Good news for Venture Capital Trust (VCT) fund raising; the UK government has increased the income tax relief rate for VCTs from 20% to 40% for the tax years 2004/05 and 2005/06. In addition income tax relief will be paid directly to the investor rather than to the VCT, as indicated in the pre-budget report. Also a potential boost is an increase in the personal investment limit from £100,000 to £200,000. Market commentators are predicting between £220m and £600m will be raised under the new tax regime. But VCTs have seen their share prices and net asset values plunge over recent years. So what good will this influx of funds do to an industry that in all honesty has not performed as well as might have been hoped? Angela Sormani takes a look at the liquidity and performance issues the managers of VCT funds are facing.
“VCTs as an asset class haven’t really performed so far. But that is changing. The people coming back to raise money are the more established players with several VCTs under their belts and this should improve the overall performance of the market,” says Sean O’Flanagan of Unicorn AIM VCT.
Since VCTs were established in 1995 around £1.5bn has been raised by over 70 VCTs and investments made in over 1,000 companies. This has created up to 100,000 new jobs, according to figures produced by the British Venture Capital Association and PricewaterhouseCoopers.
Funds raised have fluctuated year-on-year. The amount raised in the tax year 2003/04 was a mere £60m. This year should see a significant upturn, but what will happen after 2006 is unclear. The British Venture Capital Association has done much to reverse the arrest in the VCT sector and has lobbied hard for the recent changes. Now the UK government has shown its support for the sector it is hoped recent changes will incentivise investors to commit funds to VCTs.
While on the surface these incentives are bringing some much-needed optimism to the VCT sector, some managers are voicing concerns that the tax reliefs may encourage investors into the market who do not have a long-term view but look to get their money back as soon as the three-year minimum holding period is over. This could have damaging consequences for the stability of the sector.
Also on the down side, capital gains tax deferral has been abolished and the UK Chancellor of the Exchequer has declined to bring in inheritance tax relief on VCT investments, which might have encouraged a longer term view for those investors attracted to the market on the back of the new incentives.
And so unless the liquidity and performance of VCT funds see significant improvements, these incentives are unlikely to add up to much interest for the retail investor community, which is ultimately looking for performance, not just the upfront tax breaks VCTs offer. High on the agenda for the industry is a standardisation of performance reporting to encourage a greater transparency for investors. Share price is the curse of many VCTs and not an accurate reflection of their net asset value (NAV), but even if the NAV of these funds is putting in a strong performance what good will it do for those investors who want to exit their investments if the share price is performing badly? This is the issue that needs to be addressed if VCTs are to thrive in the long term.
A new investor base
VCTs were originally designed to encourage individuals to invest directly in a range of small higher risk unquoted trading companies by offering tax reliefs on any gains made by the investing individuals. With the new changes VCTs will now attract a different investor base. And an important issue for VCT fund managers now is how do they market their product versus other investment products?
One way might be as part of a pension retirement plan. Recent changes place VCTs on a level footing with ISAs (Individual Savings Account) and pension savings in terms of the tax relief offered to UK investors. ISAs have had their tax-free dividend status removed, as happened to UK pensions some time ago, so from this point of view there is no difference to a VCT investment. Capital gains are tax-free for both ISAs and pensions and are also for VCTs, although there is a minimum three-year holding period for the capital gains exemption to kick in for VCTs. But as equity investments are accepted to be for a three- to five-year term this means the three-year holding period for VCTs is unlikely to be a deterrent.
Michael Probin, VCT investor relations manager of ISIS Equity Partners, which manages the Baronsmead VCTs, says: “VCTs could be an ideal way of supplementing a pension, particularly as annuity rates are so low. Many managers will be looking at investors in that regard; it would suit the nature of the investment very well. VCTs also present a much more flexible alternative in several respects. Income from a VCT is tax-free whereas pension fund income is not. You can access your capital by selling shares in a VCT but you can only access up to 25% of your pension fund pot following retirement. In the main, the value of a pension scheme is not inheritable and annuity income dies with you, but you can pass on a VCT to the next generation. VCT investments are, however, very different from the investments a pensions scheme will make as is the income that comes from them and so VCTs should only be a relatively small, but flexible, part of an overall retirement plan.”
VCT managers may also benefit from the cap on pension funds the government has introduced; currently there is a £99,000 limit on annual pension accruals and a total fund cap of £1.4m. This limits the monthly pension income, which is taxable, to between £3,500 to £5,000 a month, depending on whether a lump sum is withdrawn from the fund before an annuity is bought and the retirement age, marital status, health etc circumstances of the policy holder. This means many senior managers may find themselves looking for other tax advantageous ways to save for their retirement. VCTs are likely to fit the bill, not just because of their increased income tax exemption (now 40%) but because they are more flexible than a pension, which must be invested in an annuity, which in turn ceases upon the death of the beneficiary/aries.
“Those who cannot put more money into their pension funds due to the lifetime cap will be looking for alternative ways to invest their money. So for the next two years those people who have excess pension money to invest may look to VCTs to get 40% income tax relief. A VCT as a supplement to a pension fund offers more flexibility in terms of a long-term investment. I think we will see VCTs being used as an overflow for surplus pension money,” says Michael Cunningham of Rathbone Investment Management, which manages The Pennine AIM VCTs.
Another incentive to incorporate venture capital into a pension retirement plan is the government’s proposed pension changes that would allow individuals to invest in unquoted companies through their Self Invested Pension Plans (SIPPs). The current SIPP rules restrict equity exposure to listed companies only. This move to incorporate private equity into a personal investment portfolio is being encouraged by many independent financial advisers who are advising clients to create a balanced portfolio with between 5% and 10% of investments in alternative assets, such as private equity and commercial property.
Martin Churchill, editor of the Tax Efficient Review, emphasises the importance of a diversified portfolio for the retail investor. “The investor shouldn’t wake up one morning and find that all his equity exposure is in VCTs. I believe 10% exposure should be in VCTs. Not everybody can take advantage of this sort of vehicle. If your tax bill isn’t big enough you don’t get your money back. The main issue is how much exposure you want in this area. The performance issue and the exit issue are major factors that come into play for investors. If there isn’t a second hand market how do you exit?” he asks.
Anyone for AIM?
The wave of funds predicted to flood the VCT market may also attract retail fund managers and unit trust managers to set up VCT offerings. Invesco Perpetual and Liontrust are two new entrants rumoured to be launching offerings on the back of their capability in investing in smaller companies. Many of these managers are more likely to set up AIM VCTs, as that’s the market they know. But if there is a mad rush to set up this type of vehicle this could present problems. Patrick Reeve of Close Ventures says: “There is a concern that the AIM market will have a shortage of new issues and there will be too much money for new issues.” Competition will also be tough for new entrants with the well-established names such as Baronsmead, Close Brothers, Northern Venture Managers and Quester, to name but a few, firmly established with multi-fund programmes.
An overhang of funds in the market may also pose a problem. VCT funds raised three years ago have struggled to meet their 70% investment requirement and many IFAs are questioning the quality and pricing of future investments. And the downside with an abundance of funds is the danger that prices get pushed up. From the investee company’s point of view this is good, but from an investor’s point of view you will have to pay a high price for good issues and try to avoid over-priced ones. Martin Churchill questions whether a wall of money is good for the industry: “Managers will have to be careful investing on AIM where there is I believe an overhang and only about 25% of new issues are qualifying for VCT investment. How do you stop a company being bid up by brokers? The brokers know there is all this money waiting to be invested and so pricing will inevitably increase.”
Michael Cunningham also sees a problem for VCTs investing on AIM keeping up with the index: “The composition of AIM has changed so much that it no longer reflects the investment arena for VCTs as many of the companies on AIM are too big for VCTs to invest in. In addition, sectors such as mining, exploration and property which do not qualify for VCT investment, have done well and have had a huge impact on the index.”
In the past for those investee companies on AIM that qualified for VCT investment, the natural place to attract funds has been the VCT funds. But in the last six months there have been non-VCT sources funding these companies, increasing competition for new issues and consequently pushing the prices up.
Michael Probin of ISIS believes AIM will nevertheless benefit from the influx of VCT funds poised to enter the market. “When there was a boom in VCT fund raising a couple of years ago with around £430m to invest a good proportion was allocated to AIM-based VCTs. Some people thought this might skew the market, but what actually happened was the VCTs continued to invest in AIM companies at a time when others pulled back. Again, a boom in fund raising could spark wider interest in investing in AIM.”
VCTs have become an important component of the AIM market investors, especially when the market was depressed because they had to invest 70% of their fund in qualifying unquoted companies in three years, which explains why they carried on investing when other investors stopped. As a result, says Chilton Taylor of Baker Tilly many of these VCTs may now have NAVs well below their subscription value because they were forced to invest in companies that now may be classified as riskier investments. “VCTs will continue to be a good source of funds on AIM, but maybe only at the smaller end. They may not be able to get the pick of the crop that they were able to in the past,” says Taylor.
With VCTs now comparable to ISAs and pension savings in terms of the tax relief offered to investors, managers must address the liquidity and performance issues if the tax changes are going to create a long-term sustainable VCT market.
David Thorp, chairman of ISIS Equity Partners, asks: “Is this a shot in the arm for VCT fund raising? More like a blunderbuss. In the next two years the industry should raise considerably more money, but what will the opportunities for investment be? The key issue for now is how do we make sure the expectations aren’t upset. We have to communicate with shareholders that this is not just a puff otherwise they will miss the point. The key phrase here is long-termism. You have to look at liquidity and performance issues beyond the first three years.”
Every month the external relations committee for VCT managers organises a teleconference to discuss the VCT market and twice a year all UK VCT managers meet to discuss industry issues. Performance measurement is always high on the agenda. A common standard of reporting for VCT performance is favoured to make it easier to understand the performance of these vehicles and to attract investors to the sector. But because a VCT is a closed fund you can only compare other VCTs launched at the same time i.e. with the same vintage year.
The industry continues to look for a way to standardise performance measurement. It would help the retail investor community to make performance comparisons, but the way in which this information is communicated depends on the audience, be it shareholders, advisors or independent commentators as well as what is actually being compared. Taking account of dividend payments as well as NAV performance is important as VCTs have a structural bias toward the distribution of profits realised from the sale of investments.
There are several ways of measuring the performance of these vehicles. The easiest method of calculating total return is net asset value plus dividends. This allows comparison with other VCT managers and is readily understood.
Advisors want to be able to compare VCTs against other investment yardsticks, such as investment trusts and FT indices. So the easiest way for advisers to compare investment performance is on a total return basis with net asset value plus reinvested dividends as calculated by the Association of Investment Trust Companies (AITC.) This allows comparisons on a like-for-like basis with investment trusts and indices that are carried out on a day-to-day basis by the financial community.
On the other hand shareholders may find it difficult to look past the effects of the J-curve (see graph) to the long term. It is this established feature of private equity those unfamiliar with the asset class must understand; that the early years of a fund’s life generally produce negative returns because investments are made some time before returns are generated. But the main concern for shareholders is inevitably what is going on with the share price. Shareholders may forget they’re receiving dividends and getting 20% income tax relief; so share price management is important, as are mechanisms to remind them of the overall package of returns on a cash-to-cash basis.
“It will be very difficult to get a whole bunch of managers to report on the same basis, but as always disclosure is an important issue. And with more players entering the market it will become even more complex to find an industry standard of measuring performance,” says Probin.
Another area of debate is how to report the performance of the investee companies so investors can monitor underlying portfolio companies and gain an insight into what to expect in terms of future returns. However, releasing that type of information might set shareholders expectations such that they are disappointed if things don’t go to plan and affect negotiations if a company is in a position to sell and is therefore price-sensitive. So this is still a grey area in terms of performance reporting. But this sort of information would be useful for investors.
One investment can boost the whole fund’s performance. For example, Electra Kingsway has a modest portfolio of 12 investments and is between £12m and £14m in size. One investment in that portfolio is AIM-listed Centurion Electronics, which has performed well and that one investment has boosted the fund’s NAV.
Probin says: “If you make a significant return on an investment this will have a huge impact on the NAV of a smaller fund. Baronsmead VCT 2, for example, which is a significantly larger fund would not be impacted as much by the performance of a single investment.”
Performing well at the moment is Foresight Technology VCT, advised by VCT Partners, which is at the top of the VCT performance tables having paid dividends of 113 pence for every 100 pence raised with an additional 160 pence of unrealised net asset value. Having recently raised more money Foresight is actively seeking new investments and recently participated in a £4m investment in Oxonica, a nanomaterials specialist.
Route to liquidity
VCT shares must be companies quoted on the London Stock Exchange so when investors wish to sell they can do so. VCT shares can be sold or bought at any time, but initial income tax relief is only available on the new issue of shares, which must be kept for three years to retain the relief. Secondary purchases of shares, created from existing shareholders exiting, lose their right to initial income tax relief. But these investors can still enjoy tax-free dividends and capital gains.
A major concern with the government’s increase in income tax relief is what will happen to the secondary market for VCT shares. Where does it leave those investors wishing to sell their shares? Sean O’ Flanagan of Unicorn AIM VCT says: “What we haven’t really seen yet is liquidity in the secondary market. The only real buyers have been the funds themselves, buying stock back for cancellation. Why would a private investor buy a share in the secondary market when you can get 40% back on a new issue?” So it is inevitable there will be more demand for new shares and not so much of a market for second hand shares. This in turn will create steeper discounts and fund managers will have to get tighter in terms of buying back their shares.
Michael Probin says: “Prior to the budget changes with 20% tax relief there was more interest in the secondary market. With 40% tax relief I can’t see that private investors have got much of an interest in buying shares in the secondary market except at an exceedingly wide discount. This will affect those selling their shares and why a share buy-back scheme is so important.”
A share buy-back scheme can offer a solution to the problem of liquidity and is an option most VCTs should provide, says David Thorp. ISIS Baronsmead VCT funds actively promote this strategy by operating a policy that enables shareholders the option of selling their shares back to ISIS at a 10% discount to NAV. In the past many VCT fund managers may not have had sufficient funds to do this. But with the anticipated boom in fund raising some VCTs may decide to allocate funds to such a scheme. This, says Thorp, gives shareholders maximum choice of holding or selling their investment. Michael Cunningham of Rathbones predicts more VCT managers following ISIS’ lead of offering a buy-back policy at a stated discount somewhere between 5% and 10%, whereby at the end of a certain period the investor will be able to effectively realise a reasonable percentage of the initial investment by inviting the manager to buy back their shares.
David Knight, director of tax shelter research at Allenbridge, says: “The share price is not an accurate reflection of the NAV. A number of VCTs run schemes to buy back shares at a discount of say no more than 10% to the NAV. Some funds have raised top-ups simply to enhance liquidity for share buy-back schemes. Buy-back schemes give new shareholders some security that they will be able to sell their shares after three years at a reasonable price without losing all the benefit of their initial tax break.”
But not all players are comfortable with such a policy. Not all managers agree they should be buying back shares; some think it unfair to other shareholders to support the share price for those wishing to sell up. Of course a manager would rather hold onto a client’s money over a ten-year period than have to buy back shares after three years. Unfortunately many fund managers will have to cater for these short-term investors if they are to sustain share price in the future. This problem may be countered if the government decides to introduce inheritance tax relief on investments, which might encourage investors to take a long-term view.
Sean O’Flanagan says: “I think the government will wake up to this loophole and introduce some sort of inheritance tax relief to encourage investors to hold on to their investment for longer rather than selling in the three years to realise their investment.”
What is going to be essential in the industry going forward is to explain to retail investors that VCTs are long-term investments. If the investor is only looking short-term tax shelter they’re in the wrong investment.
Martin Churchill says: “The Inland Revenue is very aggressive towards those who are running schemes just to profit from the tax breaks. This product needs to be careful. A scheme could be a big threat if it becomes an industry run by those only interested in tax breaks rather than venture capital.”
Patrick Reeve of Close Ventures, adds: “Understanding the performance of these vehicles is really a question of education and understanding the risk. You have to make sure people are comfortable with investments by offering a broad portfolio that produces a decent income.”
The main concerns for the industry now is that the Chancellor has abolished capital gains deferral relief and has declined to bring in inheritance tax relief on VCT investments. Either of these reliefs would have encouraged investors to take a long-term view. The concern remains among managers that the enhanced tax relief may bring investors into the market who don’t understand the long-term nature of venture capital and will start clamouring for their money back as soon as the three-year minimum holding period is over. That would not be good for the stability or sustainability of the VCT sector.
But one thing is certain; the VCT market is going to open up significantly over the next few years. The main issue will be getting the returns and keeping the shareholders happy. Churchill concludes: “There are interesting times ahead, but also worrying times. Are we targeting the right investor? Are the right managers running the funds? The industry’s got to be very, very careful.”
VCT regulation is similar to that of investment trusts and was created by the Finance Act in 1995. Under these regulations a VCT must hold 70% its investments in shares or securities of qualifying companies. A qualifying company is an unquoted trading company carrying on specified trading activities wholly or mainly in the UK and whose total gross assets (including, where relevant, those in any group companies) do not exceed £15m prior to VCT funding. At least 90% of VCT portfolio companies must be UK companies or at least have a UK office. As far as industry sector is concerned virtually any trade is allowed except forestry, financial services and anything property related.
The gross assets test is the main regulation managers identify with as the most out-of-date because it has not changed since the launch of the first VCTs. And the limit of a £1m investment per annum per VCT investee company has also not been altered since 1995. The question has been raised, if more funds become available for investment, why not raise these limits and increase the investment horizon for VCTs? Probably because the government wants VCTs to invest in companies of a certain size.