Another bumper year for VCT fundraising despite rule changes

In November 2015, the UK government made changes to Venture Capital Trust (VCT) and Enterprise Investment Scheme (EIS) structures in order to comply with European state aid rules. The new regulations mean VCT and EIS funds can no longer take ownership stakes, are limited to investing a maximum of £12m per asset – £20m where the business is judged to be "knowledge-intensive" – and can only invest in companies under a certain age.

Government changes to VCTs are nothing new, as Octopus Investments' VCT business line manager Stuart Lewis points out. "Over the last 20 years we've seen successive governments support the VCT schemes in principle, but also change the legislation surrounding them to ensure they continue redirecting money where policy wants it to go," he says. "The industry as a whole has a great track record of adapting to those changes and innovating."

Nevertheless, with the number of assets eligible for VCT funding instantly reduced, the Association of Investment Companies (AIC) revealed the VCT sector had raised £457.5m in the most recent tax year – a figure surpassed only by the £505m raised in 2004/2005 and £779m in 2005/2006. This increase is widely attributed to recent changes in UK pension laws. With a reduction in the allowance people are able to pay into their pension pots on a tax-free basis, savers are increasingly investing in VCT and EIS funds, where investment risk is mitigated by tax breaks.

Some of the wilder schemes and options open to people – film financing and similar schemes – are seen as being firmly closed now" – Russell Healey, Foresight Group

Yet Russell Healey, partner at VCT and EIS fund manager Foresight Group, believes changes to pension allowances are not solely responsible for the increase in funds raised. "Some of the wilder schemes and options open to people – film financing and similar schemes – are seen as being firmly closed now," he says. "But just as important is the performance track record of the sector. Our fund has averaged a dividend of just over 7 pence per year over the last five years. At a time when cash ISAs and savings accounts are paying next to nothing, that sort of [tax-free] yield is extremely attractive to investors."

Furthermore, there has also been a growing understanding among the general population of the potential benefits associated with small-business investing, argues Octopus's Lewis. "Barely a week goes by without a study showing the outperformance of smaller companies compared to larger more mature counterparts," he says. "That naturally leads investors to VCTs, where they also have the additional benefits and downside protection of tax reliefs."

Supply and demand
The immediate concern following an increase in capital alongside a reduction in the number of eligible assets might be fears this could lead to an increase in valuations. However, Foresight's Healey is confident that multiples for smaller businesses will not be overly affected by this. "There's a massive equity gap for SMEs in the UK," he says. "The number of opportunities we see is driven more by the amount of work we undertake in sourcing than by the pool of companies available to us, which is in the hundreds of thousands. New companies are coming into play every year and moving into the right stage of development for VCT funding."

The maturity of VCT schemes – which were introduced by the British government in 1995 – and their fund structures should mitigate against a scenario where trigger-happy fund managers are tempted by dry powder. As Octopus's Lewis points out, independent boards provide checks and balances to prevent any potential urge to "invest at crazy valuations". They also ensure funds are not raising more than they can comfortably deploy to begin with.

Yet, as we move up the SME scale towards medium-sized companies, there is naturally a reduction in the number of companies falling within the required age bracket – those whose initial sale was made less than seven years ago, or 10 years for those considered "knowledge-intensive".

For funds accustomed to taking minority stakes in very-early-stage companies it is plausible the new regulations will have little or no impact. However, those accustomed to making investments in more mature assets will almost certainly find deal sourcing increasingly competitive. Higher valuations in their customary investment realm, coupled with a maximum total investment of £12m per asset, may require them to turn their attentions to the lower end of the market. That may ultimately be the outcome the UK government is targeting.

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