Reviewing the Patient Capital Review – November 2017

Well, the uncertainty is over, Philip Hammond has taken his shiny red box and delivered the Budget and the Patient Capital Review, and was even able to throw in a joke or two.

Overall, we think that the changes proposed to EIS and VCTs are balanced. They are certainly more positive than what the market was expecting after the initial publication of the Patient Capital Review but we will of course have to wait for the details of the new principles-based test on risk-taking to be able to assess the potential impacts to the market. How that test is interpreted will go a long way to determine which of today’s range of products fall foul of the new rules.

Key changes in the Budget:

Impacting Venture Capital:

The Government will:

  • Set up a new dedicated subsidiary of the British Business Bank to invest in patient capital across the UK. The new subsidiary will be capitalized with £2.5 billion of public money. By co-investing alongside private investors, a total of £7.5 billion of investment will be unlocked.
  • Invest in a series of private sector fund of funds. The first wave will be seeded by up to £500m of investment from the British Business Bank. Up to two further waves of investment will be launched, unlocking up to £4 billion in total of new investment.
  • Back first-time and emerging venture capital fund managers through the British Business Bank’s established Enterprise Capital Fund programme.
  • Develop a new commercial investment programme through the British Business Bank to support developing clusters of business angels outside London. This programme will supplement existing programmes to support access to finance outside of London that include the Northern Powerhouse Investment Fund and the Midlands Engine Investment Fund.
  • Launch a National Security Strategic Investment Fund to invest in early stage companies developing innovative technologies that have the potential to contribute to our national security mission in areas such as sensing, materials, cybersecurity and data analytics.

Impacting Tax-Advantaged Investments:

  • Introduction of principles-based test on whether products take adequate risk which will ensure that the schemes are focused towards investment in companies seeking investment for long-term growth and development.
  • The new ‘risk to capital’ condition depends on taking a ‘reasonable’ view as to whether an investment has been structured to provide a low-risk return for investors. The condition has two parts: whether the company has objectives to grow and develop over the long-term; and whether there is a significant risk that there could be a loss of capital to the investor of an amount greater than the net return.
  • The qualifying rules regarding Entrepreneurs’ Relief will be changed to ensure that entrepreneurs are not discouraged from seeking external investment.
  • Greater flexibility will be provided for knowledge-intensive companies over how the age limit is applied for when a company must receive its first investment through the schemes. Knowledge-intensive companies will be able to choose whether to use the current test of the date of first commercial sale or the point at which turnover reached £200,000 to determine when the 10-year period has begun.
  • The annual investment limit for knowledge-intensive firms will be doubled from £5 million to £10 million through EIS and by VCTs

EIS:

  • The annual investment limit for EIS investors will be doubled from £1 million to £2 million, provided that any amount above £1 million is invested in knowledge-intensive companies.
  • A new knowledge-intensive EIS approved fund structure will be consulted upon, with further incentives provided to attract investment.

VCT:

The government will target VCTs towards investment in higher risk areas of the market:

  • from 6 April 2018 certain historic rules that provide more favourable conditions for some VCTs (“grandfathered” provisions) will be removed
  • from 6 April 2018, VCTs will be required to invest at least 30% of funds raised in qualifying holdings within 12 months after the end of the accounting period
  • from Royal Assent of the Finance Bill, a new anti-abuse rule will be introduced to prevent loans being used to preserve and return equity capital to investors. Loans will be have to be unsecured and will be assessed on a principled basis. Safe harbour rules will provide certainty to VCTs using debt investments that return no more than 10% on average over a five year period
  • on or after 6 April 2019 the percentage of funds VCTs must hold in qualifying holdings will increase to 80% from 70%
  • on or after 6 April 2019 the period VCTs have to reinvest gains will be doubled from 6 months to 12 months
  • The annual investment limit for knowledge-intensive firms will be doubled from £5 million to £10 million through the EIS and by VCTs

BR IHT

  • The government will keep BR IHT under review, and is committed to protecting the important role that this tax relief plays in supporting family-owned businesses, and growth investment in the AIM and other growth markets.

Our opinion on the Budget:

The Budget seems to have confirmed Treasury’s view that many asset-backed, lower-risk products did not fit in with a wider vision of capital being channeled towards higher-risk, scalable enterprises which fit more neatly into the Government’s broader vision of what the UK’s industrial strategy should be.

Rather than eliminate products simply based on the sector in which they are in, we welcome the principles-based test as a way of judging each product on its merits in terms of taking an appropriate amount of risk. This stops a few bad apples from spoiling the whole batch when it comes to any particular sector.

What Treasury’s measures show is that the Government will not allow taxpayers to subsidise investing in companies which exist in order to trade off the underlying assets, rather than the growth of the company itself. It does seem that the Treasury have recognised the crucial role EIS has played in funding UK Independent films.  However, the future of EIS-funded films could well be changed radically based on the new rule, with the tax credits and pre-sales used as collateral coming under the microscope. Where the line is drawn in terms of their collateral will be a key test for the new rule.

The anticipated change for constitutes a knowledge-intensive company from a backward to a forward-looking test, is a nuanced but important change, allowing companies to pivot their strategy and encourage innovation whilst still qualifying for government help.

Guidance on the principle-based test will likely reduce the number of applications for Advanced Assurance from low-risk/asset-backed businesses clearing HMRC evaluators to provide quicker Advanced Assurance for those who meet the requirements.

The increased limits of investments into knowledge-intensive companies, will mean more capital coming into the tax-advantaged space, which can only support early-stage, growth businesses and should help companies scale more quickly. Paired with the increased annual EIS investment limits, this could lead to additional eligible capital, which could help these companies in their fundraising to achieve scale and commerciality. We see the increases in the investment limits as a positive to help offset some of the expected capital outflow.

The trick will be to see how many investors will now switch from more capital preservation investments to alternative high-growth products, and how many instead exit the tax-advantaged venture space altogether rather than take the additional risk.

MJ Hudson Allenbridge’s survey of top UK Venture Capital players showed a mixed reaction to the idea of a new fund aimed at growth companies, which indeed was announced in the Budget, although the industry has broadly welcomed the Northern Powerhouse and Midlands Engine. As ever with these things, the devil will be in the detail: the success of the Fund will depend on a clear mandate, proper governance, and selecting the right managers for the job.

Broadly we support the proposed action points and the concept that start-up companies that are genuinely trying to achieve profits for their owners, i.e. investors, will need to have the owners’ capital at risk, and excluding those which do not take risk will remove products in the market that are specifically designed to maximise the tax benefit and rather than investor returns. This is certainly a positive for the taxpayer, and better for some investors. However, the consequences to investors more broadly are not entirely positive, as the rule changes will certainly mean that there is less diversity of companies and risk profiles in the sector. This makes portfolio construction less efficient.

Venture capital fund managers will likely be happy with these changes while Media focused managers will breathe a sigh of relief and others will have to revise their strategies significantly post-Royal Assent. In the coming days we will be reaching out to the market to survey opinions and any anticipated changes in strategy resulting from the budget.

We are still processing information supplied already and waiting for clarification on the principles-based test and will look to revert back with our analysis.