The new tax breaks introduced by the government earlier this year have attracted a flood of new money to the VCT sector with the total raised by VCTs this year expected to reach as much as £300m, against £50m last year. The question now is whether the opportunities are there to invest in. Angela Sormani reports.
The area causing most concern, according to many commentators in the VCT market, is the Alternative Investment Market (AIM) or, more specifically, those new entrants to the VCT arena hoping to make a fast buck through AIM.
Nick Ross, manager of the Electra Kingsway VCTs, says: “There are concerns that too much money is about to be raised in the AIM VCT arena. The majority of the VCTs coming to the market are AIM VCTs as a number of quoted fund managers have jumped on the bandwagon.”
According to Ross, an AIM-quoted fund manager traditionally relies on broker due diligence which in some cases can be poor and can also create conflicts of interests as brokers are often rewarded on gaining the highest valuation on float. He adds that an over-funded AIM market will also encourage lower quality companies to seek a listing, which will lead to a number of companies falling well short of market expectations. “One of the main restrictions with VCTs is that you have to buy primary shares. Whereas there will be no shortage of primary investments, the big question mark is over the secondary market as, on a relatively illiquid market, it only takes one small seller to push the price down heavily. Who is going to buy the secondary shares from the VCTs when they try to exit after three years? Either way, expect greater pricing volatility in the AIM market.”
As a counter-argument, Ross adds that the VCT market with the new tax breaks does tilt the balance in favour of the investor. That is, the VCT doesn’t actually have to perform that well for the investor to double his money with the tax breaks.
But for VCTs to offer the full tax benefits to investors, at least 70% of their funds must be invested in qualifying companies by the end of three years. Individual companies in which VCTs can invest must be qualifying, which includes the test that their gross assets, post-new VCT money, must not exceed £16m. A major concern, according to Luke Ahern, director of broking at Corporate Synergy, stockbrokers that specialise in AIM, is that smaller companies that have been backed mainly with VCT money might face significant problems after three years when VCTs will be looking to exit their investments.
The key challenge, according to Ahern, is for VCT-eligible businesses to move from the £16m gross asset limit to a market capitalisation of over £50m. And he argues that, unless these VCT-backed companies manage to resolve the problems that beset many small stocks, such as unpopular paper that trades only occasionally and in small quantities, they will not be attractive to new professional investors once the VCTs have moved elsewhere.
The key question many of these AIM VCT managers have to ask themselves, even before raising funds, is how do you appeal to those institutional fund managers such as Deutsche Asset Management, Isis Asset Management and Jupiter Asset Management, who will seek to acquire stocks on AIM and who are ultimately going to be the main exit route for these investments?
“Getting to the £50m size where the larger investment trusts and pension funds will take an interest in a company on AIM takes more judgement than luck,” says Ahern. He outlines several key points for managers to take into account. Even if a company is producing strong organic growth, it should not rely on this alone. It is likely that to get to the desirable £50m in size at least one groundbreaking acquisition is necessary, probably more. However, acquiring and then integrating companies is time-consuming for management and during a period of growth it is vital that management doesn’t take its eyes off the day-to-day running of the business.
Secondly, a manager must also make sure the company financial performance is consistent in terms of regularly hitting turnover, earnings and dividend growth targets. This is vital for investor relations, says Ahern, and demonstrates to the larger investors the strength of the management team and the quality of the business offer. “Companies that swing from profit to loss to profit are seen as not in control of their destiny, and are generally weaker long-term investment prospects,” he says.
And finally, although easier said than done, it is crucial to maintain a strong balance sheet. Professional investors will not support companies that are marginal and in danger of running out of cash. If a company does a fund raising on the path to profit, it should ensure it presents an enticing, well-researched and memorable investment story.
Only a favoured few companies get the City’s backing, most struggle for funds, says Ahern and so it is important to be visible to the City and to invest in financial PR and investor relations activities. Increased visibility and being a talked-about company will help interest fund managers at the appropriate time.
The VCT market, particularly on AIM, has become fiercely competitive. David Knight, director of tax shelter research at Allenbridge says: “VCTs are taking a pop at each other. Some of the established AIM VCTs are saying the new groups won’t have the relevant experience and generalist VCTs are saying the AIM market will be too crowded.” But the new AIM VCT groups are big brands such as Framlington, Invesco Perpetual and Keydata and have the marketing clout plus they have well known fund managers running their products. In addition, AIM is booming. It is growing fast and has achieved an impressive number of new issues. Mining companies have bumped up the market cap, but that area is not an approved area of investment for VCTs. In spite of that, says Knight, if AIM returns to normal levels, a significant number of the new issues would be VCT qualifying and if the supply continues over the next four years, there should be enough to absorb the new AIM VCT money.
There is little doubt among the VCT community that there will be enough VCT-qualifying AIM new issues around, but whether these new issues will be of the right quality and pricing is another question.
Norman Yarrow of Northern Venture Venture Managers voices concern that an inflation of share prices on AIM will hinder AIM VCTs from delivering decent returns. He says: “A concern is what the quality of companies is on AIM. Are there enough decent companies on AIM for managers to fund? People will be pushing all sorts of companies onto AIM because they know there will be lots of AIM VCT fund managers with a gun to their heads, having to invest their funds. But with some of these AIM funds, it could be a concern to find lucrative opportunities and if the overflow of money is pushing prices up, it will undoubtedly be harder to get a return.”
Andrew Buchanan of Close Investment Limited is taking a cautious stance. Close Investment Limited has two AIM VCTs: Close Second AIM VCT and Close Brothers AIM VCT, which was launched in 1998 and has raised £28m so far. Close Second AIM VCT was formerly Leggmason AIM VCT and Close took over its management a year ago. The vehicle is on a firm recovery track, according to Buchanan, who states the downfall of the fund was its exposure to the technology sector, but the team is now working on lessening that bias.
At Close Investment Limited, the team has taken the decision not to raise too much VCT money so they can be selective. “We are seeking to raise £15m, not three times that amount, which seems to be the average number at the moment, for the sound reason that we are here for the long term. In the past we have turned money away. We want to raise an investable sum of money that allows us the ability to say no thank-you to companies we believe to be over-priced. We don’t want to be in a position where we have to over-invest to invest our monies. I don’t think that’s in our investor’s best interests.”
But Buchanan is confident AIM will be able to absorb the VCT capital raised. He talks hypothetically: “Let’s say the VCT market this year raises £500m, which is an absurdly large amount. Let’s say half of that is targeted at AIM VCTs – historically it has been less than that and more likely to be a third or a quarter targeted at AIM if you take a generous estimate. AIM to date has raised £2.7bn. If you say 10% of that is VCT qualifying, which is £270m, you could invest the whole of what AIM VCTs are about to raise in one year.”
But the truth of the matter is AIM VCTs have three years to do this investing and they have only to invest 70% of the money. So the alarm being expressed that there won’t be sufficient supply, in numerical terms, is not necessarily justified in Buchanan’s view.
The best approach
Although much of the capital raised will be targeted at AIM entrants, many VCTs will attempt to find better value and greater growth potential by investing in good quality private equity transactions. MBOs will be particularly attractive as they tend to be lower risk and offer higher returns than pure development capital opportunities. The size constraints of VCT investments, both in terms of the size of the company (gross assets before investment of no more than £15m) and the size of the individual VCT investments (£1m from any one fund in each tax year) means an appetite for smaller MBOs may return to the UK market. Robin Stevens, corporate finance partner at MRI Moores Rowland LLP, says: “It is to be hoped that the funds raised by new VCTs will trickle down to the smaller MBO and development capital transactions that are often below the radar screens of the private equity houses.”
So what is best strategy for those wishing to invest in a VCT in the current climate? The potential risks, as with all venture capital investments, are there to be seen as demonstrated by the dismal performance of funds such as Advent VCT, now under VCF Partners’ new management and rebranded Foresight 3 VCT. VCF Partners is the manager of the award-winning Foresight Technology VCT.
Nick Ross says: “You want a balanced, diversified portfolio and to steer clear of any early stage. Don’t look for the massive returns, look for the steady returns. Performance tables over the last few years have been mixed, but the tech boom and bust has distorted that.”
Cautious investors might want to look at generalist funds such as newcomer Octopus Asset Management’s Eclipse VCT, which has raised £22m since its launch this year and was recently named New Venture Capital Fund of the Year at the Investor AllStar Awards. Further boosting the reputation of the fund is its manager Chris Allner, who has over two decades of venture capital experience at VC firms including 3i, Charterhouse Development Capital, NatWest Equity Partners and, most recently, ProVen Private Equity. Allner himself has an impressive track record, having generated an annual return of over 35% per annum between 1990 and 2003. Martin Churchill, editor of the Tax Efficient Review says of the new fund: “A generalist VCT from a relatively new entrant into the VCT market but one which has made a significant impact and is committed to shareholder communications, a role that is vital in developing an active second-hand market.”
There have even been VCTs appearing that have been targeting specific niches. David Knight of Allenbridge says: “We are seeing more innovative structures offering better deals. Now competition is growing, the fund managers have to find a way to differentiate themselves. We may see more creative structures cropping up, but maybe next year, rather than this year so as not to provoke the Inland Revenue too much or too early.”
As an example of a novel scheme, Pennine AIM VCT is offering a 30 pence share tender offer, which is essentially a buy-back. If Pennine 5 manages to maintain the NAV of the fund over the period and buys back the shares, investors will have received back a total of 70 pence in tax rebate and share buy-back for every 100 pence invested. And they will still have around 70 pence invested in AIM.
And standing out from the crowd with its novel VCT offering, Ventus, is Climate Change Capital, a group which provides financial services and products to organisations affected by climate change policy – see fund news this issue. The group is differentiating itself from the other generalist and AIM VCTs in the market by offering a specialist niche in investments in wind projects.
Ventus will invest in a portfolio of companies that will develop, construct and operate small on-shore UK wind projects typically consisting of between one and six wind turbines. Investments will generally be in companies developing community projects, projects initiated by specialist small scale developers, small industrial sites and small projects which are not of interest to large development companies and utilities.
There are plenty of opportunities for investors to diversify in the VCT segment, but whether fund managers like what is floating on AIM is another question. But it isn’t just about the flotation market, it’s also about existing companies on AIM wanting to raise more funds for working capital. That can also be raised from the VCTs.
David Thorp, chairman of ISIS Equity Partners and fund manager of the Baronsmead VCTs, sees both sides to the story: “There is more money coming into AIM, which will edge prices up and that’s good from the VC perspective which means some of our venture-backed companies will be able to come to market at good prices. Whether this is good for the AIM VCT is another matter. Those running AIM VCTs for the first time need to be wary and not invest too much. If you’re running a new AIM VCT you have to be very careful not to run before you can walk.”
Michael Probin, VCT investor relations manager at ISIS Equity Partners, adds: “It’s a double-edged sword with the AIM market. It’s good for exits for the unquoted investments, but not so good for the AIM VCTs when prices are being pushed up with an oversupply of capital. I think investors will be quite discerning and they already are.”
Norman Yarrow of NVM concludes that investing with caution is the key: “There is an air of caution. If a VCT raises too much money it is a problem because it has to invest it all in three years. Anyone can raise and invest money, but can they invest it in the right companies and get the returns for shareholders? That is the question we need to ask ourselves.”