Labour's proposal to close a tax loophole benefiting private equity investors by reclassifying "carried interest" as income, instead of capital gains, is attracting a lot of attention. While the move aims to generate an estimated £440 million for public services, the unintended consequences could cost the UK far more in lost investment, particularly in the tech sector.
What is Carried Income?
Carried interest, often referred to as "carry," is a form of compensation that general partners (GPs – the managers of the funds) in venture capital and private equity funds receive. It represents a share of the profits from investments made by the fund and serves as an incentive for the GPs to maximise the fund's performance for the Limited Partners (LPs).
Impact on Investment
Private equity is a significant source of funding for tech startups. Reclassifying carried interest to be taxed at the higher income rate could deter private equity firms from investing in the UK. These firms play a crucial role in providing capital to early-stage companies, which often struggle to find funding elsewhere. A reduction in private equity investment could exacerbate existing challenges in the UK tech sector, which is already facing a tough investment environment.
VCs have expressed significant concerns about Labour's proposed tax changes on carried interest. Private equity experts argue that the move could stem the flow of investment into the UK, potentially weakening the economy.
Claire Trachet, CEO of M&A advisory firm Trachet, warned that increasing taxes on dealmaker profits could deter private equity firms from investing in the UK, especially in a climate already challenging for attracting investment. This sentiment is echoed by the British Venture Capital Association, which highlighted that such tax changes could make the UK less competitive compared to other European countries, ultimately driving investment and talent elsewhere.
Serena Lee, tax partner at law firm Akin, pointed out that the UK's current regime is already less favourable than some other jurisdictions, like the US, which taxes “carried interest” at a lower rate of 20%. Any further increase will create a significant disadvantage, reducing the UK's attractiveness as a destination for private equity investments. Lee emphasised that asset management professionals are often internationally mobile, and many other jurisdictions would be more than happy to attract these individuals away from the UK.
These concerns underscore the delicate balance policymakers must strike between ensuring tax fairness and maintaining an attractive investment climate. The proposed changes, while aiming to address perceived inequities in the tax system, risk undermining the very foundations needed for a thriving tech ecosystem in the UK.
Current Investment Challenges
The UK tech scene has been grappling with investment challenges over the past year. According to KPMG's Q3 2023 Venture Pulse Report, while total VC investment remained stable at $5.2 billion, the number of deals dropped significantly, reflecting investor caution amid economic uncertainties. Additionally, funding for new UK VC funds fell to its lowest level since 2017, highlighting a broader hesitance to commit new capital to the sector.
Examples of Underinvestment
Several high-profile cases illustrate the difficulties faced by UK tech companies in securing investment. For instance, Babylon Health, once a promising health tech startup, collapsed in 2023 due to financial difficulties, underscoring the vulnerability of tech firms to funding shortages.
The fintech sector, which has traditionally been a strong performer, saw a dramatic 72% drop in funding from 2022 to 2023, marking the first time in a decade it was not the top-funded startup sector in the UK.
Broader Concerns
Despite government efforts to bolster the tech sector (how many politicians have said they want the UK to be the next Silicon Valley), such as reforms announced in the 2023 Mansion House Speech to unlock pension investments and increase funding liquidity, concerns remain. Key tech industry leaders have criticised the UK's support framework, pointing out that the country’s tech ecosystem has not been as favourable to ambitious founders compared to other markets like Silicon Valley.
UK’s Silicon Valley Dreams: A Mirage in the Making?
The UK government has repeatedly voiced ambitions to transform the country into the next Silicon Valley, a vision recently reiterated by Chancellor Jeremy Hunt. Hunt's optimistic projection that the UK will have seven tech giants lifting the London stock market within a decade mirrors the success seen with the US's "Magnificent Seven" tech stocks. However, industry experts and investors cast significant doubt on this vision, deeming it more fantasy than feasible reality.
Stephen Yiu, manager of the £1bn Blue Whale Growth fund, highlights the long gestation periods of US tech titans like Amazon and Nvidia, emphasising that the UK's timeline is unrealistically short. The Magnificent Seven didn't spring up overnight; they were decades in the making, benefiting from a conducive environment for innovation and investment that the UK has struggled to replicate.
Moreover, the exodus of companies from the London Stock Exchange further undermines Hunt's vision. High-profile departures, such as Darktrace’s $5.3bn acquisition by US private equity firm Thoma Bravo, underscore the allure of the US market over the UK. These moves reflect a broader scepticism about London's competitiveness and attractiveness as a tech hub.
The Long Gestation Period: A Lesson from Babylon Health
The long gestation period for tech giants points to a critical issue faced by UK startups: the need for sustained investment and time to mature. This was starkly illustrated by the collapse of Babylon Health in 2023. Once valued at $4.2 billion, Babylon struggled to maintain financial stability and ultimately collapsed after failing to secure sufficient long-term funding (Sifted Europe). The swift rise and fall of Babylon underscore the necessity of patient capital and a supportive investment environment that allows tech companies the time they need to develop robust, scalable business models.
Conclusion
Labour’s intention to close the tax loophole is aimed at creating a fairer tax system and funding essential public services. However, the potential reduction in private equity investment could hamper the growth of the UK tech sector, which is already struggling with underinvestment and financial challenges. As the sector braces for these changes, it remains crucial for policymakers to consider the broader implications on innovation and economic growth. Ensuring a balanced approach that continues to attract investment while addressing tax fairness will be key to sustaining the UK's tech industry momentum.