Thanks largely to Government tax breaks, the last financial year marked a dramatic recovery in fund raising for UK-based venture capital trusts (VCTs) but will the influx of funds improve performance? Patrick McCurry reports.
With the raising of around £500m in the tax year 2004/05, the VCT industry appears to have received a shot in the arm. While the new money will please the Government, which is keen to channel more private funds to small companies, it remains to be seen whether it will help turn around the often poor returns of recent years and lead to a longer-term re-engagement by investors. There are also expectations that the big increase in the number of VCTs seeking funds, which has left some VCTs with relatively small sums raised, could result in a shake-out with more mergers between trusts in the coming year.
A further uncertainty is what will happen when the current tax incentive period ends in April 2006. Some in the industry would like the Treasury to put in place some longer-term fiscal incentives, although they recognise the Government is unlikely to prolong the generous tax breaks currently on offer.
VCTs were introduced in 1995 and invest in small unquoted companies or those listed on the London Stock Exchange’s Alternative Investment Market (AIM). Since their launch, more than £1.5bn has been invested in more than 70 VCTs. They invest in companies with gross assets of less than £15m and the VCT has only to invest 70% of its funds in such qualifying investments. While there was a boom at the turn of the new millennium, with £433m raised in 2000/01, this was followed by a slump in the wake of the dot.com crash and stock market declines. In 2003/04 fundraising was just £58m. But UK Chancellor of the Exchequer Gordon Brown made the decision to allow 40% income tax relief in the last and current tax year, which looks likely to kick-start interest.
According to David Cartwright, a partner at PricewaterhouseCoopers, £500m raised last year is a pretty good outcome: “The pessimists were predicting £150m and the optimists £1bn. Barring any problems, I’d expect to see a similar figure raised this year, which would mean around £1bn over two years and that’s exactly the kind of boost the Government was seeking with its tax break.”
David Thorp, investment manager at the four Baronsmead VCTs, which have been among the best performing trusts, argues that the key issue is not how much has been raised but whether it can all be invested effectively. He points to the high sums raised in 2000/01, much of which was not wisely invested. “When you raise a large sum there’s always a danger that not enough care is taken in how it is invested. But I think £500m is about right in terms of the industry’s capacity and we can probably expect a similar amount next year, or perhaps more if returns are good.” Thorp says to avoid the situation of too much money chasing too few deals Baronsmead and many of the other large VCTs have been investing more in their deal origination teams.
David Knight, director of tax shelter research at research group Allenbridge, agrees that it is not necessarily a question of more is better when it comes to fund raising: “Some capital rationing is good because over-supply can cause problems, as in 2000/01 when a lot of the money went into the wrong companies because of the dot.com boom. But the evidence today suggests that there is a strong deal flow in unquoted companies and on the AIM exchange a lot of IPOs are in the pipeline.”
The confidence of investors in VCTs is crucial, says Thorp, noting that it improved significantly in 2004/05 but had been weak in the first half of the year, due to disappointing stock market performance and the fact that the new tax incentives were not announced until September.
But unless VCTs can offer investors good, sustainable returns then there may be a risk that once the tax incentives are phased out at the end of this year, investor confidence could slump. The historic performance of VCTs has been extremely variable, with a few very good performers but many displaying indifferent or extremely poor performance. According to the UK Shareholders’ Association, by last year the total return of funds (net assets plus dividends reinvested) of the longest-running VCTs ranged from 175p to 45p from an issue price of 100p. The worst performing represented a negative annual return of 10.1%.
Given the generous tax breaks last year and this year, indifferent performance can be made to look good. But in the long term returns need to offer investors what they are seeking. On the other hand, some in the VCT world argue performance has not in fact been as poor, relatively, as has been made out. “You have to see it in context and remember that 3i, for example, has seen its share price halve since 1999/2000,” says Baronsmead’s David Thorp. He adds that VCT performance has been roughly in line with the FTSE All-Share and that, when you add the benefits of the recent tax incentives, VCTs offer investors an even better deal.
Alastair Conn, managing director of Northern Venture Managers, which has four VCTs with over £100m in total, argues returns will improve over time. “By its nature it takes a while to build momentum in this industry and to become profitable. We’re talking about smaller early stage companies and that means long-term investment and less substantial returns than big MBOs.”
Conn believes it is not just the tax relief that helped boost investment last year but also the recovering stock market. “There was a lack of appetite for equity investments generally but that began to shift with the recovering stock market.”
One question investors have had to ponder is which of the three types of VCTs – generalist, AIM-quoted or specialist – are likely to perform best in the coming years. David Cartwright of PricewaterhouseCoopers says of the first £300m raised last year more than half was in generalist funds, 38% in AIM funds and only 8% in specialist VCTs, such as those focusing on technology, media or green companies. Cartwright says: “That’s not a bad balance because some people were concerned there would be too much investment in AIM funds and not enough opportunities on AIM to justify it.”
The funds most successful in fund raising are those with the best track records, says Allenbridge’s David Knight, and that tends to mean VCTs in unquoted companies. These include Baronsmead, which raised around £50m for two of its funds, and Close Brothers’ Income and Growth VCT, which raised £45m. Another big fundraiser was the Artemis AIM fund, which raised around £50m.
But alongside these market leaders are a whole bunch of smaller and relatively new VCTs, some of which have struggled to raise significant sums. Knight says in 2004/05 there were some 45 new VCT offerings, which is higher than the boom of 2000/01 when funds were opening and closing at a rapid rate. This rapid growth and the tax breaks have led to concerns at the Financial Services Authority (FSA), the UK regulator, that some investors are being attracted to VCTs without fully understanding what they are buying into.
The FSA reported an increase in the number of offerings and in marketing to investors. Of particular concern, it said, was that some promotional material was not setting out the risks adequately and that some funds were targeting not only high net worth investors but also less wealthy individuals. The FSA also pointed out the poor performance of some VCTs, the lack of transparency and difficulties in comparing performance.
A further concern was that some VCTs were investing the 30% of their funds that are not required to be held in “qualifying investments”. This 30% has traditionally been held in cash or fixed income securities but is increasingly being held in more risky investments, says the regulator.
David Thorp of Baronsmead says the funds that attracted the FSA’s concerns do not appear to have done well in the recent fund raising. “I’m glad that investors seem to have drawn their own conclusions and not gone for funds that are difficult to understand.” In one case, he says, the fund’s non-qualifying investment was in housing bonds and this investment was given more prominence in the prospectus than the qualifying investments. “That’s like the tail wagging the dog,” he says.
A handful of the less successful VCTs withdrew from the market before the end of the financial year, thus allowing people that had invested to use their tax allowance and find an alternative investment before April 5. Most of the remaining VCTs raised at least £5m to £10m and will be looking to raise more funds in the current year so that they are a viable size, says Alastair Conn of Northern Venture Managers.
Opinion is divided on what constitutes a viable size, which allows a VCT to gain some economies of scale and to spread its risk. Conn puts it at around £20m, while John Spooner, director of the Quester group of VCTs that are being merged, says the bigger the fund the better: “If you’re putting 75% of your fund into your chosen area and you have £40m, that’s around 30 investments of £1m. But if you halve that to £20m in total you’re getting a spread of smaller, higher-risk investments.” Because of this pressure, some believe there will be more mergers among VCTs, following changes last September by the Inland Revenue, which made mergers a more realistic option for VCTs.
Since then there have been a couple of merger announcements. Chrysalis, formerly Classic Fund Management, is merging its trusts into one vehicle, while in February the boards of four Murray VCTs opted to move to Close Venture Management and those VCTs could merge in the future. The technology-oriented Quester group of funds are also merging. Allenbridge points out that these funds are currently experiencing poor net asset values but are well respected and could benefit from a turn in the market for life technology and ICT investments.
John Spooner of Quester says one of the main reasons for the merger is gaining critical mass: “It’s quite expensive running a VCT because it’s a public company and so the costs are higher than for a limited partnership in terms of reporting requirements, non-executive directors and so on.” The other reason for the merger, he says, is that pooling the funds will allow the firm to access larger companies rather than taking lots of smaller, higher-risk stakes. Spooner says: “Then again, you have to weigh up the costs of merger because it’s not a cheap exercise and the costs of merging two £5m funds are not much lower than two £10m funds.”
He argues that, while technology-based VCTs like Quester have not generally performed well since the dot.com crash, the cycle may be changing. Spooner says: “We did very well in the 1990s and perhaps we shouldn’t have raised as much as we did in 2000. The problem is that investors will seek the safer investments and so they’re only interested in funds with a good track record over the last few years.”
Alastair Conn believes there may be more mergers and consolidation in the VCT market in the coming year but he notes that so far there has been remarkably little evidence of one management group taking over another. “We’ve seen examples of funds in the same management group coming together, such as at Quester, but nothing ‘hostile’,” he says.
For Baronsmead’s Thorp, however, there is little to be gained from merger for his funds. He says Baronsmead has little interest in merging, not least because having four funds means each can invest, say, £1m in the same company. This means the house can invest £3m to £4m at a time, which gives it access to larger companies and allows it to do more due diligence.
In terms of which of the different kinds of VCT will perform best, Conn goes for the generalist, although declaring an interest given that NVM’s funds are in this category. The generalist funds are able to spread their investments between markets and so can iron out peaks and troughs affecting any particular market, he says. As for the specialist sector, that will depend in large part on the market cycles affecting particular industries. “For the specialist VCTs it’s all about investing at the right time,” he says.
As for the AIM funds, much will depend on the performance of the AIM market as a whole, he adds. The growing interest in AIM has pushed prices up, however. “We like doing the odd AIM deal but at the moment it’s too expensive,” says Quester’s John Spooner. It is AIM, however, that has attracted some of the larger investment houses into VCTs and this is a welcome trend, according to Alastair Conn. “The arrival of houses like Framlington and Invesco is a vote of confidence in the sector and they’re hoping to transfer their expertise to smaller quoted companies.”
But David Thorp, while welcoming this influx, sounds a note of caution: “I hope it’s not a case of them whizzing in and whizzing out. The VCT market is different to small cap investment because there are a lot of rules and regulations that can bite you and so a lot of technical knowledge is required.”
For Thorp, one of the most important issues in the coming months will be what kind of system governing VCTs will be in place when the tax incentives end. He does not expect the Treasury to allow the current incentives to continue beyond next April but says it is unclear how the system will evolve.
“We want a system that will help sustain annual investment of £300m, £400m or £500m.”
He adds that while the Treasury is keen to avoid market distortions by over-generous tax breaks, it is also keen to encourage long-term investment in small companies. Thorp says one of the aims of talks with the Treasury could be to seek fiscal measures that will encourage investors to hold VCT investments for several years.
The uncertainties over future tax treatment mean the longer-term outlook for VCTs remains unclear. But if enough VCTs can generate good returns in the coming years, possibly following a shakeout in the number of funds, the investor interest of the last six months is likely to continue.
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