In the previous edition of View From the Bridge, I outlined the first half of a presentation which I gave in Liverpool, focusing on investment into businesses operating in and around the North-West. More specifically, it addressed the recent review of Inheritance Tax (“IHT”) undertaken by the Office for Tax Simplification (“OTS”), and the potential implications, if any, which this could have on qualifying trades, as well as a brief examination into the impact which the AIM sell-off through Q4 2018 may have had on sentiment around AIM IHT products.
In this edition, I will address the second topic covered in the presentation: an examination into the effects which the Patient Capital Review (“PCR”) has had on the EIS and VCT market, and more pertinently the implications which this has had on the due diligence process in this space.
Back in November 2017, Philip Hammond delivered the annual Budget, including the outcome of the Patient Capital Review. The outcome of the review was largely in line with expectations, and confirmed MJ Hudson Allenbridge’s expectations that many asset-backed, lower-risk products did not fit in with a wider vision of capital being channelled towards higher-risk, scalable enterprises which embodied the Government’s broader vision of what the UK’s industrial strategy should be.
The rule changes received Royal Assent on the 8th of March 2018, and, as we pass the one year anniversary of this, we feel it is meaningful to examine the market and assess the implications of the changes.
The optimist’s view is that the move is in line with the spirit of the legislation, which is positioned to promote investment into smaller start-up companies, and is therefore net beneficial to the UK economy. The industry should, consequentially, continue to flourish.
However, pessimists might argue that many people will now simply move away from EIS and VCT investments due to the move up the risk spectrum, and that managers in the old, asset-backed space will add competition to a crowded group of managers chasing a smaller amount of investor money. This new-found competition will make it harder for investors to know who really are venture-capital, growth-oriented managers, and who are simply pivoting because their business now demands it. It’s our job, as independent reviewers, to help them pick through the propaganda and buzzwords and to see whether products are supported by the teams, strategy, and pipeline to make growth investments work.
From our perspective, the data would suggest that EIS managers are crowding into a narrower space. Evidence suggests that the number of products that we have reviewed over the past year is broadly similar, and that it is the type of product on offer, which has changed. The PCR resulted in a number of changes to qualifying trades, in particular those that included an element of asset backing or had a pre-determined exit. As a result, many EIS products are no longer allowable, and, as would arguably be expected, there is now also a narrower focus toward certain sectors, in particular investments with a tech aspect.
A number investment managers have had to move away from these structured, lower risk investments towards a more recognisably venture-style model of investing in young companies. For example, media products which used to invest in films and recoup money from tax credits and pre-sales have been abandoned in favour of media specialists looking to invest, in a venture style, in young production and post-production companies in the wider media space.
It should equally be noted that those managers, that had previously been investing in growth-orientated investments have had to change very little if at all. These Managers will have built up the relevant experience and have developed the relevant investment processes in order to undertake growth investment. However, many other managers have been forced to either close existing products or, in a sense, reinvent themselves. It is important, therefore, to be aware of any EIS (or indeed VCT) manager which has had to pivot toward riskier growth-orientated investments.
We have noticed a number of new, smaller VCTs come to market. Many of these VCTs have the appearance of an EIS portfolio, but within a VCT tax wrapper – that is they are smaller portfolios, which will need to be built up over time before they are able to pay dividends. These VCTs will create some competition for the more established VCTs, many of which had used less risky strategies such as management buy-outs, which are now having to pivot toward riskier investments into newer companies.
We have also noticed that VCTs are undertaking smaller and more frequent fundraises. New rules for VCTs mean that 30% of new funds raised must now be deployed within 12 months in qualifying investments and, given the stricter qualifying criteria, managers have taken a more cautious view with regard to the size of the fundraise.
We expect to see greater volatility in NAVs going forward, as legacy portfolios get smaller to keep up regular dividend flows, and the younger, riskier companies into which VCTs now invest will under- or over-perform more than the later-stage, lower-risk companies which many VCTs used to specialise in (as well as taking longer to get to the stage where they might be in a position to generate cash for dividend payments themselves). A number of clients have enquired about the ability for VCTs to pay regular dividends. As a result of this we are currently undertaking research into the proposed source, scale, and expected regularity of dividend payments going forward – look out for this research piece in the coming weeks!
As the market moves toward a focus on venture capital and growth companies, it is even more important to conduct thorough due diligence. Having worked as a tax-advantaged investment analyst both before and after the PCR, I have seen the effects of this first hand. Previously, the significant focus in this space has been around issues such as whether the particular trade would qualify for tax relief, an assessment on the level of asset backing which an investor may benefit from, or whether the Manager had accounted for a timely exit after the three-year holding period.
In the new regime, new investments which, by definition, must be at risk of capital loss, need a more specific focus around venture capital knowledge and experience in the investment team. We have found, therefore, that research in this space has become far more focused on the experience and ability for Managers in undertaking venture capital investments, as opposed to their ability to structure products which will qualify for tax relief.
Unlike many other research providers within this space, the team at MJ Hudson Allenbridge can leverage the experience of the wider business, and we have ensured that our research process has been amended in order to take into account the recent developments in the market (an examination of the MJ Hudson Allenbridge Tax Advantaged Research Methodology bears testament to this). As the market has come towards managers who were already in this growth-oriented space, it has certainly helped that we are alternatives specialists- including making up part of the Venture Team at MJ Hudson Allenbridge- and not just tax-advantaged reviewers.
EIS and VCT managers must now be viewed as part of the wider UK, early-stage ecosystem, and knowing how everyone fits- or doesn’t fit- is a key part of evidencing a manager’s capabilities: What are their links into incubators and accelerators? How strong is their brand with entrepreneurs? Who do they co-invest with? Can they help companies get financing at the next few rounds of investment? Does the Manager really demonstrate knowledge of the sectors into which it hopes to invest? Context here is key rather than simply looking at what a manager says, and as the market has been forced to change focus, so too must the due diligence process, and, here at MJ Hudson Allenbridge, we will continue to adapt in step with the market and ensure that our research remains relevant.
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