Kuber Ventures looks at how the ‘new-old’ style of venture capital will help the UK grow post-Brexit
For tax efficient investment, these are, in some ways, the best of times and in others what could politely be described as sub-optimal.
Those of a sunny disposition may well point to welcome changes in the fiscal environment announced at the end of 2017 which were designed to encourage investment in genuine growth companies as opposed to capital preservation schemes.
Cloudier by far is the political backdrop to tax efficient investing, one so overcast that Parliamentary deadlock over Brexit is actually not the worst outcome, that honour being awarded to a full-blown constitutional crisis. This has created opportunities.
Small businesses adapting
In the current climate, it is not surprising that investment of all kinds has been affected, and that this impact has perhaps been felt most keenly in terms of funding for growth businesses, because of the additional risks. In reality small businesses are often more dynamic and able to adapt to changing environments.
A lack of enthusiasm for shouldering an additional political risk is understandable, especially as the danger of stalemate in Westminster is magnified by what, at the time of writing, is a complete lack of clarity as to what will emerge at the end of the process: a no-deal Brexit, a sort Brexit, a clean Brexit or no Brexit at all.
As a result, investors have been slower to get involved in EIS and similar tax-efficient investment products. However, does that mean the tax efficient market has come to a standstill? Not at all.
While investors are wary of the political climate and delaying their decisions, interest in tax efficient investment schemes is growing strongly. Investments deferred during the latter part of last year are starting to feed through in the first quarter of 2019, as experience shows that potential investor demand can turn into actual investment very rapidly.
In part, of course, this reflects the coming of the end of the tax year, which always tends to spur decision making. Alongside this, Britain will also be departing from the European Union, which if finalised, would alleviate some of the market uncertainty Brexit has created, although whether parliament extends this deadline remains to be seen.
Perhaps the biggest opportunity is one of straightforward arithmetic – the subdued investment climate seen at the end of last year forcing companies to drop their valuations to draw investors, creating attractively-priced opportunities for those willing to move swiftly. Furthermore, the macro-economic climate is supportive for growth businesses. In its most recent estimates, published in January, the International Monetary Fund (IMF) cut the forecast that it made in October for 2019 growth in advanced economies by 0.1% percentage points, but left the UK forecast unchanged at 1.5%.
More broadly, the new fiscal framework has bedded down and appears to be working exactly as intended, to screen out the ‘pastry cutter’ schemes designed solely to take advantage of tax breaks and to divert investment into firms with a fighting chance of emerging as the giants of tomorrow.
Not all will succeed, of course, which is why portfolio diversification is essential, as is skilled selection of investable companies. But given the whole point of the 2017 criteria was to ensure that investors faced a real, rather than hypothetical, risk of loss, there does need to be some hazard in the market.
A new breed
The criteria was designed, in the words of the Chancellor Philip Hammond, to ensure tax-efficient investment schemes were not co-opted to provide ‘a shelter for low-risk capital preservation schemes’ and instead provided backing for ‘knowledge intensive companies’.
The changed incentives have also led to a new breed of venture capitalists, although perhaps they would be better described as a ‘new-old’ type, given they have imported, mainly from the more mature US venture capital market, a traditional model of risk capitalism far more in keeping with the spirit of Hammond’s reforms than were the tax avoidance schemes that he sought to banish.
True venture capitalists create value, while the tax avoidance schemes sought merely to harvest it and this is precisely what separates investments within EIS in comparison to other types of investments – the creation of value which in turn has a positive impact on the country’s economy, due to the heavy emphasis on investing within knowledge intensive businesses.
Venture capitalists work with the businesses in which they are invested to build up long-term worth, whereas tax-avoidance specialists construct their schemes around the available fiscal breaks with the prospects for investee companies proving something of an afterthought.
Private capital stepping up
It is not hard to see which approach will be of greatest benefit in the years ahead. If Britain is to stimulate small companies that have the potential to become large ones, significant amounts of capital will be needed. Institutional investors tend not to get involved in funding growth companies, believing the sector is too small to warrant attention.
That means private capital must step into the gap and that, in turn, means venture capitalists have a central role to play within the UK’s enterprise sector. Funding tomorrow’s growth businesses will be more important than ever in the period during and after Brexit. The figures speak for themselves.
On most recent data, the total population of businesses fell by 0.5% in 2017 but private sector employment grew by 2%. According to the Federation of Small Business, the number of smaller, one-person businesses with no employees declined, but there was a 2% increase in the total of larger small and medium-sized enterprises (SMEs), those with employees.
It is no exaggeration to say that the post-crisis UK jobs miracle has been an SME phenomenon, and the sector currently accounts for about 60% of all private sector employment, not to mention more than half of all private-sector turnover. In light of this, it is not surprising that, in October, the Treasury said: ‘The government is committed to supporting the UK’s fast growing and innovative firms to secure the external finance they need as the UK leaves the EU.’
It added: ‘Access to equity finance is particularly important for knowledge-intensive businesses such as those creating and developing new technologies.’ As we have seen, it was the intention of channelling investment to precisely such businesses that was at the heart of the 2017 changes to the fiscal regime and the consequent end of the low-risk, assetbacked schemes that had little or nothing to do with promoting such investment.
Interestingly, however, some former providers of capital preservation schemes have decided to follow this new trend, reinventing themselves as venture capitalists. Some may prosper, others may find it hard to make the transition.
Ultimately, there is plenty of room for everyone in what is an exciting and dynamic sector and one that will be hugely important for the country’s economic future, long after present domestic difficulties have dropped out of history’s rear-view mirror.