What effect Brexit is likely to have on VCTs

The report from the IESE Business School at the University of Navarra, suggested the UK's attraction as a place for international venture capital and private equity investment would fall from its current 2nd place to 6th place.

The data, based on the Venture Capital and Private Equity Country Attractiveness Index, which analyses 125 countries according to metrics such as economic activity, depth of capital markets and corporate governance, suggests the UK has always scored "very high" based on such metrics.

Over the past nine years, the Index has put the US at the top, followed by the UK and then Canada in third place. But this all could change based on the IESE's Brexit scenario for the various metrics that make up the Index.

The table highlighting the UK's possible drop is pictured below.

According to Professor Heinrich Liechtenstein of IESE Finance: "A loss of several positions [for the UK] is almost inevitable.

"Additional regulatory burdens, as well as a slowing economy and an inevitable brain drain will make the UK less attractive to venture capital and private equity investors."

But while some organisations are predicting a down-draft on international fund flows into venture capital and private equity in the UK post-Brexit, will this also mean a lack of possible funding for start-ups and therefore a lack of investment opportunities for venture capital trusts (VCTs)?

Does what happens on a macro level necessarily percolate through to the British entrepreneurs being targeted by VCTs and enterprise investment schemes (EIS)?

There are two potential ways in which Brexit could have an effect on VCT investment, according to Alex Davies, chief executive of Wealth Club. One is whether Brexit means the rules dictating where VCTs can invest are relaxed, and whether Brexit will affect VCT investment.

Rules on where VCTs can invest

The Patient Capital Review was crystal clear about where VCT managers could put their inflows to work to best boost British business.

Under the Review, the 30 per cent income tax breaks within VCTs are provided in order to give investors a reason for putting their money to work in higher-risk, start-up businesses in Britain.

Areas of specific interest include technology developments, the gaming industry, biotechnology and financial technology, as outlined in the November 2017 Budget statement by chancellor Phillip Hammond. 

It is possible the government may choose to provide greater support to earlier-stage companies that typically find it difficult to secure the capital required to scale up their operations. Chris Hutchinson

For Mr Davies, therefore, the fact the UK is heading into a Brexit world is unlikely to mean a significant shift in this emphasis. 

He explains: "We've seen an alignment of legislation between what was emphasised in the Autumn Budget [2017] where VCT investment needs would have to be channelled into young, knowledge-centric, risk-taking companies, and the previous compliance with EU State Aid rules."

The EU State Aid Rules basically gave approval to the changes made in 2015, which included age limits on companies that qualify for VCT money, and the ban on VCTs being able to buy a business (effectively through a management buy-out) and instead put money to work with more knowledge-intensive companies.

Currently, as Stuart Veale, managing partner of Beringea, explains, UK legislation on the types of investments that VCTs can make has to conform to EU directives.

He says: "This may change at some point following Brexit, allowing the UK government to change the rules and address some of the serious anomalies in the existing legislation, particularly those relating to the age limits on the companies which can receive VCT investment."

George Bull, senior tax partner for RSM UK, also thinks Brexit "could provide an opportunity for the government to renegotiate some of the EU State Aid rule changes".

Chris Hutchinson, manager of the Unicorn AIM VCT, makes the point that the private sector of the UK economy is mostly made up of small companies, with approximately 16.1m people working in small to medium-sized businesses, and any softening of rules might end up helping, not hindering, their growth.

"Clearly", he says, "the continued support of small businesses is crucial to the UK's economic future post-Brexit.

"It will be interesting to see whether Brexit has any impact on the VCT sector. Much will depend on a successful conclusion to negotiations surrounding an EU-UK trade deal.

"If these go well, it is possible the government may choose to provide greater support to earlier-stage companies that typically find it difficult to secure the capital required to scale up their operations."

While he acknowledges this could be "a long way off", this might be good for small companies and for the VCT sector, he believes.

Mood music

While Jason Hollands, managing director of business development and communications for Tilney, concedes a shift away from the EU State Aid rules could happen, leading to more flexibility for VCTs to invest in small companies, it is not a scenario he believes will play out any time soon.

According to Mr Hollands: "It is possible that, over time, there could be opportunities for greater divergence with EU State Aid rules, but we do not think that will happen in the foreseeable future." 

And Annabel Brodie-Smith, director of communications for the Association of Investment Companies, says it's "too soon to tell what the implications of Brexit will be".

She adds: "It's reassuring to know that, at nearly 22 years old, the VCT industry has the benefit of highly experienced managers who continue to deliver good returns for shareholders."

There is considerable evidence that decent British-backed VCT companies can prosper whatever the state of the economy. Alex Davies

With the UK government pledging funding for fledglings, the mood music has already been set by the government in terms of areas it plans to bolster over the next five to seven years, regardless of what happens with Brexit or whether overseas venture capital or private equity money does not flow into these sectors of the UK economy.

That said, Mr Davies does acknowledge that, if there is a significant downturn in the economy - a point made by the IESE - then "it is not inconceivable that the government would relax the rules in order to give the economy a boost".

The effect on VCT investments

For Mr Davies, Brexit is unlikely to have a "significant" impact on people's VCT investments, partly because of the nature of the businesses that occupy space in VCT fund portfolios.

Mr Davies comments: "If the UK economy takes a hit, you need to remember that a significant proportion of VCT investee company income comes from exports."

This makes it safer in terms of any sterling-based downturn, although if Brexit makes it harder for the UK to export, this could be a potential issue.

However, he continues: "In addition there is considerable evidence that decent British-backed VCT companies can prosper whatever the state of the economy.

"Look at Zoopla, which was backed by Octopus Titan VCT. It launched in 2007, just before a property crash and the worst recession in many years.

"It went onto become a household name and the first £1bn company to come out of a VCT."

Mr Bull thinks Brexit uncertainty might have an "adverse effect" on the UK small and medium-sized sector, if the UK's economic slowdown continues and Brexit ends up restricting access to EU markets.

However, he adds: "In 2016 to 2017, VCT managers saw little change to demand for financing from UK SMEs due to Brexit."

The AIC's recent VCT investment review, Transforming Small Business, gives figures showing just how much of a contribution to the UK economy VCT investors have made. 

According to the review, 57 per cent of smaller companies supported by VCTs received total investment between £2m and £10m. Ms Brodie-Smith says: "This is a level of funding typically out of reach of the business' own resources but too small for conventional private equity funds.

"Businesses currently benefiting from VCT investment now employ 50,000 staff and have created 27,000 jobs across the UK since VCTs invested." 

Talent and resourcing

There could be an issue in terms of getting the best brainpower - again, a point raised in the attractiveness index cited at the beginning of this article.

Mr Davies acknowledges: "One negative effect could be that Brexit makes it harder for fast-growing VCT companies to attract talent from abroad."

Paul Latham, managing director at Octopus Investments, states: "It's really important that early stage companies have access to the talent and financing they need in order to grow.

"We know VCTs have played a meaningful role in helping the UK entrepreneurial market to thrive. We do not yet know what impact Brexit will have on VCT legislation, but successive governments have continually demonstrated their support for VCTs."

How much of a problem getting the right talent and resourcing for UK SMEs might be is difficult to quantify, although there is evidence to suggest this is starting to happen. 

Last year, sister paper the FT ran a story citing Office for National Statistics data that showed migrant workers from Europe were starting to diminish in the UK.

Also in 2017, Currency Fair produced a blog on the way in which Brexit could affect start-ups, and it cited research from the Centre for Entrepreneurs to suggest a lot of entrepreneurs are European citizens, not British ones.

The centre's 40-page report, Migrant Entrepreneurs: Building our Businesses, Creating our Jobs, revealed:

• One in seven UK companies is founded or co-founded by a migrant entrepreneur.
• There are currently 456,073 migrant entrepreneurs representing 155 nationalities.
• They are responsible for 1.16m jobs within the UK.

The Currency Fair blog suggested: "If such future entrepreneurs look elsewhere, thousands of future jobs will be lost."

But investment professionals are used to dealing with change. Mr Latham says: "We are used to adapting to any changes within the legislation, and will continue to do so as and when required."

As Mr Hollands comments: "We don't think Brexit will have an effect in the medium-term. VCTs invest in small, UK trading companies and their shareholder bases entirely consist of UK taxpayers."

simoney.kyriakou@ft.com