The VCT generation

In the last month, Matrix Private Equity Partners made 4x money on one company while backing yet another. In the last week, NVM Private Equity generated more than 3x on the sale of a software company, while Foresight Group completed its sixth venture deal of 2009. This is hardly a round-up of an asset in distress.

Nevertheless, VCTs are facing increasing difficulties, just as the rest of the market. This has led to a survival of the fittest - with the top managers coming up with new and clever ways to ensure they remain successful. An example of this is the enterprise value (EV) limit on the companies in which VCTs are investing. In 2006, this limit decreased from £15m to £7m. In theory, this should have halved the pool of backable companies for VCTs, which would have made fundraising difficult.

"In the long term, such regulations could be counter-productive, as they are pushing VCTs to invest solely in small, high-risk companies. It is important to have a balance in your portfolio, otherwise VCTs will have a hard time raising money from the public," says Alastair Conn, financial director of NVM.

To skirt round the issue, many existing VCTs will raise additional money through new share issues to create a "hybrid" VCT, a combination of capital raised under both the new and old regulations, rather than launching a brand new VCT. "It would be difficult to invest only under the new rules and I'm not sure investors would buy into the attraction of an entirely high-risk small company portfolio where there may be little or no dividend yield for an extended period," insists Conn. Just last month, for example, Albion Ventures (formerly Close Ventures) launched a new share issue to raise £25m for its Albion Development VCT. The offer would create a separate class of shares, D shares, which would eventually merge with the existing ordinary shares, creating a vehicle that would invest under both the new and old rules.

Mark Wignall, chief executive of Matrix, says there are both trade and private equity buyers who are looking for companies that have demonstrated resilience in the downturn through their earnings. He should know - just last month, Matrix completed two deals in a matter of days, proving that the industry is not as quiet as one might expect. The team recouped 4x money on the £10m sale of Tottel Publishing and teamed up with Aberdeen spinout Maven to back the £4m MBO of Westway Cooling.

More recently, NVM reaped 3.3x money on the £10m sale of software provider Liquidlogic to IT specialist System C. Separately, Foresight invested £4m into tyre recycling company Crumb Rubber, in what was a first round of institutional funding for the business - the VCT manager's sixth new deal of this year.

"The risk in VCTs has been overdone. There is a perceived truism that large is good and small is risky. But the reality is that many generalist VCTs didn't get distracted by the boom. They haven't overspent capital or horribly overpaid or overgeared their investments. Surprisingly, there are actually very good pockets of health in the smaller space now," says Wignall.

That said, VCTs only managed to raise £150m last year. Is this now set to change?

Unexpected tax relief

With the new budget proposals announced in April of this year, most VCT managers are predicting the industry will pick up again. This is primarily because of the restrictions placed on pension tax relief for those with an income of £150,000 and over.

"VCTs have become more appealing now. The tax relief of 30% is much better proportionately, simply because the alternative tax breaks are now much worse. With VCTs, there is no tax on capital gains and on dividends. As a result, I believe the demand for VCTs will grow and the industry will raise £250m this year," asserts Patrick Reeve, managing partner of Albion Ventures.

Wignall agrees with Reeve's prediction and believes that the upfront 30% tax break is a "very powerful" benefit. He explains that investors receive a performance at least 30% up from the net cost to invest in a VCT, even if the fund did not make money, simply because of the relief. This is essentially cushioning the risk for investors.

The question is whether this is enough to sustain interest in the VCT industry. Some would argue that the 30% tax relief is simply not sufficient: "The tax relief on VCTs should go back up to 40% because at 30%, not enough money will go into the industry to make up for running costs associated with buybacks and dividends. If the government was serious about helping the small company sector, it would address this issue," says Bernard Fairman, managing partner of Foresight.

At least twice the £150m raised last year went out of the industry in dividends, share buy-backs and fund running costs, Fairman explains. "For this reason, the VCT industry in general is gradually falling in size and I believe that the budget proposals will only marginally increase the amount raised by VCTs this year, but it is too early to tell as fundraising typically begins in the autumn."

The decline in the venture sector is not due to a shortage of ideas: the UK government just launched a £1bn specialist technology fund-of-funds aimed at boosting the venture capital sector, to which it committed £150m. The rest is to be supplied by private investors.

Fairman comments: "The new government fund-of-funds is a good idea if it ever happens, but I'm not holding my breath. The initiative has nine months before the general election and the government has lots of others priorities."

VCTs not created equal

Despite their relative success, Foresight, Albion, Matrix and NVM are not representative of the VCT industry as a whole.

AIM-listed VCTs, those that invest in publicly listed companies, are quite another story from generalist venture capital trusts: "AIM VCTs have deployed all their capital into the market, where there has been a significant reduction in asset values. Over the last two years, assets under management of AIM VCTs have halved. As a result, AIM VCTs don't have the track record to raise capital anymore," says Wignall.

Fairman agrees and believes that AIM funds are not the right vehicles for VCT money: "It is really a dead part of the industry." Therefore, there is reason to believe that consolidation in the venture capital sector is underway. Fairman notes that the top five players in the VCT industry make up approximately 40% of the market, and that Foresight itself has acquired five venture capital trusts from other managers in the last five years.

"The stronger get stronger and the weaker get weaker in this industry," says Wignall. The top venture players attribute most of their success in the sector to their combined debt and equity model, which leaves them able to invest in companies with very little third-party gearing. Consequently, these VCTs are filling a gap in the market made from the lack of available bank debt. Fairman says that as a result of this, approximately £3-4m more was invested into Foresight's portfolio companies this year than would have been the case had the banking environment been more stable.

Whether it is a downturn in the markets, government restrictions or AIM VCTs, the venture industry seems to have adapted to survive it all. New budget proposals and government initiatives could make the industry due for further innovation, making it an area to watch in the coming year.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Fundraising
• UK / Ireland
• Technology