November 2011

VENTURE CAPITAL TRUSTS: Small is beautiful

Sprouting-budVenture capital trusts in the UK are facing significant regulatory upheaval. However, some changes could make the sector more attractive to investors, though there are mixed feelings about fund raising, writes Muriel Oatham.
Not many parts of the financial services industry are excited about regulatory changes. With venture capital trusts (VCTs) in the UK, however, there is some optimism. The UK Budget in March set out several regulatory changes, including letting VCTs invest in larger companies. A Treasury consultation is currently underway. As the industry prepares for its annual fundraising period which reaches a height between January and April when the tax year ends, views about prospects differ. By the end of April this year, VCT inflows had reached £365 million (€419 million), the fourth highest 12 months since their launch in 1995. But looking forward to the end of this tax year, a number of providers are not expecting similar success. Paul Jourdan, chief executive officer at Amati Global Investors, a specialist for VCTs listed on the Alternative Investment Market (AIM), is cautious. “Fundraising will be fairly muted this year. We are hoping to raise money, but it is always unpredictable,” he says. Tim Levett, chairman of NVM Private Equity, shares his line. “VCTs with a decent track record will be able to go out and raise money. There will be lots of competition but reasonable demand. But I am not sure it will be as good as last year.” NVM Private Equity predominantly focuses on development capital deals and management buyouts. Levett says they have already completed “half-a-dozen or so” deals. As he prepares his next fundraising portfolio, Levett says: “There are a good following of people who want to do genuine private equity deals. So I am optimistic.” Matthew Woodbridge, the head of investment products at Chelsea Financial Services, is anticipating “a healthy amount of product”. He is backing well-established generalist VCTs to do well. “Those with a demonstrable track record are attractive. Investors get immediate access to dividends. But we are also seeing some good numbers from AIM VCTs.” Woodbridge adds that there will be a race to invest in VCTs that derive revenue from payments for renewable energy, so-called feed-in tariffs, as they will cease to be eligible for VCT investment after April next year. Paul Latham, the managing director of Octopus Investments, says it has just launched Octopus 3&4, twin VCTs predominantly focused on solar energy. “We have raised £100 million in the past six months in solar,” he says. “Investors get two lots of government support – the tax breaks from the VCT and the government-backed 25-year index-linked return from the feed-in tariff.” The rule change states that investment can only be made into sites, which are connected to the National Grid, by April. Tax relief
This means money needs to be raised now. “So we have had to move the market for VCT investment from the traditional January-April,” says Latham, adding that the “relatively fast fundraising” has been successful so far. But he says the increase in tax relief available on Enterprise Investment Schemes (EIS), raised from 20% to 30% in March’s Budget, could threaten the VCT market. “Previously, EISs and VCTs gave almost exactly the same comparative return. Now, EISs offer the same initial tax break, but investors can get their money back after three years, with additional capital gains and inheritance tax benefits.” He expects to see fewer VCTs launched, and specialists begin to move towards EISs. Woodbridge, however, says that while some wealth managers may look to take advantage of the wider range of tax breaks offered by an EIS, clear distinctions between the products remain. “VCTs and EIS are very different beasts – from the number of investments to transparency of performance,” he says. “A genuine EIS has to be held for a long time and you do not get dividends. “There is some appetite for EIS with a planned exit less than VCTs, say four years. But it is difficult to get in and out of companies within that time.” But the combination of Budget changes, some awaiting state approval, and the outcome of the Treasury consultation, expected in early December, is creating some uncertainty. “Some advisers will not offer VCTs until December in case the rules change or are applied retrospectively,” says Woodbridge. Similarly, he says, providers may be reluctant to raise money if they risk being unable to offer what they have set out in their prospectus. Employment
Ian Sayers, the director general of the Association of Investment Companies (AIC), a trade body, agrees that this uncertainty could affect this year’s fundraising. Nevetheless, he says he is “cautiously optimistic”. He says he hopes potential rule changes will encourage greater flexibility and scope for investment by VCTs. One change proposed in the Budget was to increase the size of companies eligible for VCT investment, raising limits on the number of employees from 50 to 250, and gross assets from £7 million to £15 million. Naturally, Sayers is strongly supportive. “Creating employment is critical,” he says. “It is ridiculous to say that you can fund a company with 30 employees, but if it grows to employ another 30 you cannot supply follow-on funding.” He adds that limiting employee numbers restricts investment in some types of business, and he would be happy to see it removed altogether. “There are other measures, such as the gross assets test, which provide a restriction on size.” Providers agree. “Moving back [to the limits we had in 2006] is extremely sensible,” says Jourdan. “These changes had a disproportionate effect on AIM VCTs, who are normally co-investing with others for whom VCT rules mean nothing. So reversing them will have the biggest impact [on us]. And these companies are more representative of where the equity gap lies.”  The AIC also supports the removal of the annual investment limit, which currently states that a single VCT can only invest £1 million in one company per year.  “Why does the size cap matter?” asks Sayers. “If a company needs £3 million of funding, there is no reason why it should not come from a single VCT. There are other rules in place to support diversification. “The current limit raises costs and increases administration at a time when we need to get money to companies,” he says.  Levett agrees. “The rule has led to a very fragmented market with a proliferation of VCTs and lots of orphans.”   Jourdan highlights the benefits to investors of removing it. “All [this rule] does is to keep VCTs relatively small and inefficient. There is no benefit to the taxpayer to having lots of VCTs run by one company.”  He says removing this restriction could increase merger activity among VCTs. Octopus is one of several groups to undertake internal consolidation in order to seek economies of scale. “With [a trust of] less than £10 million, it is difficult to look attractive because of the fixed costs of running a public limited company. While consolidation is relatively complicated, and incurs some up-front costs, you do achieve savings,” says Latham. Principles-based rules
But Latham opposes the proposed move from a rules-based to principles-based approach by which to determine eligible investments. He says he is concerned about the potential for confusion, and for discrepancies to arise between different interpretations of the rules.
“We would favour a more proscriptive approach,” he says. “Make it plain what the rules are going to be and we will work within them.” Sayers, on the other hand, supports the change. He says that the greatest risk of rules-based legislation is excluding a great business idea. “Principles-based rules are slightly more uncertain, and they do have to be applied sensibly,” he says. “But they allow the ability to have a discussion.” Jourdan agrees. “An element of principles-based rules would be helpful. It is desirable to have some flexibility.” He welcomes the prospect of simplification. “Layer after layer of rule changes have made VCT tax legislation as complicated as possible. But [simplifying this] will allow us to get on with finding companies to invest in rather than worrying about tax rules.” Jourdan says this is critical. “The funding gap has grown substantially and has extended again this year.”   Levett agrees, but says the situation could worsen. “The impending cash call on European states to put more money into the bailout fund will put pressure on banks’ ability to fund borrowing. “Banks are not very active in the sub-£10 million investment range. We have all learnt to do deals with less or no bank debt. But it is not good – banks should provide working capital [while we] provide long-term capital.” Says Jourdan: “So we will see VCTs providing both debt and equity. And the debt will be more expensive as there are greater risks attached. Investing in VCTs is really about investing in small businesses. They are the engine of the British economy. It is where VCTs came from and what they should be about.” ©2011 funds europe

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