Venture Capital Trusts (VCTs) remain a highly attractive investment option, providing investors with the possibility of generous tax-efficient returns.
Research from the Wealth Club indicates that the combined raise of VCT providers was £91.3 million in January 2019 alone, up by 245 per cent year on year.
This follows a record year in 2017-18 in which £728 million was raised – the highest figure for a decade and second-highest figure since VCTs were launched, according to the Association of Investment Companies (AIC).
However, there has also been a significant shift in the venture capital landscape brought about by the adoption of EU state aid rules in 2015 and the 2017 Budget and Patient Capital Review.
As a result of these changes, venture capital trust managers must now invest in younger, earlier stage companies, creating a new set of challenges they need to address.
Changed regulatory enviroment
EU state aid rules were designed to limit tax-efficient investments, such as VCTs, to early stage companies seeking start-up capital as opposed to more established businesses seeking investment.
Reinforcing the emphasis for younger, innovative companies, the EU state aid changes limited VCT investment eligibility to firms in commercial operation for seven years or less, or 10 for ‘knowledge intensive’ companies.
Two years later, in response to the Patient Capital Review in 2017, the government introduced a new principles-based test, preventing tax-efficient schemes such as VCTs from investing in significantly asset-backed companies, and instead encouraged greater investment in businesses seeking to grow and develop.
Given these combined changes, many established VCT managers have adapted and refined their approaches to invest in early stage companies.
Experienced, well connected team
When looking for suitable early stage companies to back, managers should not underestimate the value of a well-connected, experienced network. Having a diversified and knowledgeable team across different sectors can help managers source and analyse the best opportunities in the market and ensure they are making the right investment decisions.
For example, Triple Point has established a Venture Network, whose members include business advisers and entrepreneurs who have a proven track-record of transforming innovative start-ups into established leaders. By helping us screen investment opportunities our Venture Network helps us mitigate some of the risks associated with this asset class.
Cast the net wide
VCT managers should be researching a broad base of SMEs across a range of sectors. This enables a VCT portfolio to effectively spread the risk associated with exposure to earlier stage businesses, while ensuring sufficiently high-quality assets with the potential for strong returns.
In terms of potential companies in which to invest, we have witnessed a boom in the UK in the growth of start-ups and young businesses in recent years, all offering a wide variety of products and services across different sectors.
New business formations reaching a record 663,272 last year, up 5.7 per cent on the previous year, according to data collated by the Centre for Entrepreneurs (CFE).
Have an established customer base
One of the main challenges faced by VCT managers in a landscape that has nudged them towards investing in younger companies is the risk associated with early failure. To mitigate these risks managers should be mindful of the core reasons why failure occurs.
Research shows that more than 40 per cent of start-up failures are due to there being no market demand for the product or the service the business provides.
For this reason, some VCT funds have taken a “challenge-led” approach — investing in early stage businesses which already have a proven solution to the challenges faced by larger businesses and blue-chip enterprise that often alone do not have sufficient in-house expertise to solve.
Marks & Spencer’s joint venture with Ocado shows how a large corporation can find itself falling behind, and therefore turning to another company to help it catch up. In the case of Marks & Spencer, this was the retailer’s failure to compete on grocery home deliveries; a problem which it hopes Ocado will now help it overcome.
The challenge-led approach works in much the same way.
By assuring a customer base is already formed — and there is a known and established need for the service or product that the start-up is providing — it is possible to mitigate much of the risk associated with early-stage businesses.
At Triple Point, we are already championing the challenge-led approach, having launched generalist VCT the Venture Fund. The fund draws on the expertise and reach of our experienced and well-resourced management team and our Venture Network, which has close ties to over 100 large corporates and over 5,000 innovative companies.
By focusing on early-stage businesses that have established a market for their products and services with large corporates, we address one of the most significant risks of early stage venture capital, all the while helping companies we back make the successful transition from start-up to scale up.
Belinda Thomas is partner and head of sales and investor relations at Triple Point