SME Funding Crisis - Part 4: The Investment Desert

The investment landscape in the UK presents a brutal reality for aspiring entrepreneurs. With rejection rates by both VC and Angel investors exceeding 90%, 000s SMEs are turned away from equity investment each year. This staggering rejection rate represents more than just rejected applications—it represents innovation stifled, jobs not created, and economic potential squandered.

The reasons behind these astronomical rejection rates are multifaceted and most SMEs, particularly those seeking pre-seed funding, should forget approaching VCs. Why? Because venture capitalists are increasingly focused on 'unicorn hunting'—seeking only those rare businesses with billion-pound potential that can achieve a valuation exit of 10x or more. This is because the VC model relies on a "power law" distribution where a few massive successes (e.g., unicorns) drive the entire fund's performance, as most investments are expected to fail or produce mediocre returns. Consequently, 99% of applications to VCs are rejected but the message clearly isn't getting through as 000s SMEs continue to send off pitch decks in the blind belief that they will become the next unicorn. A huge waste of time and effort by small business owners that they can ill-afford.

The narrow focus of VCs therefore leaves the vast majority of perfectly viable, profitable businesses to focus on Angel investors - they can forget institutional investors for reasons detailed below. However, Angels are increasingly risk-averse due to economic uncertainty and are now concentrating investments in proven sectors and established founders with track records.

Geography compounds the problem. Investment capital remains stubbornly concentrated in London and the South East, with regional businesses facing even steeper odds. A Manchester-based tech startup or a Birmingham manufacturing innovator must work exponentially harder to secure the same funding that a London-based competitor might access more readily. This regional disparity doesn't just hurt individual businesses—it perpetuates economic inequality and prevents the 'levelling up' that political leaders promise.

The cumulative effect is devastating. Thousands of businesses with genuine growth potential, innovative products, and viable business models are left without the capital they need to scale. Many fold before they can prove their worth. Others limp along, never reaching the potential that proper funding could unlock. And, the opportunity cost to the UK economy is estimated at £90 billion of unrealised GDP.

 

The Institutional Investor Paradox: Why Pension Funds Ignore SMEs

Perhaps the most perplexing element of the SME funding crisis is the absent elephant in the room: UK based institutional investors.

The Local Government Pension Scheme (LGPS) alone manages over £400 billion in assets. UK pension funds collectively, control well over £3 trillion. Insurance companies, endowments, and sovereign wealth entities add hundreds of billions more. Yet these vast pools of capital invest virtually nothing in UK SMEs, preferring overseas markets, public equities, and property over the businesses driving domestic economic growth.

Conversely, overseas pension funds and institutional investors hold a significantly higher share of UK-listed shares and private capital compared to UK pension funds. While UK pension funds have drastically reduced their domestic equity allocation from 50% in 2000 to around 4%–6% today, foreign investors dominate the ownership of UK-listed companies.

The irony is rich. UK Pension funds exist to provide retirement income for workers, many of whom are employed by the very SMEs that pension funds refuse to finance. Insurance companies collect premiums from SME owners, then invest those premiums everywhere except back into the SME economy. The disconnect is staggering: institutions created to serve the British economy systematically starve it of capital.

Why UK Institutional Investors Avoid SMEs

Several factors explain institutional reluctance to invest in SMEs, many being based on outdated assumptions, lack of the latest technology or that require addressing through policy intervention.

Liquidity Concerns: Institutional investors prize liquidity—the ability to buy and sell investments quickly without moving prices. Public markets offer this in abundance. SME investments, particularly equity stakes in private companies, can be illiquid for years. Fund managers worry about being unable to meet redemption requests or rebalance portfolios if capital is locked in private holdings. This concern, while legitimate, ignores that pension funds operate on decade-long timeframes and don't actually need daily liquidity for their entire portfolio.

Perceived Risk: SMEs are viewed as inherently riskier than established corporations or government bonds. Higher failure rates and volatile earnings create uncertainty that conservative trustees and investment committees find uncomfortable. Yet this perspective conflates risk with lack of diversification. A portfolio containing stakes in hundreds of SMEs across diverse sectors and regions would be substantially less risky than concentrated positions in individual larger companies, and quite possibly less risky than portfolios heavy in a few sectors or geographic markets.

Due Diligence Costs: Analysing a potential £100,000 investment in an SME requires nearly as much work as evaluating a £10 million investment in a larger company. For institutions deploying billions, this creates unacceptable economics. Why spend weeks researching a business that will absorb only 0.001% of the portfolio when you could invest in a large company with a single call to a broker? This 'transaction cost barrier' effectively prices SMEs out of consideration, regardless of their underlying merit.

Regulatory and Fiduciary Constraints: Pension fund trustees face legal duties to act prudently and in members' best interests. Many interpret these obligations conservatively, favouring 'safe' investments in blue-chip companies and government bonds. Some regulations explicitly limit exposure to certain asset classes. Investment committees, often composed of people with limited private equity experience, default to familiar territory. Better to match peer performance with mainstream investments than risk underperformance with unconventional ones—even if the unconventional approach might deliver superior long-term returns.

Lack of Expertise: Managing SME investments requires different skills than managing public equity portfolios. It demands understanding of business models, operational challenges, and growth trajectories in detail. Most institutional investment teams lack these capabilities, having spent careers analysing publicly traded companies with extensive financial disclosures and analyst coverage. Building internal SME investment expertise is expensive and time-consuming, creating another barrier to entry.

Fee Structures and Incentives: Fund managers are typically compensated based on assets under management and performance relative to benchmarks. Standard benchmarks consist of public equities and bonds, not SME investments. Managers who allocate significant capital to SMEs risk benchmark underperformance in the short term, potentially costing them bonuses or even their jobs, even if the strategy would deliver superior long-term returns. This misalignment of incentives systematically biases institutions away from patient, productive capital deployment in favour of benchmark-hugging mediocrity.

The LGPS: A Case Study in Missed Opportunity

The Local Government Pension Scheme exemplifies the broader problem. With over £400 billion in assets across 87 pension funds in England and Wales, the LGPS represents one of Europe's largest pension systems. Its members—teachers, nurses, council workers, emergency services personnel—form the fabric of local communities and local economies. Yet LGPS investment in SMEs is negligible.

Instead, LGPS funds invest heavily in overseas equities, foreign property, and alternative assets with minimal connection to the communities they serve. A Manchester council worker's pension might be funding commercial property in Singapore or technology companies in California while Manchester-based SMEs struggle to raise £50,000 for equipment purchases. The absurdity is self-evident.

Defenders of this approach argue that fiduciary duty requires maximising returns regardless of geography. But this defence crumbles under scrutiny. First, evidence suggests that properly structured SME investment portfolios can deliver competitive or superior returns to mainstream alternatives. Second, fiduciary duty should incorporate long-term systemic considerations—if the local economy collapses due to SME failures, pension members' retirement security is threatened regardless of portfolio performance. Third, investing locally can reduce costs and improve due diligence quality through proximity and local knowledge.

The LGPS's recent pooling agenda, consolidating 87 funds into eight pools, actually worsens the problem. Larger pools mean larger investments, making SME deals even less attractive relative to transaction costs. Without specific mandates and structures for SME investment, pooling will further concentrate capital in large-cap public markets and overseas assets.

Further to this, a white paper published in September 2025 by The Good Economy, argues that a new era of place-based investing is required, that the UK needs a stronger domestic economy rooted in inclusive, long-term growth.

Will the the LGPS significantly investing in SMEs? Will the Mansion House Accord etc lead to institutional investors en masse, investing? In short, “no”, most SMEs will continue to be ignored. NEXT: The Economic Consequences of Doing Nothing: Growth Foregone