Business Before The Budget

 

In this newsletter, Simon Radford looks at the challenges to capacity, and the constraints inherent in the tax-advantaged sector, in light of the Patient Capital Review and other trends in the sector.

There is a spectre haunting the tax-advantaged market: the Patient Capital Review. The thinking of the Treasury is much remarked upon, but little known, with mentions like that of the Chancellor’s in his party conference speech mined for potential hints. While many of us have had conversations with policymakers in terms of the consultation, launched a couple of months ago, speculation has varied as to their true intentions: some managers raise the possibility of a National Investment Bank for early-stage investments, much like those funds deployed by managers as part of the British Business Bank’s “Northern Powerhouse Investment Funds”. Others reassure the sector that changes will be incremental more than radical, while lobby groups representing both EIS and VCT managers seem ready to retreat on keeping “asset-backed” products in order to preserve the tax advantages for investors ready to fund early-stage growth capital.

What is clear, however, is that the tax-advantaged sector is already feeling the effects of the upcoming announcement on November 22nd. Our team has seen higher demand than ever for EIS and VCT products and four main reasons stand out as likely drivers:

  • higher market valuations are seeing businesses sold with the gains seeking tax-efficient investment outlets to avoid a large tax hit;
  • the greying population has seen a secular rise in the number of people planning to pass on money to their children;
  • the pension cap has raised questions for those who can no longer plough money into their usual pension vehicles; and,
  • the uncertain macroeconomic environment makes the search for higher returns or decent yields more challenging than ever, with the gains from tax advantages even more attractive than the alternatives on offer without such inducements.

Supply has expanded to meet this demand, both in terms of new Managers entering the tax-advantaged market, and in expanded product ranges and larger fundraises from established managers. Those managers who formerly benefited from the rules on management buyouts (MBOs) and renewables, are seeing those investments exit, and have assembled new or retooled investment teams in a bid to reinvest this money in strategies currently permitted under the rules; there has been an expansion of IHT/Business Relief providers as the level of demand has come through above expectations, we have also seen a rise in the number of AIM-related vehicles in recent years as that exchange venue has broadened and deepened; and the tax-advantaged market has matured more generally as the opportunities in this sector have become better-known by managers and investors.

The final piece of the puzzle for increased supply has been the worry about the results of the Patient Capital Review and, to a lesser extent, the prospect of MiFiD II and other regulations. Many think it better to raise money now, while their strategies are unaffected, than take the risk of raising money too late with strategies and teams scrambled by news from No.11 Downing Street on November 22nd.

These changing dynamics have led to both capacity challenges and constraints in the tax-advantaged sector.

In terms of capacity, HMRC has been struggling to provide Advanced Approval and EIS certificates in as timely a fashion as wished for by managers and investors respectively: new products and a greater array of investors, along with restraints on hiring and pay at HMRC, have posed a challenge, with reports of extreme variability in the timeliness of despatching the correct paperwork back to managers and investors. Changes to rules tend to also create an understandable lag in response time, as both investment houses and tax officials feel out the interpretations and boundaries of those new rules.

The influx of money also poses unique challenges to managers in the sector:

  • How can managers deploy more money in as timely a fashion as before, and without unwelcome cash drag?
  • With more money chasing a similar level of opportunities, will this see a drop in the average level of quality of investment?
  • With higher valuations more generally, and this new influx of demand, the search for value and yield has become more challenging than ever. Will managers be tempted to overpay for investments?
  • With more investments, more money to deploy, more boards to sit on, a broader investor base,etc., does the manager have the infrastructure and governance to cope?

Our team has a long track record of evaluating managers and products on a consistent basis: we look at a manager’s profile in the tax-advantaged world, its governance, fundraising, and financial stability; and we evaluate its investment team, strategy, risk management, portfolio and pipeline, fees, and performance, in terms of its product. These recent changes make certain of these categories all the more important; the governance of the manager, the track record and experience of the investment team, risk management approaches and practises, and pipeline and deployment prospects, inevitably come under stronger focus.

With managers raising more money than they ever have before, this is a challenge of kind and not just of scale. And when the Chancellor stands up on November 22nd and announces the changes which he envisions for the tax-advantaged sector, there might be even more challenges for managers ahead. But even now, it isn’t as easy as simply making hay while the sun still shines…

We will be providing commentary on the potential changes to the rules governing the tax-advantaged investment world further to the Chancellor’s Budget. Look out for more newsletters in the months ahead and do check MJHudson.com for the latest on what investors and managers should expect.