The Age of Venture Capital

by | Mar 24, 2014

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Guy Myles, co-founder of Octopus Investments, looks at the reasons for the current popularity of Venture Capital Trusts and Enterprise Investment Schemes

Venture Capital Trusts (VCTs) are 18, and the Enterprise Investment Scheme (EIS) is about to turn 21. It’s time for a party – all the more so because this coming of age isn’t just a matter of numbers in the calendar. VCTs and EIS really have become more mature, and they now have an established place in the investment world. The Treasury mandarins who dreamed up these schemes back in the 90s must be proud of their work.

Rocketing Demand

The clearest sign of the higher profile that VCTs and EIS now enjoy is the amount of money investors are putting into them. This has been rising steadily since the financial crisis and has now reached new heights. According to the Association of Investment Companies (AIC), VCT fundraising by this point in the current tax year is 69% up on the level for last year, and at Octopus we have noticed an even bigger surge in demand, with this year’s inflows expected to more than double those of 2012/13.

The statistics for EIS are just as impressive. The latest figures from HMRC relate to the 2011/12 tax year and show that EIS fundraisings attracted just over £1 billion – nearly twice as much as the £545 million in the previous tax year. Again, our first-hand experience at Octopus suggests that this trend is getting stronger all the time. We have released three tranches of our EIS product so far in 2013/14 and have had no trouble reaching our fund-raising targets.

An Extra Option for Hard-Pressed Investors

VCTs and EIS, it seems, are the right products at the right time, and there are a number of reasons for this. In the first place, it’s worth pointing out that there has been increasing government support for both VCTs and EIS.

In April 2012 fund managers were given much more flexibility about the companies they could invest in. The maximum value of a portfolio company went up from £7 million to £15 million and it could have up to 250 employees, rather than just 50. At the same time, the limit on an individual investment was raised from £2 million to £5 million.

But you could argue that these changes are nowhere near as significant as the developments we have seen in pensions legislation. Over recent years, governments have severely curtailed the amount of money that investors can save tax-efficiently in pension schemes. The Lifetime Allowance was cut from £1.8 million to £1.5 million and will go down to £1.25 million this April. At the same time, the annual allowance is being cut from £50,000 to £40,000.

Now, this has left thousands of people — and not just the mega-rich — hunting around for other tax-efficient ways to save for their retirement. And many of them are turning to a VCT or EIS, or both. As they do so, I believe they are discovering that the tax incentives available with VCTs and EIS are proving just as attractive as those they receive from pensions, if not more so. They are also realising these investments have a lot more to offer, mainly that they give them access to an asset class they have probably been neglecting for far too long — smaller companies.

The Real Source of Economic Growth

This echoes the point that I made earlier about now being the right time for VCTs and EIS. Investors have understandably become jaded with the larger companies that form the bedrock of a traditional portfolio. As I write this, the FTSE 100 is no higher than it was 14 years ago. And the major market players — banks, oil companies, utilities — have all lost favour among investors as well as the population at large. Against this background, more investors are keen to look further afield and consider an investment in smaller companies.

They can see for themselves that larger companies are not creating any jobs — hardly a week goes by without a news story about a blue-chip company laying off staff. At the same time there are small businesses springing up in workshops, offices and innovation centres all over the country. These companies are taking on staff and laying the foundations of the UK’s economic recovery, yet many of them are being starved of cash.

Since the credit crunch began in 2007, banks have been less willing, or less able, to lend to small and medium-sized businesses. As a result, there has been an increased emphasis on alternative funding sources, from venture capital to crowdfunding, which is a sure sign that the UK population is keen to back smaller companies and, by extension, the UK economy.

These trends have given a boost to VCTs. The average fund – again according to the AIC ­– is up 8% over one year, 24% over three years and 53% over five. And an impressive 73% of VCTs are yielding over 5% (source: AIC). I’m pleased to report that Octopus is among the leaders in the market. Our two AIM VCTs have seen their net asset value rising by 34.6% and 31.9% over a year, and 145.1% and 113.4% over five years. The equivalent figures for the most established of our five Titan VCTs, which invest in unquoted early-stage companies are 10.7% and 52.5% (source: Trustnet).

Vital Funding

So, a VCT or an EIS investment helps on both sides of the equation. It offers much-needed funding to early-stage businesses, and it can help an investor share in the buzz that currently surrounds smaller companies as the new lifeblood of the economy.

All of this supports an argument we have been making at Octopus ever since we set the company up in 2000 – that smaller companies are too important an asset class to ignore. They deserve a place in everyone’s portfolio, for the diversification and the growth potential that they offer.

Only smaller companies can generate the earnings growth that is a key element of the ideal investment – a £1 million company is much more likely to double its earnings than a £1 billion company.

Of course, investors do need to be comfortable with the fact that they face more risk with smaller companies than they would with larger ones. On the other hand, I would argue that there are risks involved in not investing in smaller companies — a portfolio is less diversified without them and has no exposure to a key driver of growth in the economy.

Tax Incentives

On top of that, the generous tax advantages of a VCT or an EIS are specifically designed to reward investors for taking on these risks. Both a VCT and an EIS come with 30% upfront tax relief, as long as the investor holds on to their shares for five or three years respectively. This is a welcome addition to the returns shareholders may receive and helps to reduce the overall risk profile of the investment.

VCTs come with the extra advantage of tax-free dividends — a welcome bonus for anyone who sees their investment as part of their retirement planning. The dividends can either help boost long-term growth or supplement their pension income.

With an EIS, investors also have the option to shelter capital gains from tax and to protect part of their estate from inheritance tax. This is another example of the EIS market benefitting from negative developments in a separate section of the tax regime. The government has frozen the nil-rate band for inheritance tax at £325,000 and has made trusts less attractive as an estate planning tool. With property prices moving ever upwards, it is no surprise that more people are looking to an EIS as a way to ensure their loved ones don’t have to pay more inheritance tax than they need to.

In a Nutshell

With VCTs and EIS offering income tax relief, an alternative to ever more restrictive pensions and access to a key asset class that is helping to power the UK recovery, it is easy to see why they are finally becoming mainstream in the eyes of both investors and advisers.

 

Sources

1AIC

2Trustnet

  

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