The current tax year looks to be another strong one for venture capital trusts (VCTs) after a bumper 2018/19 that saw the tax-efficient vehicles raise a record £731m for small UK businesses.
As it stands, there are 17 products seeking approximately £500m from investors to invest in.
Whether or not this figure will be raised in full or even exceeded, such ambition is a strong indicator for both the VCT sector and the UK as a whole.
It not only means that the products are being used for their intended purpose – supporting the next wave of British start-ups – but it also shows strong confidence the UK economy in spite of Brexit fears.
However, with regulators tightening the rules governing VCTs considerably in recent years, these lofty cash targets also raise concerns.
With fewer firms qualifying for VCT investment and products facing stricter limits on the cash they can hold, a record amount of client money is now chasing a shrinking pool of potential deals, particularly if VCTs are competing in similar sectors.
With regulators tightening the rules governing VCTs considerably in recent years, these lofty cash targets also raise concerns.Fundamentally, we believe that it has never been more critical for VCT managers to ensure they have a clear pipeline of excellent investment ideas before they raise money so they are ready to deploy that cash sooner and investors can begin to benefit from the off.
Shifting landscape
Changes to the rules governing VCTs have arrived in two waves over the past five years.
Firstly, in 2015, the government limited the maximum amount a VCT-qualifying company can receive over its lifetime to £12m or £20m for knowledge-intensive start-ups.
It also limited investment to businesses that have made their first commercial sale in the past seven years (or ten years for ‘knowledge-intensive’ firms) and banned investments into management buyouts and acquisitions.
Following this, several critical changes to the rules governing VCT cash allocation were unveiled in the 2017 Finance Bill.
Notably, from the current tax year, 80 per cent - rather than 70 per cent - of VCT funds have to be invested in qualifying companies, and 30 per cent of funds must be allocated within the first accounting period following fundraising.
The raft of changes was designed to achieve several clear aims.
First, they ensure that VCTs provide genuine risk capital to British-based growth businesses.
Second, they lead managers to give money to an adequate spread of start-ups (granting investors additional diversification benefits along the way).
Finally, they prevent VCTs from holding too much uninvested cash, where it incurs punitive management fees and cannot be used to advance Britain’s entrepreneurial spirit.
These are all admirable aims that steer VCTs back to their original purpose and force the industry as a whole to check itself.
However, a potential consequence of legislating the speedier investment of larger sums of cash into a more limited pool of investments is that an increasing amount of competition will arise for each deal.
In this increasingly competitive environment, the key to achieving this is to maintain a pipeline of investment ideas.This becomes especially evident where the total amount of money being sought out by the VCT industry remains high – as appears to be the case.
The clear risk here is that managers sitting on a large pool of uninvested cash post-raise, are forced to find qualifying investments simply to meet their regulatory obligations.
This could not only see them compromise their investment goals – something that would have been a major factor in many clients’ decision to invest – but may also impact future performance.
A prudent approach to raising money
So, how can this be avoided? For us, the answer is clear.
Although it will always be necessary to keep some cash on hand in a VCT portfolio, managers should not raise funds from clients unless they have a clear plan for its allocation.
In this increasingly competitive environment, the key to achieving this is to maintain a pipeline of investment ideas in an area of the market where management has particular experience.
By ‘sticking to their onions’, as it were, managers will not have to compromise on quality because their experience, knowledge and skill will ensure they know their area of the market better than anyone else.
The very best, hidden investment gems will naturally present themselves, and they can be the first to pounce.
In our case, we are a team of entrepreneurs with a long track record of successes in consumer-facing sectors.
As such, we have a bias towards early-stage companies in the wellness, apparel and accessories, hospitality, and media and technology sectors that can provide our investors with a combination of growth and income.
Our existing knowledge means we are ideally placed to find hidden gems in these areas boasting strong foundations like a disruptive model, management driven, sustainable cash generation, and strong brand identity.
Not only that, our cumulative experience means that we can support these businesses after investment as they scale up and reach the radar of large institutional investors – often injecting additional capital along the way.
Give and take
The numerous VCT rule changes introduced in recent years have been essential in ensuring that much-needed capital reaches the UK start-ups that need it most.
However, to work in the best way possible, the changes must be accompanied by an ongoing, sector-wide shift towards raising money based on an existing pipeline of opportunities.
If not, then investor’s cash is presumably simply idling, which neither supports the start-ups that can out it to good use, nor the investors who want their investment to grow.
Equally, this not only prevents VCT managers from compromising on quality as they fight to ensure regulatory compliance but also supports British entrepreneurial spirit in the most effective way possible.
Andrew Wolfson is chief executive of Pembroke Investment Managers
