Growth capital giants

With traditional sources of funding still in short supply, venture capital trusts are looking more attractive than ever to entrepreneurial ventures.

GB meets the managers holding the purse strings.

It was a good year for VCT managers. After funds raised by the tax-efficient vehicles dwindled as low as £158 million in 2008/9, forecasts of a revival in interest were vindicated, with the total amount raised doubling to £340 million.

The boost may reflect greater warmth towards growing companies on the part of investors, but fund managers agree that the main explanation is simply changing tax policies. In turning the screw on high earners through a new 50p top rate and less generous pension allowances, former Chancellor Alistair Darling proved to be a friend to VCTs, adding lustre to the tax breaks they offer. In fact, some managers have all but declared VCTs the new pensions. Tim Levett, chairman of NVM Private Equity, says, ‘VCTs were in a secondary position to pensions when it came to opportunities to mitigate tax. They are now in the number one spot.’

There was further good news in Darling’s final Budget, a recognition that ‘there may be a case for reviewing the investment criteria’ for VCTs. These criteria were tightened in 2006, for example by restricting the maximum number of staff in an investee company to 50. That particular restriction has been criticised by many fund managers – Patrick Reeve, managing partner at Albion Ventures, brands it ‘completely barking’ because it cuts out most investable AIM-quoted companies and makes it impossible for VCTs to follow investments in businesses that succeed in growing their headcount. So the former Chancellor’s hint that this, and other unpopular rules, may be relaxed was greeted with relief.

Unfortunately, a helpful approach from the Treasury is not enough. The EU will have to agree that any proposed changes are allowable under its “state aid” rules, which restrict the extent to which governments can offer a helping hand to enterprises. According to Reeve, the VCT industry must now ‘give the Treasury sufficient evidence to go to the EU and negotiate along the lines laid out in the Budget, to persuade them to change their rules’.

Mountain of cash

Research from Business XL shows that, following last year’s fundraising, established VCTs have £765 million to invest. That includes the money sitting on their balance sheets in the form of cash (some £214 million) as well as that invested in companies or securities that do not qualify under VCT rules. Add to that total the £340 million raised in the last tax year and there is a potential £1.1 billion available for growing companies.

Baronsmead VCT 2 tops the ranking by funds available for investment, with £23.8 million in cash and non-qualifying holdings, including nearly £18 million in interest-bearing securities). The fund raised some £8.8 million in the 2008/9 tax year. Andrew Garside, a partner at ISIS Equity Partners which manages the Baronsmead VCTs, says their success is built on ‘a very good underlying portfolio of private equity investments, which have historically delivered good returns’.

For growing businesses, the value of VCTs has been clearly demonstrated over the past two years when other sources of funding, including bank loans, have been hard to come by. London pub chain Antic secured £4.2 million from VCTs managed by Downing in early 2009 to buy the leasehold of three pubs from Punch Taverns.

‘From my perspective, standard debt would have been a better option, a simpler scenario too,’ says Antic’s founder Anthony Thomas, who adds that his bank pulled out of funding the deal despite initially appearing interested.

Antic now runs 13 outlets and has seven more in the pipeline. Thomas, an ex-Army man, is brutally frank about what he wanted from his VCT saviour. ‘It was about the money, just the money. I didn’t need someone to tell me how to run pubs.’

It is a quite different story for innovative search engine True Knowledge, which aims to answer users’ questions intelligently rather than simply combing the web for certain phrases. The company raised seed funding of £650,000 in 2007 from Octopus Ventures in conjunction with the firm’s network of private investors. That was followed in mid-2008 with a further £2 million from Octopus funds, including the Titan VCTs.

‘Our investors offer us ad hoc help and advice’

‘I’m not going to pretend that cash isn’t a very large part of why you do a deal with a VCT,’ says True Knowledge’s founder William Tunstall-Pedoe, adding that the equity injections have boosted the company’s headcount from two to 25. ‘But we’ve also been supported in a lot of other ways. [Octopus director] Alan Wallace attends our board meetings, and the shareholders in the investor network also offer advice and support on an ad hoc basis. Octopus also introduced our chairman, William Reeve, who was one of the founders of Screen Select [later acquired by LoveFilm].’

While VCT money fuelled growth for Antic, it has been the lifeblood of True Knowledge. Such an early stage company could never attract bank funding, even in rosy economic times, and big-name VC houses are focusing on larger deals. Simon Rogerson, chief executive of Octopus Investments, says, ‘Virtually every other finance provider has left the £1 million to £5 million space. There is a real shortage of capital.’

The Treasury estimates that VCTs, together with fundraisings conducted under the Enterprise Investment Scheme, have been responsible for £10.5 billion of backing for more than 17,000 small and medium-sized companies. Data from the Association of Investment Companies suggests that VCTs alone provided £1.6 billion to growing businesses in the five years to April 2009 and boosted employment in those companies by an average of 47 per cent, offering tax returns to HMRC that dwarf the cost of the incentives granted to investors.

The investment case for VCTs is less clear-cut. Since their shares are difficult to trade on the secondary market, share price is a poor indicator of performance. The usual yardstick is the change in net asset value plus any dividends paid by the VCT. Using this measure and ignoring tax breaks, returns over the past ten years range from 63 per cent for the best VCT to minus 73 per cent for the worst, averaging out at roughly minus 7 per cent.

Ben Yearsley, investment manager at financial adviser Hargreaves Lansdown, says, ‘There are some outstanding [VCTs], and some really mediocre ones. The general quality of performance has picked up over the past ten years and there are now several VCTs providing decent returns.’

Levett of NVM agrees. ‘The industry is consolidating. Generally speaking, money is flowing more and more to competent managers and the others are dropping out. I would say Baronsmead, Albion, and ourselves are the ones which are consistently performing, though others have done pretty well.’

Growing pains

Now in their 15th year, VCTs are fighting a war on two fronts. There is the marketing campaign to persuade investors that there is more to the trusts than a quick tax break, and the more complicated battle with the EU over regulation. But there is a mood of confidence in the industry. Says Yearsley, ‘VCT managers are generally an ingenious bunch.

Whatever rules are in place, they will find ways around them.’ NVM’s Levett agrees, pointing out that the new rules only affect money raised since April 2006; the old rules still apply to ‘old money’, which after all makes up the bulk of the funds currently held by VCTs.

For businesses seeking investment for an ambitious programme of growth, the revival in VCTs’ fundraising fortunes is unambiguously good news, and they won’t have to wait for an EU rule change to benefit. Says Tunstall-Pedoe, ‘In general, £2 million takes a business a long way – and that’s £2 million a year. There is a point where a business will outgrow VCT funding, but it can get you to the stage where other sources of finance become available.’

Top VCT managers, by net assets under management
Octopus: £302m
ISIS Equity Partners: £251m
Downing: £221m
Albion Ventures: £190m
Foresight: £159m
Source: Business XL VCT Report 2010

VCT Report 2010
The full Business XL report reveals:

• Financial details for each and every VCT, including cash levels and funds available for investment
• Contact details of VCT fund managers, and a ranking by assets under management
• The views of the market’s leading managers
• Details of those funds currently open for investment, and the cash they have raised so far
• A guide to VCT rules and categories, together with a comparison with the equivalent French scheme, the FCPI
• And, for the first time, annualised performance information by sector, revealing whether VCTs have made money for investors beyond the tax breaks

Nick Britton

Lexus Ernser

Nick was the Managing Editor for when it was owned by Vitesse Media, before moving on to become Head of Investment Group and Editor at What Investment and thence to Head of Intermediary...

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