Recent rule changes make venture capital trusts a riskier choice – but they are still a useful option for wealthy investors, argues Cherry Reynard.
In its 2017 Patient Capital Review, the government made its position clear – tax incentives would only be on offer where capital was genuinely at risk. This has seen the venture capital trust (VCT) sector undergo a number of key changes in recent years, designed to steer it towards smaller, higher-risk companies.
Investors are understandably nervous. They worry that the sector now comes with far higher risk, too many VCTs will be competing for too few deals, and the trusts don’t have the in-house experience to analyse smaller opportunities. These concerns are valid and should be front of mind for investors during this year’s VCT fundraising season.
There have been two lots of significant change in the VCT sector. The first wave happened in 2015, when management buyouts and acquisitions were banned, not only for new money but for rollovers of existing capital in the funds. This removed an important lower-risk option for VCT managers.
At the same time restrictions were placed on the size of target investments and their longevity. Companies needed to have made their first commercial sale in the past seven years (this extends to 10 years for ‘knowledge-intensive’ companies) and they also had to have fewer than 250 employees.
Rules stop investment in bonds
In 2017, the rules were tightened on how quickly money had to be invested and how it could be invested – it could no longer be in a company’s bonds but had to be in its equity. There were also restrictions on the amounts that could be invested in individual companies.
There have been fears that the rules make VCTs a much riskier prospect. Certainly, it means that new companies coming into the portfolio are younger, earlier-stage enterprises. However, Alex Davies, founder and chief executive of Wealth Club, points out: “It is not a cliff edge. The rules have actually been tightening for some time. Fund managers have had time to adapt to these new rules and, if needed, change their strategy and recruit new people with the relevant skills to manage money under the new rules.”
For older trusts, there will still be plenty of existing companies in the portfolio at a more mature stage. Davies adds: “Don’t forget that when you invest in a VCT you get access to the whole portfolio, not just the investments it makes after your subscription. This is important, because many VCTs still hold a considerable proportion of old-style investments, which should give investors a good deal of protection. These should continue to churn out returns while the newer venture-style investments have a chance to mature. Indeed, returns in the short- to medium-term (three to five years) are likely to be driven by how these perform, rather than the newer investments.”
Risk increases over time
That said, it means that incrementally, the risk will increase over time. Will Fraser-Allen, deputy managing partner at Albion Capital, says that Albion used to have half lower-risk asset-backed securities in its portfolios, and half higher-growth areas. From here on, it is focused solely on adding investments in the higher-growth area.
The new rules are also changing the sector balance of VCTs. Jason Hollands, managing director of business development and communications at Tilney, says that inevitably many VCTs are gravitating to technology-enabled or enabling enterprises. Nevertheless, some have retained their specialisms. The Albion team, for example, has built specialist expertise in healthcare companies.
Analysing this type of early-stage company requires different skills, and not all VCT managers had the expertise in place when the changes happened. Hollands says this is a competitive market for talented venture capital professionals. “These groups have had to ask themselves whether they have the right skills in place to deliver successful outcomes. They are competing not just with each other, but with the large venture capital funds for skilled teams. Some have done a lot of hiring,” he says.
However, this is not true across the board. Hollands says that the Octopus Titan VCT has always done early-stage investing and has therefore not had to make the same changes. The same is true for ProVen. “But other managers have had to start with clean sheets,” he says, “or have brought people over from their EIS [Enterprise Investment Scheme] teams.”
The need to get money to work more quickly also has implications, particularly during periods when the sector is attracting significant capital. There are currently 15 offers open, says Hollands, with another three in the pipeline and six already closed. “By my calculations, there is around £850 million being sought from investors by the different providers. That’s very high. I don’t think it will all be raised. There is already around 40% less raised this year than last year.”
Companies chasing fewer deals
Nevertheless, even if only a portion of it is raised, it adds up to more companies chasing fewer deals. Jack Rose, head of tax-efficient products at LightTower Partners, says that potential investors should avoid falling into a trap whereby a VCT is trying to raise capital without having expanded its deal flow capacity. This may put it under pressure to find qualifying investments just to keep the portfolio compliant, compromising its investment goals and potentially undermining future performance.
Rose adds that competition for deal flow has increased quite a lot. He believes that the larger experienced managers will have a head start, as will small regional managers who have built a niche.
Fraser-Allen says that deal flow remains sound for the time being: “It is important to consider that entrepreneurship is increasingly popular. It used to be investment banking and consulting, but now young people are just as keen to get involved in an early-stage technology business.”
For investors, all this may mean that it is more difficult to judge the track record of some VCTs. There may be new managers, picking different types of investment. They may be very good, and past performance is clearly no guide, but it should give investors pause for thought when selecting a manager for this year.
If there are advantages to the new regime, they come from a greater focus on diversification. Rose says he sees far less reliance on performance being driven by one or two investee businesses; instead, it is coming from a wider base of investee companies.
Fraser-Allen says this is a priority for Albion: “Diversification is critical to delivering steady returns. We have increased the number of businesses, going from around 65 to 70. We are always looking at the portfolio and ensuring it delivers a cross-section of sectors and businesses.”
A key attraction of VCTs has been the tax-free dividend income stream they provide – particularly for retirees; here, too, there are concerns that the new investment rules will prove disruptive.
Disrupting the income stream
Davies says: “The new rules mean new investments have to go into typically younger and riskier companies than previously. Tax-free dividends of 8, 9 or 10% have been common over the past 10 years. Future returns are likely to become more volatile and much lumpier.” Dividends are likely to come when there are exits, rather than from company profits or loan repayments.
However, Fraser-Allen says that most of Albion’s dividends have historically been delivered by exits anyway: “The way to deliver longer-term dividends is to get the right balance, a flow of exiting business. At the same time, we can use the investment trust structure to retain profits to smooth out dividends.”
A final worry is that a focus on smaller companies leaves trusts more vulnerable to a shift in economic fortunes, such as if Brexit were to prompt a significant slowdown.
Investors may be reassured by the structure of VCTs. If a management team shows that it is not up to the job in the new investing environment, it can be replaced. Rose says: “Investors need to remember that these are listed companies with a board of directors. They are responsible for looking after the interests of shareholders.”
This is a new environment for VCTs, but the sector isn’t lurching into high-risk, speculative investments overnight. The profile of VCTs may change, but for now, they still have a place.
Is a VCT still a pension alternative?
Alex Davies says: “Rather than an alternative, VCTs should be seen as a pension supplement. If you have put all you can in your pension and Isa, then VCTs (new rules or not) should be the next port of call for experienced and wealthy investors. Indeed these investors ignore VCTs at their peril. Money outside of a tax shelter will be potentially subject to income, dividend and capital gains tax. These can have a savage effect on returns.
“In addition to the tax benefits, VCTs can help you diversify. You will be investing in companies likely to be very different from your main portfolio. Historic returns have been good. That said, VCTs are for wealthier investors and I wouldn’t recommend you put more than 10 to 15% of your portfolio into them.”