Venture Capital Trusts (VCTs) may not sound like interesting entities, but don’t be fooled by the moniker. Indeed, if you need expansion capital, VCTs should be making you very excited because they have a lot of cash to invest.
The funds – which are in essence investment trusts – were conceived ten years ago by the then-Chancellor Kenneth Clarke. Investors were given generous tax breaks to invest their money. In return, the Government stipulated that 70 per cent of the money raised by such trusts had to be invested in new shares of smaller UK businesses within three years of the cash being raised.
Last year the tax rules were relaxed further to make these vehicles even more attractive. This prompted a further flood of money to be committed – just over £500 million in all – which added to the £300 million already held by existing VCTs. All of this is now seeking a suitable home and much of it will go to fast-growing small businesses with annual sales below £10 million.
AIM is the target
If you’re thinking of floating your business on London’s ‘junior market’, it’s worth noting that £235 million, or almost a third of the spare VCT money, is destined for AIM new issues. The AIM funds are spread amongst 32 trusts. Artemis AIM 2 leads this group by some distance, with £38 million awaiting investment. Invesco Perpetual AIM is in second place with £25 million spare. Three others with more than £20 million are Framlington AIM, Unicorn AIM 2 and Pennine AIM 5, run by Rathbones.
Close Brothers, which is sixth in the table, raised £18 million in a ‘D’ share issue of the Close Brothers AIM trust. Interestingly though, Close fund manager Justin Jordan admits his company could have raised much more, saying, ‘We deliberately set out not to raise more money than we could manage last year. Having limited sums means we are sensible when it comes to investing.’
Close’s method, according to Jordan, is ‘to assess each new issue and work out which will work and which will be also-rans.’ He adds that this process ‘is not just a case of looking at valuations but is also partly an artistic rather than scientific skill.’ Because of a commitment to meet the management of every company seeking AIM money, he says, ‘It takes time but it’s worth it.’
New issue frenzy
Of course, VCTs aren’t the only backers of new companies on Europe’s biggest growth market. Since the start of 2004 no less than 571 companies have joined AIM, raising £4.3 billion between them. Jordan estimates that ‘VCT-qualifying issues probably only account for 20 per cent of the fundraisings by value, although slightly more by number since they tend to be smaller issues.’
Nevertheless, ‘Deal flow has been amazingly busy,’ he adds, and the types of business joining remain as diverse as ever. Two-thirds of the 1,200 companies listed on AIM at the end of May were worth less than £25 million. And only a third of the companies joining during the past month were worth more than that at flotation.
Valuation difficulties and differences
With this array of AIM new issues to choose from, brokers, in particular, have noticed that VCTs that were originally planning to back private businesses are now also choosing to invest in AIM companies as well.
Patrick Booth-Clibborn, head of institutional broking at boutique investment bank Noble & Co, comments, ‘Generalist VCT managers are definitely looking at AIM. There is a surfeit of deals at the moment with a host of companies queuing up to float. This means fund managers can sit back and choose those they prefer.’ For Booth-Clibborn, this scenario obviously has implications for entrepreneurs of aspiring AIM companies who have lofty ideas about how much their businesses are worth. He reckons many may have to reassess their opinions in light of the competition.
That said, not many VCT managers themselves will admit that valuations on AIM are temptingly low. ‘We believe AIM is definitely overvalued at the moment,’ says Nick Ross, manager of the two Electra Kingsway VCTs that have over £40 million between them to invest.
‘Our main concerns are the pricing of new issues on AIM, which has been high; the volume of flotations, which has been hectic; and also the fact that there has been little aftermarket. This means the smaller issues tend to drift off and hardly ever recover as there is little demand from retail investors. This is a big structural problem.’
The Electra trusts are part of a group of generalist trusts that back both AIM and unquoted companies raising fresh finance. Others include the Baronsmead range of four trusts managed by ISIS Private Equity Partners. Part of the large team at ISIS, which has £87 million of spare VCT money at present, is explicitly focused on assessing AIM new issues. One of the managers at Northern performs the same role for this group’s four trusts, which have £40 million to invest at the moment.
In addition, many of the AIM VCTs will also back private businesses on occasion.
Electra’s Ross, who has the ability to choose between these two paths, is certainly favouring the unquoted route at the moment. ‘Our last seven deals have all been in private businesses. You can achieve lower valuations as deal prices tend to be at a discount to public ones.’
Solid businesses in vogue
Although the structure of VCTs best lends itself to providing extra development capital for businesses seeking to expand, the trusts are now keen to finance a range of deals, including management buyouts and asset-backed ventures, with slower growth but more solid assets such as property behind them.
Indeed, a number of the trusts that raised money in the past tax year have this exact intention. Close Income & Growth VCT, which was the most heavily supported trust, raising £45 million, will put 45 per cent of the cash in pub operators with freehold properties. And Downing has launched two ‘protected’ trusts that together have £30 million to back similar businesses with freehold premises, such as children’s nurseries, garden centres, and health clubs as well as pubs.
Related: VCTs: the good, the bad and the ugly
Meanwhile, Mark Wignall of Matrix Private Equity Partners, which attracted £20 million from subscribers for its own Matrix Income & Growth VCT, plans to back management buyouts of cash-generative businesses exclusively. He will make maximum use of private equity techniques to gear up these investments using high-yield loan stock. Other VCT managers, such as Northern, also increasingly employ these methods.
‘VCTs are becoming more mature. People have tried various things and realised what works,’ comments Noble’s Charlie McMicking, who manages the Enterprise VCT, which has £6.4 million available. He agrees that VCTs ‘are certainly becoming more risk averse, doing asset-backed deals and using private equity techniques, such as loan stock, for smaller deals.’
Funds for new ventures
If you are running an early-stage enterprise in technology and other high-growth areas, there are still funds that support this arena. Notable players are Foresight Partners, with £33 million to spare, and Quester, which has £26 million available.
Foresight’s original VCT has produced the best returns of all trusts so far. The group raised £18.5 million for its second trust recently and partner Matt Taylor says Foresight has completed five deals since the end of the tax year. ‘Prospects for our sector have been improving over the last two years with IT spending definitely on the rise,’ he explains.
Quester has had a more chequered history and has recently merged its first three trusts in an attempt to rationalise and save costs. Seed Capital, which runs the four Oxford Technology trusts, will also consider start-ups. It has £9 million available.
However, it’s fair to say that the nature of the new investors in VCTs are that they are more risk averse and would prefer to retain the value of their assets rather than take greater risks for higher potential rewards. Simon Kiero-Watson of fledgling stock exchange 5353x has just launched a fund of Enterprise Investment Scheme companies and believes such EIS funds ‘are prepared to do more speculative deals that VCTs no longer do’.
Another trend is that some VCTs are specialising in very specific industries, such as wind farms (Ventus and Keydata Income) and music-related ventures (Ingenious).
However, while trying to complete larger, lower-risk deals, VCTs are also aiming to avoid syndicating their deals. The three largest VCT managers – Close Brothers, ISIS and Octopus – all have at least two generously funded trusts. This enables the VCT manager to put the £1 million maximum investment from each of his trusts into deals, as well as debt finance from a third-party provider.
Octopus closed its fundraising for its first Eclipse VCT at £30 million earlier than planned last year so it could launch a second Eclipse trust in order to spread its investment in a particular situation across both funds. Most serious newcomers to this sector – such as Stephen Edwards’ Core Growth Capital – are attempting to replicate this and launch two VCTs at the same time so they can conclude larger deals.
Despite £810 million being available for fresh investment in smaller growing businesses, the promised bonanza for such enterprises has yet to arise.
Noble’s Charlie McMicking maintains, ‘Everyone thought that valuations of private businesses would increase with the amount of VCT money coming in. But this has not been the case so far. The boot is still on the foot of the fund managers not the businesses. We are the pace-setters.’
Table 1: The rules and tax breaks
- VCTs are listed investment trusts that invest in a spread of unquoted and AIM trading companies
- They must invest 70 per cent of their money in qualifying companies within three years of launchBanking, insurance, those dealing in land or properties, leasing, legal and accountancy companies do not qualify for VCT investment
- Aggregate gross assets of an investee company must not exceed £15 million before investment or £16 million immediately after
- No single investment can make up more than 15 per cent of a VCT’s assets. A VCT can only put £1 million into a company in each tax year
- Each tax year, investors can claim up 40 per cent income tax relief on up to £200,000 invested in new VCT shares, provided they are held for three years
- Investors also get capital gains tax exemption on disposal of VCT shares and dividends are paid tax-free
Case Study – Find locates its financing
Roy Abrams has recently raised money from Electra Fleming’s two VCTs to help conduct the management buy-in of financial website Find Portal. Bank of Scotland provided the debt element. Abrams came across the deal in his previous role as chief executive of leading web consultancy LB Icon, which had earlier bought Aspect Group, a similar business that he set up.
LB Icon had done some web application work for Find Portal. ‘I liked the company a lot,’ recalls Abrams, who led the buy-in when the previous owner John Perceval decided to exit earlier this year. Perceval, who remains on the board as a non-executive director, founded the business at the dawn of the internet era in 1996 and, remarkably, it has been profitable ever since.
‘I knew Electra from a previous life and approached them for funding,’ says Abrams, when speaking about financing the buy-in. ‘However, to be honest, the fact it was done through the two VCTs was neither here nor there.
‘Yes, VCTs have raised a lot of money recently but I don’t know whether this means it is easier to obtain funding at the moment.’ Having said that, he admits the environment is right at the moment to conclude deals.
‘For amounts of up to £1 million, VCTs are ideal – there’s plenty of money around.’
Abrams has ambitious plans to grow Find Portal. His decision to seek Electra Fleming’s backing was in part ‘because the firm has the firepower to support further fundraisings in the future, when we expand’.