FTAdviser.com

Advertising

Campaigning for the private equity and venture capital industry now compared with a year ago is like abandoning King Midas for one of his servants. In 2007, private equity in particular had become a victim of its own success. Cheap debt and a rising stock market had produced enviable returns. Everything private equity touched turned to gold, and governments wanted a piece of it.

But now private equity financing has become more restricted, and UK venture capital looks a little less rosy. The announcement by 3i that it was cutting back on venture capital development was an especially tough moment for the industry. And as the US giants assimilate the acquisitions of 2007, the days of mega-buyouts and parliamentary inquiries seem to be on hold.

Yet although the sector is looking less healthy from a financial perspective, the assets it is trying to buy have rarely looked cheaper. From the venture capitalist’s perspective, smaller company valuations have dipped and, in some areas, crashed. Private equity houses like Texas Pacific Group are sniffing out bargains in UK financials, while local sell-offs have presented the emerging market players with plenty of opportunities.

Patrick Reeve, managing director of the UK’s largest VCT player Close Ventures, says this contrast has created a fund-raising paradox in the industry. He points out valuations have much further to grow if investors buy in at a low point. But he admits clients are least inclined to commit capital during periods of negative sentiment.

"Recovery is the story of the next two years. If you invest during a slowdown, the chances are your returns are going to be higher than if you invested during a boom, which is borne out by the figures from the British Private Equity and Venture Capital Association. The most successful periods for raising assets are during the booms, however."

In February, the BVCA demonstrated its members had achieved their strongest results in downturns. From 1980 to 2006, they returned an average of 16 per cent a year. But in 1994, they hauled in a record 34.3 per cent.

The problem of marketing the industry during lean years is the short-term uncertainty. Most investors already associate private equity and venture capital with risk, even during a bull market. This is understandable given the leverage of private equity and the variable returns of venture capital.

But Mr Reeve observes companies can overcome this risk in the longer term by concentrating a team of highly skilled staff on a unique asset. He takes the example of a budget hotel Close Ventures bought near Stansted Airport. The enterprise had the right of refusal over any budget hotels planned in the area.

"If you make an investment, you monitor it. That concentrates the mind, because if it is a bad investment, it is hanging around your neck for the next five years. What we invest in needs to have strategic and rarity value, so when we come to selling the investment, it is a must-have."

In a profession that deals in small, isolated investments, Mr Reeve emphasises Close Ventures’ community approach. "It is very collegiate. There are 20 of us and everyone sits in one room, including support staff, so you can throw around ideas and listen in when someone is having a difficult conversation. You automatically know what is going on."

For the investor, evaluating the entire team on a venture capital portfolio is crucial. David Thorp, managing partner at Isis Equity Partners, which manages the Baronsmead VCTs, says a key factor in Baronsmead’s outperformance has been the number of qualified staff on each deal.

And although Mr Thorp says his underlying investments contain a certain amount of debt, this is by no means obligatory for venture capital investments. For those worried about conditions in the credit markets, Mr Reeve uses no leverage in his underlying companies. As a sector, the VCTs themselves are practically debt-free.

Nor must a different business model apply to the private equity arena. Aim-listed investment trust Trikona Trinity Capital, which focuses on Indian infrastructure and real estate, uses no leverage and relies on a cash reserve to make its acquisitions. The fund replenishes the reserve through cash-generative core holdings. It has also hired new employees since the start of the year to extract as much value from its investments as possible.

But single manager private equity funds are still not diverse enough for some retail investors’ tastes, particularly in vulnerable times like the present. As a result, there are many funds of private equity funds available for those who want an expert to pick their managers for them. The Pantheon International Participations investment trust, for instance, puts money in hundreds of funds with thousands of underlying assets worldwide.

Less diversified managers still de-risk their portfolios as much as possible, according to Mr Reeve. He points out a VCT in particular gives older investors a regular pay packet rather than gambling their money on vulnerable assets.

"It is a savings product. A savings product needs to be predictable and reliable. What we are trying to do in the uncertain world of venture capital is to create certainty. Private investors generally do not want the excitement.

"I am trying to give people a quasi-pension fund, so they are getting their annuity tax-free, plus their capital is growing. It is an income investment. I am trying to pay out a dividend that is not going to have a long-term detrimental effect on the net assets. Our VCTs all ought to be called Close Income & Growth, but we can only use that name once.

"The only thing that is going to get people moving is if they can see a predictable and high level of tax-free return from the dividend, particularly if more private client stockbrokers start to put secondary VCT shares into their clients’ portfolios. In an ideal situation, we would be paying out a dividend of 10p per annum with the NAV growing in line with inflation."

But one crucial problem with selling VCTs to the long-term investor is the number of rule changes that have afflicted the sector. The government has hit the industry with as many tax hikes as private equity. An EU directive also limited the number of employees in a VCT investment to 50 or fewer.

Mr Thorp says the Baronsmead VCTs have got round the 50-employee rule by splitting their assets between holding and trading companies. The trusts use share sales to pay dividends and keep capital from before the rule changes took effect.

As a result of the legislation, Mr Reeve sees the industry moving to higher-margin technology businesses with a few highly skilled employees. But he says he will profit from low valuations by raising funds for existing VCTs rather than launching new products.

"What the rule change probably means is that there will be fewer new VCTs being launched, and those new VCTs that can only invest in smaller companies will probably be more techie.

"From now on, the chances are we will be doing top-ups into existing VCTs rather than raising new VCTs. We have now got seven of them of varying sizes between £20-50m. If we can build them all up so they are all about £50m, that will give us a lot of scope for the next few years."

And although private equity bosses are usually dealing with larger sums, the same attitude to distressed assets is consistent across the industry. It remains to be seen whether its clients prove the exceptions to the trend.