating portfolio values for members challenging, which matters for fair payouts on retirement, death or transfer.

Further, investment in high growth companies requires considerable skill. Industry professionals fear that pension funds may lack necessary specialist expertise to invest substantially in private equity whilst maintaining robust protection of members’ assets. It is unclear whether reliable market solutions to this issue both exist and will be utilised.30 

The proposals will achieve greater success if some other structural challenges for scaleups are addressed. For example, access to international talent remains problematic for scaleups. The Scale-up Worker visa is intended to help and it has been welcomed. But seven in ten scaleups lack sufficient knowledge of the scheme.31 Furthermore, the Capital Markets Industry Taskforce recommends measures to address underlying incentives, including ‘reversing the dividend tax impact on pensions funds introduced in 1997 by re-introducing tax credits on dividends received from UK companies’ and ‘exploring ways to lower or remove Stamp Duty Reserve Tax (SDRT) on shares.’ 32Additionally, Nathan Benaich, Founder and General Partner of Air Street Capital, warns that government investment could create ‘artificial demand’, distort the market and inefficiently extend the lives of weak firms,33 thereby damaging growth.

If the challenges to the success of the Mansion House proposals could be overcome, will the changes delivered be of sufficient scale?

The seriousness of the challenges cannot be ignored but success, if it materialises, could be at a valuable scale. While estimates of the scaleup funding gap vary,34 £80bn of funding would close a significant portion of the total mismatch between demand and supply of capital: Deloitte estimated in 2020—leveraging analysis from Beauhurst—that a flow of around £18bn per annum would be required if all firms sought capital.35 It is worth noting that ‘some of these will likely never, in reality, be ready for investment,’36 as ‘scaleups don’t always fail because of the ecosystem’.37

What is the underlying issue?

Before considering what (else) might be done to improve the situation, it is worth reflecting on how the large deficit in UK allocation of risk capital to growth companies, relative to demand, came about. Generally, British pension funds have reduced exposure to domestic private equity in recent years. For example, the proportion of UK private sector defined benefit funds invested in UK assets has remained stable at around 60% but, shockingly, their allocation to UK equity fell from 32% to under 2% between 2006–23 .38 UK Defined Contribution schemes have reduced exposure to domestic assets, with investment in domestic listed equities falling from 40% to 8% between 2012–23, although the proportion of domestic private equity exposure increased modestly over the same period.39 Overall private sector DC asset allocation to private equity, though, is 0.5%.40 This suggests that materially increasing pension fund allocation to domestic private equity may require interventionist policies or amelioration of relevant conditions.  

If the policy goal is to increase investment in innovative British companies, two overlapping issues are in play: flight from equity and flight from domestic assets. The latter could be rational, based on perceptions of UK prospects, costs and currency considerations. The starting point of pro-domestic bias in investment could also reflect behavioural biases, information issues and patriotism.41 Flight from equity has been driven by some combination of regulatory innovations over recent decades such as changes in accounting rules for pension schemes (FRS17), more salient risk warnings to retail investors, guidance by The Pensions Regulator on equity exposure and tougher prudential requirements, especially for insurance companies. All of these innovations bring benefits, although it should be noted that the highly impactful accounting changes were made without any accompanying cost-benefit analysis. This issue aside, if there is a challenge to the regulatory innovations, it is about their cumulative impacts. For example, UK investors previously marvelled at the conservatism of the archetypal ’Belgian dentist’, but now UK retail investment in equities is the lowest among G7 countries.42

What are the prospects and can they be improved?

Overall, the Mansion House reforms could help pension savings returns and boost the UK’s slow-moving productivity growth. The figures in the Mansion House speech suggest that the level of funding that could be mobilised is significant relative to the scaleup funding gap. But the reforms will not strictly mandate pension funds to invest a certain proportion of funds in domestic private equity, so success will depend on fund managers choosing to or being effectively incentivised to invest in innovative domestic companies. Whether they will do so at scale remains to be seen. Consecutive Lord Mayors of London have spoken of the need for changes by government to achieve this.43 There remains a question as to whether private sector schemes for solving the problem (some have been proposed) are getting the support they need.44

On a positive note, the FCA and PRA have already published letters explaining numerous steps they will take to assist growth.45 Empirical academic research suggests that strong and smart regulation is necessary to produce a capital market which both gives investors confidence to risk their funds in truly innovative young companies46 and allays concerns that prudential and pension regulators may otherwise hold about this. Public policy, however, can best be calibrated if the cumulative costs and benefits of the entire system of relevant regulators, including the setters of accounting standards, are properly analysed. Perhaps the Financial Policy Committee could co-ordinate an action plan?47


1 Romei, V. (2025), ‘Falling birth rates raise prospect of sharp decline in living standards’, Financial Times, 15 January, accessed 21 January 2025.

2 Susskind, D. (2025), ‘Britain needs to rediscover its economic spirit of adventure’, Financial Times, 18 January, accessed 21 January 2025.

3 Financial Times (2025), ‘How Oxford and Cambridge spinouts could boost UK growth‘, 28 January, accessed 29 January 2025.

4 This figure does not include growth equity investments, angel investments or venture secondaries. See BVCA (2024), ‘Venture capital in the UK’, 24 November, p. 23.

5 British Business Bank (2024), ‘UK now the third largest venture capital market in the world, with biggest increase in share of global investment’, Press Release, 11 July, accessed 21 January 2025.

6 BVCA (2024), ‘Venture capital in the UK’, 24 November.

7 ScaleUp Institute, Innovate Finance and Deloitte (2020), ‘The Future of Growth Capital’, August.

8 British Business Bank (2024), ‘Small Equity Business Tracker 2024’, 11 July, p. 9.

9 BVCA (2024), ‘Venture capital in the UK’, 24 November, p. 3.

10 BVCA (2024), ‘Venture capital in the UK’, 24 November, p. 19.

11 Dealroom (2024), ‘UK Innovation Update – Q3 2024’, October, p. 20.

12 For a list of UK unicorns (private companies with a valuation of at least $1bn), see: Beauhurst (2024), ‘UK Unicorn Companies’, 14 March, accessed 21 January 2025.

13 González-Uribe, J. and Klingler-Vidra, R. (2024), ‘Venture capital literacy could boost the potential of UK pension funds’, 8 October, accessed 21 January 2025.

14 The OECD identifies scalers through growth metrics related to employment or turnover. High-growth enterprises are defined as firms with at least ten employees that grow at a yearly rate of 10% or more in either employment or turnover over three consecutive years. See: OECD (2024), ‘Helping SMEs scale up’, accessed 21 January 2025.

15 Small and medium-sized enterprises.

16 ScaleUp Institute (2024), ‘ScaleUps in the UK’, June, p. 3.

17 ScaleUp Institute, Innovate Finance and Deloitte (2020), ‘The Future of Growth Capital’, August.

18 BVCA (2024), ‘BVCA Report on Investment Activity 2023’, May.

19 The Rt Hon Rachel Reeves (2024), ‘Mansion House 2024 speech’, 14 November, accessed 21 January 2025.

20 The Rt Hon Rachel Reeves (2024), ‘Mansion House 2024 speech’, 14 November, accessed 21 January 2025.

21 Ward, S., Waters, B., Conticelli, S. and Giblin, S. (2024), ‘Government announces £7.3 billion National Wealth Fund’, 24 July, accessed 21 January 2025.

22 Lifetime Pensions and Savings Association (2024), ‘Pension fund consolidation brings benefits, but UK growth needs much broader strategy’, Press Release, 26 September, accessed 21 January 2025.

23 Cumbo, J. (2022), ‘Pension funds must take ‘extreme care’ with liquidity risks, says OECD’, Financial Times, 31 December, accessed 21 January 2025.

24 Oxera (2006), ‘Current trends in asset management’, October, accessed 21 January 2025.

25 FCA (2024), ‘CP24/16: The Value for Money Framework’, 18 October, accessed 21 January 2025.

26A popular fee structure for venture capital funds is the two and twenty model, which is when a VC firm annually charges a 2% assets under management (AUM) fee and a 20% performance fee that’s based on the fund’s returns above a given benchmark’. See Campbell, T. and Safane, J. (2024), ‘What is venture capital (VC)?’, Business Insider, 6 December, accessed 21 January 2025.

27 Campbell, T. and Safane, J. (2024), ‘What is venture capital (VC)?’, Business Insider, 6 December, accessed 21 January 2025.

28 The Pensions Regulator (2024), ‘Private markets investment’, 24 January, accessed 21 January 2025.

29 Bank of England (2022), ‘Investing in Less Liquid Assets: Key Considerations’, Productive Financing Working Group, November, accessed 21 January 2025.

30 Conchie, C. (2024), ‘Could venture capital firms miss out on the great pension fund start-up splurge?CityAM, 3 September, accessed 21 January 2025.

31 ScaleUp Institute (2023), ‘ScaleUp Annual Review 2023’, 11 October.

32 Capital Markets Industry Taskforce (2024), ‘Delivering Over £100bn of New Capital into the UK Economy Every Year’, 6 September.

33 Woolcott, T. (2024), ‘How will the Mansion House reforms turbocharge investment in the technology and life sciences sector?’, BMS Group, 9 July, accessed 21 January 2025.

34 ScaleUp Institute, Innovate Finance and Deloitte (2020), ‘The Future of Growth Capital’, August.

35 ScaleUp Institute, Innovate Finance and Deloitte (2020), ‘The Future of Growth Capital’, August.

36 ScaleUp Institute, Innovate Finance and Deloitte (2020), ‘The Future of Growth Capital’, August.

37 ScaleUp Institute (2024), ‘ScaleUp Annual Review’, November.

38 Department for Work and Pensions (2024), ‘Pension fund investment and the UK economy’, 27 November, accessed 21 January 2025.

39 Department for Work and Pensions (2024), ‘Pension fund investment and the UK economy’, 27 November, accessed 21 January 2025.

40 Department for Work and Pensions (2024), ‘Pension fund investment and the UK economy’, 27 November, accessed 21 January 2025.

41 Department for Work and Pensions (2024), ‘Pension fund investment and the UK economy’, 27 November, accessed 21 January 2025.

42 Abrdn (2025), ‘UK retail investment in equities lowest in the G7 and ‘streets behind’ the US, as abrdn urges action to address risk culture and boost capital markets in new report’, 6 January, accessed 21 January 2025.

43 City of London (2024), ‘Lord Mayor urges Government to accelerate UK investment reforms’, 2 December, accessed 21 January 2025.

44 Council for Science and Technology (2024), ‘CST advice on scale-up finance for innovative science and technology companies’, 7 October, accessed 21 January 2025.

45 Financial Conduct Authority (2025), ‘FCA letter on a new approach to ensure regulators and regulations support growth’, 16 January, accessed 21 January 2025.

46 James, K., Kotak, A. and Tsomocos, D. (2022), ‘Ideas, Idea Processing, and TFP Growth in the US: 1899 to 2019’, Systemic Risk Centre Discussion Papers, DP 121, 13 July.

47Bank of England (2024), ‘Financial Policy Committee’, 10 December, accessed 21 January 2025.

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