‘We’re too big for business angels but too small for corporate venture capital,’ says Kevin Lee, managing director of fast-growing financial services company Calastone. ‘VCTs are a perfect fit in between.’

This painful condition, as suffered by Calastone and countless other young companies, is the reason venture capital trusts were dreamed up back in the 1990s.

By providing tax relief to investors, these investment vehicles are intended to attract risk capital towards UK small and medium-size enterprises (SMEs) and bridge the ‘equity gap’ between banks, government grants and business angels on the one hand, and institutional venture capital on the other. There’s debate about exactly where this gap lies, but the government defines it as being between roughly £750,000 and £2 million in terms of the equity investment required.

This is exactly what Calastone, a two-year-old company serving the mutual funds industry, and many others like it, is looking for. ‘We looked at investment banks but because the amount we required was lower than their general minimum, VCTs were the obvious choice,’ says Lee.

Research from Business XL magazine finds that VCTs currently have more than £600 million available to be invested in suitable growth companies. To retain their privileged tax status, they must invest at least 70 per cent of their cash within three years of launching and, while they hunt for suitable targets, they keep much of their funds sitting in non-qualifying assets, such as other stock market funds and money market tools. And yet some £230 million is held in actual liquid cash in the bank, with the pot soon to be topped up with up to £131 million from funding rounds currently open to investors.

Now is the time

Calastone’s new backers are Octopus Ventures, whose various arms operate VCTs specialising in early-stage capital, mid-sized management buy-outs (MBOs) and mezzanine finance. According to our research its coffers contain £66 million yet to be invested.

Chief executive Alex Macpherson says his early-stage Titan funds will be investing ‘around £20 million’ in the next 12 months, while the mezzanine fund ‘has £25 million to invest’ in the same time in more established, profitable businesses.

‘I think the irony is that these times which are most difficult for businesses are the best for making investments,’ he remarks. ‘We’re in that fortuitous position where we can invest at the bottom of the market.’

Although this may imply firms are looking to drive some hard valuation bargains, many profess to offer investee companies more than just cash. ‘Our Titan VCT funds are very much investing in those smaller businesses with growth potential,’ says Macpherson. ‘This makes them higher-risk than more developed rivals but to mitigate risk we see what value we add from our network, providing experience from people who have been there and done it before and can open doors.’

That was one of the factors that most attracted Calastone’s management. ‘When you get engaged with these organisations you’ve got to work with them – it’s not just about the money,’ counsels Lee, who adds that the relationship is different from what you would expect with a larger private equity house. ‘VCTs offer a perfect match between the skill sets they can provide and what growth companies need.’

If you fit the bill for VCT investment, you will need to embark on a bit of self-promotion. Some firms are more willing listeners than others: the team at Octopus sift through around 1,000 business plans a year and see 250 companies in the search for investees.

One way of maximising your fundraising potential is to engage in some creative, but entirely lawful, accounting, according to Chilton Taylor, head of capital markets at accountancy firm Baker Tilly.

‘To get the most out of VCTs you may need to access different products of the VCT group, with part of the cash from one fund and more from another. You also need to look at when the funds were raised as there are different restrictions applying. To access the maximum amount it’s usually sensible to restructure, often with a new holding company. You can also do things like creating separate classes of shares,’ Taylor suggests.

A lack of alternatives?

While VCTs were set up in response to a shortage of available funding in the ‘equity gap’, that shortage is now more acute than ever. Global economic turbulence has purged investors of their appetite for higher-risk fare, which has seen the money raised by these trusts plunge 85 per cent to £135 million since 2006.

‘There is very little venture capital in this country at the moment,’ Taylor says. ‘Most private equity houses are not investing as they cannot get the debt, meaning VCTs are one of the few sources of early-stage finance in the country.’

However, VCTs have suffered too, and not just due to falling risk appetite but because changing legislation has stifled their fundraising ability. In 2005-2006, when the level of tax relief for investors was 40 per cent, VCTs collectively raised some £790 million. In the subsequent three tax years, as the relief was cut to 30 per cent and the eligibility criteria for investees tightened, this fell to £269 million, £290 million and, for the last tax year, just £135 million.

For example, Triple Point, one of the most successful fundraisers over the last couple of years, has recently had to extend the deadline for investment in its TP5 VCT to a full year from its launch, while its new TP70 2009 VCT raised only £3.5 million of an expected £50 million.

‘There has been a dramatic contraction in the amount of money available for UK SMEs,’ says Octopus’s Macpherson. ‘Legislative changes have forced investment into areas where businesses are smaller, so we tend to have only backed the very best companies with the best teams and really good growth opportunities rather than established business looking to do MBOs and then grow their business.’

Taylor argues that the emphasis on sub-£2 million equity cheques has done nothing to fill a larger hole for investments of up to £20 million. ‘Although the legislative changes have refocused the funding down on to smaller companies, which I suppose was the aim, they’ve left a hole above it,’ he says.

Macpherson concurs, to an extent. ‘Previously a lot of VCT money was directed towards businesses quoted on AIM but the new limit of £2 million on investment and the requirement that investees should have no more than 50 staff has reduced this activity, if not pretty much killed it,’ he says. ‘This has taken away an important source of funding for these companies.’

Turning the screw

Such restrictions are not only frustrating for businesses but, laments Macpherson, also for fund managers who spy a fast-growing opportunity. ‘You could have a “virtual” business with very few employees that is a really quite significant company in terms of revenue or value and it would qualify, but a business in food or manufacturing, which has to rely on lots of employees, would not. These are the sort of businesses that should be getting VCT funding. It’s also a significant barrier to growing companies, because as soon as you go over the 50-employee limit you can’t take VCT money.’

Even if there was the will in Westminster to revitalise VCTs, it could take a year or two before the laws are changed, according to Taylor, given that tectonically-paced Brussels administrators took over three years to approve the vehicles for anti-protectionist state aid legislation. But in the meantime VCTs still have to invest their existing funds, and time is running out.

Top ten VCTs by cash in the bank

British Smaller Cos VCT (£16.3m)
TP70 2008 (i) VCT (£15.6m)
TP70 2008 (ii) VCT (£15.4m)
Northern 2 VCT (£11.9m)
Northern Venture Trust (£9.7m)
Ventus 3 VCT (£7.7m)
Ventus 2 VCT (£7.7m)
Puma VCT V (£7.4m)
Spark VCT 2 (£7.1m)
Spark VCT (£7.0m)