2014: the year of the VCT

VCT fundraising for the 2013-14 tax year has seen a significant increase of cash raised, estimated to be more than £300m, with 96 funds active in the market. According to Jason Hollands, managing director at Bestinvest: "It has been a very buoyant year for VCTs, especially given how seasonal this market is; it is driven by the tax year, meaning significant assets come in throughout March – fundraising is expected to reach peak levels for this tax year."

Indeed, in a continued low interest-rate environment, investors are piling into VCTs in search of yield and to benefit from the attractive tax shelters. While the FCA labels VCTs as "high risk", many investors are realising that returns based on the tax benefits alone make these schemes almost risk-free. Says Hollands: "HM Revenue & Customs is cracking down on more aggressive tax shelters, whereas VCTs are seen as key for government aims to boost SME growth, providing them with a level of protection and making them seem much safer from an investor's point of view."

On top of investor demand for these products, VCT managers are raising funds against the backdrop of banks still offering limited lending options to UK SMEs – arguing there is a wealth of opportunity in the market, with SMEs desperately in search of development capital.

While there is no doubt about the funding gap left by banks, there is already a large number of buyout and venture capital houses focused on lower mid-market deals. According to unquote" data, some of the most active players in this segment (with equity tickets of less than £10m) over the past four years have been the Business Growth Fund, having done 35 deals; Index Ventures and LDC with 21 deals each; and DFJ Esprit with 19 deals.

Despite the increasing confidence in the UK economy, reflected by a record year for VCT fundraising, the big question is whether this growing pool of capital will find enough opportunities for investment. Perhaps more importantly, with an increasing number of players chasing deals in the lower mid-market, will pricing become unsustainable in terms of delivering returns down the line?

Banking on behaviour
If VCTs' primary opportunity is to replace bank lending, how many SMEs are struggling to raise debt? According to a recent survey of VCT managers by the Association of Investment Companies (AIC), nearly half (44%) of managers reported that investee companies had experienced difficulty in raising bank debt in 2012. However, this year, 41% of managers said that bank lending has become easier for investee companies.

Furthermore, while risk-adverse credit committees have been blamed for the lack of lending to SMEs, it would appear the issue is slowly being dealt with. Towards the end of March, the Bank of Scotland announced that local managers would be given more control over lending decisions, with the bank putting £1bn aside this year purely for SME lending.

And, as confidence in the UK economy improves, surely traditional lenders will return to the market? "We don't know when banks will come back fully, but we don't expect them to do so for a few years," says Eliot Kaye, investment director at Puma Investments. "Also, there is so much space in the market that even if all the banks returned, the economy is at a stage of growth where it can soak up all available capital." Kaye believes that if and when the banks return, they will not behave in the same way as before the financial crisis because of significantly more onerous capital requirements, which will restrict over-enthusiastic lending. "We are already seeing a level of re-entry; Santander is providing some development finance and Barclays is dipping its toe. If banks come back seriously we will innovate, but, crucially, we will always be more flexible and quicker even if we are a bit more expensive than the banks," says Kaye.

Preferred debt
Whether or not banks are lending, SMEs will instinctively seek debt before equity in order to avoid dilution of ownership stakes and the strict discipline enforced by equity investors. According to BDRC Continental's most recent quarterly report on SME financing, 40% of SMEs were using external finance in Q4 2013. Of these companies, 31% used loans, overdrafts and/or credit cards, while another 33% used personal funds over the past 12 months.

And it is not just VCTs that have realised the investment opportunity left by the banks' funding gap. The most obvious contender to fill this void is the Business Growth Fund (BGF), set up in 2011 and backed by Barclays, HSBC, Lloyds, RBS and Standard Chartered. BGF sits on a £2.5bn war chest, aimed purely at supporting growing SMEs unable to access bank financing.

Furthermore, invoice discounting and asset-based lending have seen increased levels of activity, while the rising popularity and sophistication of new forms of financing, including peer-to-peer lending and crowdfunding, have the potential to disrupt SME financing in a significant way.

But Neil Worsely, managing partner at corporate finance house Convex Capital, believes the tide is turning and SMEs are far more accepting of equity investment: "A lot of clients have had a tough time with banks; they have found them to be unsupportive and that was detrimental to the business. This means that supportive funders are in demand, with more emphasis on relationships and what happens if something goes wrong."

However, Scottish Equity Partners managing partner Calum Paterson wonders how much VCTs have done to fill the funding gap: "We didn't see a rush of companies seeking equity investment after the banks pulled out of the market. There are still a very small percentage of businesses with equity backing. Owner/managers are still reluctant to take on equity."

In order to create more opportunities for equity transactions, a level of education is still needed. "When selling only part of their equity (rather than the whole business), owners tend to know less about their options," explains Worsley. "Often they need educating; generally their understanding is limited to just bank finance."

According to Alex Macpherson, who looks after Octopus Investment's Titan VCTs: "SMEs want to access more than finance; they want expertise. It's about bringing knowledge and skills and experience, and providing strategic advice. It's more than just money."

Close competition
Once the case for equity has been accepted by SMEs, with so many funds seeking high-quality assets, competition between equity providers could be expected to heat up. Says Worsely: "During the past 12 months, bank lending has returned and dealflow is improving, causing competition and, in turn, prices to increase."

According to Macpherson, as the Titan VCTs invest in a similar manner to pure venture capital players, Octopus often sees similar faces when looking at opportunities: "As Titan is the only VCT focusing on the early-stage market, we most commonly come up against Index Ventures and DFJ Esprit."

That said, Connection Capital partner Claire Madden points out how consolidation among VCT funds has reduced the level of competition: "The more established managers have taken over certain funds. This means there is less competition between the VCT funds as there are fewer of them. In terms of deals, they don't bump up against each other that often so I don't see an impact on terms. But we might see more deals being done as there is pressure to get money out the door."

And, as VCT fund sizes swell, the amount they can deploy per transaction will increase accordingly. This will cause a shift in VCT funds looking at deals typically done by smaller private equity houses. "The higher amount raised means we're deploying at a higher level," says Mark Wignall, managing partner at Mobeus Equity Partners (pictured, on right). "But competition is modest outside the three main houses; it's not like the mid-market where there may be 10 or more houses in the initial process. Essentially, there has been an upward shift in confidence throughout the UK economy, which has created opportunities for growth and transactions - people want to get on and do things."

Tim Levett, chairman of NVM Private Equity (pictured on left), which looks after the Northern VCTs, echoes Wignall's sentiment. "More money creates more deals; advisers are aware that there is more money chasing deals, so they are seeking transactions with confidence." Of the seven transactions NVM has completed over the past 12 months, several saw them compete with private equity houses and one was lost to a buyout shop. But, as NVM deploys cash by co-investing from its VCTs and its LP fund, it naturally seeks larger deals, where it is more common to come up against buyout houses.

Despite being named as a familiar Octopus/Titan competitor, DFJ Esprit does not feel threatened, says partner Richard Marsh: "From our perspective, VCTs are filling the gap for mini-mezzanine or mini-buyout investors, as they increasingly look to remove risk from their deals. They are replacing bank financing more than venture capital investment."

Where VCTs operate and in which funding gaps they fill, the general feeling among industry practitioners is positive: "The market always has been and always will be competitive for the best opportunities," says Andrew Garside, partner at Isis Equity Partners (pictured, middle), which invests on behalf of the Baronsmead VCTs.

Rules of evolution
Underneath a top layer of positivity, venture capital funds, private equity houses and VCTs must return cash to investors, meaning they are all under equal pressure to find the best assets. How this hunt for quality deals will impact pricing remains to be seen. But, as investors become more sophisticated, with many finding ways to provide senior loans as well as equity, it is likely that the most significant impact of the increased competition will be on terms. With limited-life VCTs (see box, page 5) able to provide senior style loans to businesses at rates in the high single digits, it could well be that pure equity players will need to reduce their rates, or expand their offering to include debt as well.

The Darwinian nature of the VCT industry also means that only high-quality, well-established funds will survive, as shareholders will reinvest based on performance. "The majority of VCT investing in traditional buyouts is carried out by a half-dozen houses," says Stuart Marcy of Menzies Corporate Finance. "They prefer regular private equity buyout and development capital structures. However, these players can also do deals where they provide the full financing package – supplying both equity and debt – and this has been prevalent during the downturn. Some funds are also able to operate on old investment scheme rules and some can still invest in property."

Essentially, if advisers and vendors know that financing is available - both debt and equity – then they have the confidence to seek a transaction. Regardless of bank lending levels and SME attitudes towards equity, the growing number and types of investors in this market segment can only be good for the wider economy as it encourages business owners to seek capital for growth.

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• Topics
• Buyout
• Expansion
• Buyouts
• UK / Ireland
• NVM Private Equity
• Mobeus Equity Partners
• ISIS Equity Partners
• BGF (Business Growth Fund)
• LDC
• Index Ventures
• DFJ Esprit
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