Back in the summer, Darius McDermott, Managing Director of Chelsea Financial Services, told GBI Magazine how opportunities abound in the VCT market
A spate of regulatory changes is slowly forcing the VCT market to return to its roots and re-affirm what the product is all about – backing small growth businesses with big futures.
The changes have been taking place over a number of years and are designed to bring VCTs back to their original guise – and for once, it’s government tinkering I agree with. VCTs had started to move away from their origins. It made them lower risk investments, but that wasn’t what they were designed to be. The very spirit of venture capitalism is risk-taking and the generous tax-relief of VCTs was the ‘pay-back’ for investors for taking said risk.
In 2015, then Chancellor George Osborne set the ball rolling and took the decision to stop VCT money being used to fund management buyouts and acquisitions. More recent changes have focused on cashflows, with VCTs now having to invest 80% – rather than 70% – of their funds in qualifying companies; while 30% of a raise must now be invested in the first full accounting year. Finally, they can no longer invest in a company which has been trading for more than seven years.
That’s a lot of changes and has raised challenges for many VCTs. But despite these changes and ongoing concerns over Brexit, VCTs have remained resilient, with the 2018/19 fundraising for the sector coming in at £731 million, edging the amount raised in the previous tax year to be the second highest annual raising since the products were launched in 1995.
The tax-free dividends and the 30% income tax relief on investments have both played big roles in this resilience. But another reason for the resilience is that flows are now coming from numerous directions: five or six years ago the market was execution-only led investors aged between 50 and 70 years old placing reasonable sums of money each year and getting strong performance. Today the investor base is larger thanks to the cap on pension contributions: higher rate taxpayers who have maxed-out on their pensions are turning to VCTs as an alternative. This is one of the principle reasons I believe VCT fundraising will stay strong in the next couple of years.
What impact will the changes have?
With fundraising remaining robust, the challenge for many VCT players is what to do with those assets in a climate where tightening rules have shrunk the pool of investments available to them.
A smaller pool of companies means there is likely to be more competition from VCTs to invest – which could result in valuations increasing.
This is where existing providers offering top-ups have an advantage – for now. They can still hold existing investments in some of the less risky investments.
The fact VCTs must now invest 80% of the portfolio in qualifying investments, up from 70%, places them under more pressure, as does the decision that they now have to invest 30% of funds raised in the first 12 months. Dividend payments have been a popular way for providers to pay off excess cash in their portfolios in the past couple of years and this is likely to remain so in a bid to comply with the rules – there may even be some special dividend payments.
The new rules place stricter guidelines on cashflows in general within VCTs, and this is one of the reasons I expect a large number of issuers in the coming year as they will be keen to retain a strong hold of their liquidity levels by replenishing their cashflow.
What should investors be looking for?
Past performance is something investors must keep a closer eye on as this transition continues to take place. Those VCTs which have not been as focused on growth companies in the past few years arguably have track records which will not be as relevant in the future.
When it comes to new issuers, the first thing I would look for is those with a unique deal flow. Groups with size like Octopus – who get their deal flow through their entrepreneur and high-net-worth networks. Investors must also look at what VCTs raise and decide how confident they are in those firms being able to invest that money under the new qualifying rules.
Much also depends on the quality of the VCT manager and their ability to invest into expansion capital deals – and whether they have the right personnel to do that given the changing strategies. Managers with a growth focus will naturally have an advantage.
NVM, the company behind the Northern VCTs, for example, was very good at management buy-outs. Their lower risk VCTs had done very well and they were known for good, regular dividends and decent returns for investors – ‘giving you your pound back’ after the required five year holding period.
Since the changes, the company has taken significant steps to adapt its skill set to the new VCT rule requirements. This includes a new nine-person strong investment team and investment partner. The wider investment team has been recruited from across the global investment industry and they are now looking in a strong position.
At this early stage of the season, there is only a handful of VCTs open. We currently like ProVen given it has a strategy that is well-aligned to the rule changes by focusing on growth rather than replacement capital deals – they also have an experienced management team.
The ProVen Growth and Income VCT is currently over 80% subscribed, so investors may need to move quickly. It’s a generalist VCT investing across a spectrum of sectors, from telecom and media, services, healthcare and artificial intelligence, and the companies have a global footprint, accessing markets spanning North America, Europe, Asia and Australia. ProVen targets companies with strong demand for the good or service they provide, and evidence for rapid growth potential in sales and profits is sought. Strong leadership is also critical, as is a management team aligned with the success of the company through substantial share holdings. ProVen typically look for the potential to sell a company after a four or five-year holding period.
This is the quiet point in the VCT calendar, but we expect issuance to pick up around September or October. Overall, 20 VCT share offers opened during the last tax year, raising funds for 33 VCTs in total – twelve of these offers were fully subscribed before tax year end. So I’d be waiting for the right companies to come out and drip-feed my money into the markets as and when they do. Diversification is more important than ever as a way to combat the move back to higher risk investing.