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Attracting private equity skills to VCTs by David Thorp

VCTs were introduced after lengthy collaboration between the BVCA and HM Treasury before the legislation was finalised in August 1995, says David Thorp, an Investment Manager at the Baronsmead VCTs and Chairman of ISIS Equity Partners plc. The rationale was to raise capital from high net worth investors for investment in a portfolio of fast growth companies.

Originally the focus was on unquoted companies, but the definition was extended to AIM-traded companies as this junior stock market was also launched in Summer 1995.

The design of VCTs has proved to have a good degree of elegance, mimicking the investment trust regime and, in particular, the rigours of full list investor protection. The additional overlay has been the VCT tax reliefs and the detailed rules which define the qualifying status of individual companies, the purpose of the investment and the terms that are then attached to the ‘equity’ investment. Broadly, the geared nature of private equity structures can be applied to achieve additional controls and returns for the practitioners and investors respectively.

VCTs are essentially entry level vehicles for private equity teams who handle third party funds. In 1995, the larger BVCA members still had a minimum investment level of £1m or less. Since then there has been a dramatic move to larger size transactions, so that the economics of £1m per VCT per company per year are difficult to achieve, unless deals are syndicated - either with other clients or other like minded practitioners. Managing several VCTs has become popular: there are 30 or so firms managing 75 VCTs, of which about two-thirds have a private equity bias.

Revision of VCT tax reliefs

The BVCA campaign to address the paucity of funds raised in the three years to April 2004 has succeeded in the introduction of a 40 per cent income tax relief for the two financial years to 5 April 2006. Hopefully this will have the consequence of boosting the number of HNW investors from some 5,000 in 2003/04 to perhaps five times this or more this year. There is now an important dialogue between the industry and Government to establish any revisions to VCT tax reliefs and rules beyond 5 April 2006.

Partly, the revisions then will depend on the amounts of capital raised, but - longer term - two key issues are to:

• improve the skills and capacity of the VCT practitioners in the medium term; and
• demonstrate that VCT investments provide a good experience for HNW investors.

Attracting private equity practitioners to VCTs

The initial response from private equity and AIM fund managers suggests that funds raised in 2004/05 will be allocated 50:50 to unquoted and AIM portfolios respectively, as opposed to 75:25 previously. It is considerably easier for a manager of quoted small cap stocks to switch into AIM focussed VCTs than it is for a private equity firm that has to build additional skills and abilities over several years.

Attracting new private equity practitioners will be desirable to both grow investment capacity and provide more choice for investors. The £1m annual limit per investee and the £15m gross assets test are two potential hindrances for established private equity teams. Only when several VCTs can invest in parallel to provide £2m-£5m of investment, is it more possible to meet the selection and active management standards that they may have historically provided for institutional shareholders.

The BVCA regularly measures the economic impact of venture backed businesses. The only survey of the impact of VCT backed companies – published in August 2002 – showed even higher rates of job creation and investment. As a consequence, the commitment of HM Treasury has been strong during 2003. The growth of business angel investment, EIS schemes and now the proposed Enterprise Capital Fund scheme all cater for the sub-£2m investment.

Performance for VCT investors

The overall track record of VCTs to date is similar to the rest of the private equity industry - with a wide range of outcomes since 1995. The technology specialists were hardest hit when the bubble burst several years ago. But, if the tax reliefs are added back, the picture looks more favourable and betters a number of larger Investment Trusts with a focus on unquoted company investment. Shareholder friendly policies, like buy backs for infrequent sellers, are becoming common practice, as are reporting standards which give greater transparency.

Governments wish to sustain the amount of capital retained within VCTs, and the current mergers and acquisitions legislation being introduced for VCTs will allow sensible consolidation. Just as with institutional investors, who were won over to allocating their funds to private equity in the late 1990s, there is now the opportunity for private investors to similarly use VCTs as an alternative investment in their portfolios and ‘enjoy’ the excitement, and hopefully success, of the fast growth companies of tomorrow.

David Thorp is an Investment Manager at the Baronsmead VCTs and Chairman of ISIS Equity Partners plc.