The future for venture capital trusts

Venture capital trusts are crucial for helping to fund management buy-outs or growth through acquisitions. But will government tinkering prove a set back for future funds? Andrew Chilvers reports

It was a typical tale of entrepreneurial business nous that paid off.

Last summer, the owner-manager of Black Country logistics supply firm Product Support Ltd (PSL) was looking to exit the business and decided the best route was an institutional buy-out. Unfortunately, while contracts were being discussed, the deal fell apart.

It was at this point that the PSL team decided to push for a management buy-out. They told the vendor they could raise funds for the deal and then asked accountancy advisers BDO Stoy Hayward to find potential backers. Eventually, the new managers agreed to work with NVM, which put up £7 million in equity, while RBS added £9 million of debt.

For chief executive Andrew Sheppard, using a venture capital trust [VCT] such as NVM was the perfect split between the equity and debt balance needed for signing the deal. He was also impressed with how much the investment managers of NVM already understood about his business and their long-term commitment post deal.

“What they saw was a strong management team, long-term contracts in a strong sector that was going through growth and change, highly profitable and going to deliver it for some time,” Sheppard says. “They bought into the business plan we put forward and post transaction we’ve hit every target.

“Of course, they want to exit at some point to realise their value. They’ve been honest about that and the normal term is three to five years, but they don’t have any pre-defined plan.”

Sheppard’s MBO is typical of the deals signed off by VCTs every month; the funds operating around the UK generally back smaller, fast growing unquoted businesses. This also includes AIM and PLUS-quoted companies, which for tax purposes are officially unquoted.

Looking for investments

As a rule VCTs will be looking for businesses that have gone beyond the initial start-up phase with an established market position run by a competent management team. Buy-outs comprise a large percentage of these types of deals. NVM is typical of a VCT active throughout the UK provinces, from the Northeast where it’s traditionally headquartered down to the Thames Valley and Southwest England and Wales. The company manages five investment funds, four of which are VCTs, with funds under management worth about £180 million.

Alastair Conn, NVM’s managing director, maintains that the generalist approach to investing is the best way to spread investments. This then hedges against any downturns in particular sectors.

“We tend to invest in anything,” Conn says. “The rationale is that if you tend to invest in too narrow a specialisation you will run into trouble when that sector is on the down phase. The idea is to get a good spread of industry sectors in the portfolio that we can balance out.”

He’s also wary about rushing into too many deals and prefers to do about eight-10 deals a year, investing some £30 million-£40 million.

“It’s a tailored approach to each deal,” he adds. “We have a team of 13-14 investment executives and we expect them to complete eight-10 deals a year.

“It’s not a pile-it-high and sell-it-cheap process. Each investment we make involves a lot of preparatory work and then a period of intense investigation and negotiation before we sign on the line.”

Above all, he believes the key to any investment is the management team. Indeed, this is the common criteria set for all fund managers across the industry.

“The quality of the management is the first and foremost factor that we look at in the due diligence process,” Conn says. “History records that if you invest in a good idea but have a mediocre management team running the business chances are you will come unstuck.”

One of NVM’s most recent deals was a £7 million investment in the £14 million MBO of building services consultants Foreman Roberts. HSBC was the debt provider for the buy-out investing £6.5 million, while the management added the final £500,000 between them.

Managing director Stuart Alexander led the buy-out and chose NVM after a series of presentations to different funders. “There’s a balance between being hands on and hands off and I think they [NVM] have a good balance between the two,” Alexander says. “They weren’t going to come in and change all the systems on reporting. They work with you to develop the business.”

For NVM, Foreman Roberts has the ideal young, ambitious and highly acquisitive management team dedicated to the sustainability market, which is a popular environmental angle. Moreover, the company already has high profile clients, including Bankside, Wembley and Heathrow Airport. For Conn, the deal ticks all the relevant boxes.

Meanwhile, Close Brothers VCT has seven funds and £250 million under management and has an enviable investment record. Like its competitors, the funds invest £1 million-£10 million in a range of growing companies, from technology-oriented companies to service and asset-based businesses. The company’s recent Close Enterprise VCT fund closed earlier this year having raised the targeted £20 million.

To ensure that shareholders make a decent return, Close tends to divide its portfolio between low and high risk investments. The degree of risk will also dictate the amount that the company is prepared to invest. So low risk investments will be up to £10 million, while high risk will be around £1 million-£2 million.

Managing director Patrick Reeve admits most of the lower risk investments tend to be property backed and a typical deal would be the Ramada Hotel in the Birmingham Mailbox, which was sold in March. Close originally invested £4.6 million in equity and loan stock in Ramada between 1999-2003 and through the sale realised a profit on investment of £3 million, in addition to receiving an annual return of 14% of its loan stock. The overall IRR for Close on the deal was 19%.

“The property-based investments are often start-ups; the Ramada was a start-up seven years ago,” Reeve says. “What we do is tend to divide the portfolio into two. Half the deals are lower risk and often property backed. An example of that is the West Kensington health club. We’ve bought up a 999-year lease on a building that’s part of the Olympia and which is being turned into health and fitness club.

“We provide the debt and equity for that. So that puts into our funds a decent amount of capital security because it’s a decent freehold. It’s a nice level of predictable income because we fund it mainly through loan notes.”

Having that lower risk chunk of investment means Close can then take higher risks with others. So 30% of the company’s investments by value are technology, while the rest are in varying degrees of lower risk, including at least a third that have freehold property behind them.

Like Conn at NVM, Reeve highlights two key areas that determine an investment. The first is a strong market opportunity, “something like a jet engine, where no one else can do this. Or in the case of Olympia, it’s in a fantastic location. So it’s a great market opportunity.”

The second is an excellent management team. “You need both,” Reeve says. “You can’t have one or the other. And if you have both it makes any investment decision much easier. Normally, when you sit there scratching your head it’s because one of two elements is not there. In which case, move on.”

Above all, what a company needs is a strong chief executive, which can be difficult to find. “We don’t have endless numbers of those that we can draw on,” Reeve continues. “If there’s a strong chief executive in there, then if it’s a young company it’s quite possible there won’t be anyone that is particularly good around him. At which point we help to find a chairman and a finance director.”

Nevertheless, placing a new team among an existing one can be risky. VCT managers prefer continuity and tend to avoid full management buy-ins unless the company has a clear strategic path that can almost guarantee success. NVM’s Conn will do some form of MBI, but more on the model of that carried out by Reeve. So, one key element of the team will already be in place, with the rest of the team strategically parachuted in.

“MBIs as a class perform less well than MBOs,” Conn admits. “I can’t remember the last time we did a pure MBI with a completely new management team coming in. We have done some MBOs with an element of MBIs, where you have a continuing management team, but you have people coming in to beef up the mix.

“With an MBI you can be heading into the unknown. You’ve got a management team with a track record in another place. You’ve got a business whose track record is known, but under a different management team and you don’t always get an ideal mix when you put the two together.”

But regardless of the type of deal – and Reeve even admits to doing turnarounds from time to time – investment executives of VCTs believe they are doing essential work to promote business and stimulate UK enterprise. For Reeve it’s money properly invested by professionals who keep an eye on the management structure and the bottom line of the business. VCTs also have the numbers behind them and this continues to rise. Since 1995, £3.5 billion has been raised among them and Reeve claims £2.7 billion is currently looking for a home.

“The key thing about VCTs is that it’s professional money,” Reeve says. “It’s not going to go away in a recession. Business angels have not got the professional disciplines. They don’t have the lack of emotion that you need to assess businesses carefully. They’re idiosyncratic, some are fantastic, some are hopeless.

“Also there’s a strong argument to say they will become more risk averse in a slowdown. That’s when you actually need to invest. We’re neutral and we all have pots that need to be invested and we are professionals. That has a lot of value.”

Likewise, Conn argues that VCTs fill a funding gap that has been left behind as many private equity houses and VCs have moved into larger deal territory. This funding is crucial for helping to finance smaller, fast growing companies already established but unable to fund strategic plans such as MBOs or acquisitions. Conn uses 3i’s move away from small, regional funds as an example of how times have changed and how VCTs are now a necessary part of the funding mix for small companies.

“When I started in the mid-1980s, 3i had offices in about 15 cities,” he says. “If you wanted to raise £100k to buy a new machine you went to 3i. That has changed dramatically.

“The VCT sector is something that has happened through sensible government intervention in introducing them. Between the sub £1 million deals, which tend to be financed by regional VC funds and which have an element of public sector funding, the next layer up is VCTs.

“The important thing is there is a growth story and there’s a company we can back. That will create growth in sales, generates sales in exports etc, which is good news for the UK economy, good news for the shareholders of the companies and for VCT shareholders.”

Reeve concurs: “VCTs have effectively filled the gap left by 3i when it moved out of this end of the market. There are about 100 professionals or more investing in the VCT market who simply weren’t there before.”

Conn is also critical of what he believes is the one-sided public debate about venture capitalists and private equity houses carried out in the media by politicians.

“I’m not critical of the big firms,” he says. “Where they sit and where we sit is a big gulf. But the criticism of the big firms by politicians and the press has been misdirected. It’s easy to pick on selective aspects of how they go about doing their operations. But you don’t see the other side of the coin, where you see business growth and employment are often underplayed.”

Nevertheless, VCTs have been subject to tinkering by government and during the recent budget new legislation was introduced affecting the investment criteria. For example, new money from forthcoming funds raised can only back companies with fewer than 50 employees. With Close and NVM, the legislation will not affect current funds, but could have an impact on the future funds.

“The legislation will only affect us with the regards to future fund raisings. It will make the market tighter,” Reeve says. “I’m still confident we can continue to fund raise because we have a good record and because at least half of our investments fall within the rules.

“They key rule that is the limiting factor is that you can’t have more than 50 full time employees. About half of our investee companies at the moment would classify that rule.”

Meanwhile, Conn warns that government interference will inevitably affect VCT investments and the returns for shareholders, admitting it will have “an impact on new funding raising going forward”.

“In the past we had a period of a couple of years when the government gave a big boost to VCT fund raising by improving the tax reliefs for a set two-year period. That had a marked impact in terms of the amount of money coming into the industry.

“Last year, with slightly less attractive tax reliefs we did see a downturn and everyone is waiting to see how many funds will be launched in the 2007-08 tax year and how well they will do.

“The bottom line for us is that if we don’t show a reasonable return for our shareholders – and you have to take the VCT tax reliefs into account – then our shareholders will not want to come again.”

Ultimately, this will mean a tighter investment portfolio and a lower risk threshold, which in turn will mean that VCT managers such as Reeve and Conn will plump for the risk averse asset-based projects at the expense of higher risk businesses.

All that spells bad news for buy-out entrepreneurs such as Andrew Sheppard who are risk takers by nature, but rely on the crucial support of funders such as VCTs.

Marc Barber

Marc Barber

Marc was editor of GrowthBusiness from 2006 to 2010. He specialised in writing about entrepreneurs, private equity and venture capital, mid-market M&A, small caps and high-growth businesses.

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