VCT returns under pressure

The government’s new investing rules will change the way VCTs invest and reduce the scope for raises and returns in the industry

The government’s new rules around VCT investing are placing tight investment timescales on VCTs and restrictions on types of investment they can make which could mean returns may not be as high as they once were.

The amount of money flowing into VCTs in the 2017/18 reached a record £728 million, according to figures from the Association of Investment Companies, with a few investment houses registering mammoth raises over the period.

However, the bumper inflows may be coming to an end due to the government’s new VCT rules that demand VCT are focused on growth not lower risk investments and that money raised is deployed quicker than it was before.

This means that companies are unlikely to continue with large scale raises, preferring instead of raise smaller amounts of money that they know they can invest under the new rules in the newly-tightened timeframes.

The fact that companies can no longer make lower risk MBO and MBI type investments, that typically pay out a steady income stream and are fairly reliable, and must instead put money into pure growth plays, which re more volatile, could mean that returns are lower and more variable

VCTs are now required to invest 80% of funds, rather than 70%, in qualifying companies, and 30% of the funds raised must be invested by the end of the first accounting period following the one in which the fundraising took place.

The fact that companies can no longer make lower risk management buyouts (MBO) and management buy- ins (MBI) type investments, that typically pay out a steady income stream and are fairly reliable, and must instead put money into pure growth plays, which are more volatile, could mean that returns are lower and more variable.

Older VCTs have also lost their ‘grandfathered’ status, which means they can no longer operate under previous rules and are also pushed towards being growth investors, and VCT managers are now in effect all fishing from the same pool of investments.

John Glencross, Chief Executive and Founder of VCT and EIS provider Calculus Capital, says it will be more challenging for fund managers to invest the money they raise.

He says that all VCT providers will now be “in the same pool”.

“There are more looking for the same type of investments than before; you have VCTs, EIS investors, and other small non-tax advantaged funds in the same area, all looking for growth,” he says.

“I think the challenges for VCTs are that they have had to move from being MBO investors to growth investors, which has required a change of investment strategy and skill.”

The change in skills may mean that a VCT’s historic returns are less relevant as managers can no longer rely on the investments that they are used to picking.

“The performance put forward may be based on a set of investment rules that may no longer be appropriate,” says Glencross. “If you look at those VCTs which previously invested in both MBO and growth investments, in the MBO and MBI investments historically they were delivering higher returns and lower volatility in their MBO investments than in their growth investments.”

However, he said this consistency is not translated into growth portfolios as easily due to the more volatile nature of growth investments.

“In growth investing, their overall returns are probably slightly lower, and there is greater volatility,” he says. “It means now that VCTs are likely to not necessarily deliver the returns they’ve earned before, although they get good returns within the market, and VCTs by and large know what they’re doing.

“The VCT sector is looking at good returns, but not as healthy as the past few years, although we have had a buoyant economy.”

Growth portfolios will by their nature be more divided into winners and losers, says Glencross.

“If investors look at returns, they might have to get used to the fact that there are more marked winners and losers in a growth portfolio than was hitherto the case,” he says.

“In looking at VCT share offerings now, it’s important to look at where the returns have previously come from, and to take a view of what life may be like going forward.”

The changes to the investment timeframe means that VCT fund managers have to work harder to put money into a smaller pool of investments more quickly, and as the pool is smaller there is a good chance that sectors may become crowded and subsequently returns will diminish.

“Everyone is investing in a smaller pool and the government is saying you have to put more money to work faster. I think it is likely to put pressure on returns,” says Glencross.

“It means there is a challenge that VCTs will now have to face, to work harder, and to probably put more into being growth investors in order to deliver commensurate returns to before. More money being put to work in general, and faster, means that within the investment universe there are area which are starting to get a little overheated, and areas in which there are opportunities.”

Glencross says the key to investing in the right VCT, as with any investment, is to “look under the bonnet” and “don’t take what has been the case as a given”.

“I would caveat that by saying that there are experienced and skilled VCTs [managers] who are capable of finding their way through the challenges of the changing environment. It’s important to look at what’s going on in the engine room,” he says.

Looking under the bonnet of an investment may be difficult for advisers working independently, but Jeannette Cottrell, Associate Director at financial planning business Tilney Group, says they have a dedicated VCT research team and write substantial VCT execution-only business.

“[The team] goes out and does the underlying research, so when clients go onto our website they can print out a factsheet,” she says.

“They have to do a questionnaire with qualifying questions. Hargreaves Lansdown do this as well, and others. We know our top picks as a company. The research team has good relationship with the various VCT managers.”

This also means Tilney knows who is coming to the VCT market and they organise teach-ins for the planners and investment managers.

“Normally, we do VCT work from November to April, along with the tax year, but this year we’re starting it earlier, in September. We think some long-standing VCTs will come to market with top-up offers,” says Cottrell.

We offer VCTs via our execution only service and they attract a 5% initial charge which can be rebated back to the introducer and subsequently the client, and there is an underlying trail commission “typically 0.5% ”.

“If you are an existing investor you get a bigger discount on the initial charge, and there are opportunities to buy in on the secondary market, so when you buy a significant size on the VCT you get that extra rebate,” says Cottrell.

However, Cottrell says Tilney are “expecting competition” in the VCT space as making VCT investments becomes more challenging.

“The supply is going to go down, VCTs are going to come to market with smaller tranches, and the demand is going to continue to go up, and that’s why we’re doing it earlier,” she says. “We want to be ready for when the top-ups come to market.”

Glencross is not sure top-up raises will even need to come to market for new investors as they could be filled by existing investors.

“I think some VCTs have done the fundraising before 6 April 2018 because certain rules would hit afterwards,” he says. “It may be that people are coming back with £10 or £20 million, and it’s likely to be filled up with existing investors without going up in the market, the demand-supply equilibrium is going to be tighter.”

It is not just Tilney that is getting an early start on VCT season, David Golding, an independent financial adviser at Charterhall Associates in Essex, says he is already talking to a number of players in the market.

“The thing I really like about the industry is that they aren’t necessarily all going to have great ideas all the time; it’s refreshing that they will say you can get a lot of ideas by discussing with others in the marketplace,” he says.

“If they don’t have the capacity to take your money, they would rather it went somewhere where it would do OK.”

Glencross says that this should be more the case moving forward, with money shared more equally among managers as their raises are smaller.

“My observation is that there have been managers who are quite happy to take as much as possible on the basis they will put it to work,” he says. “That should change, and it will change. VCT managers will only raise what they feel they can employ, they don’t want to impact their ability to provide good returns.”

He says although all managers say they can continue to find opportunities, those who have raised more money will find it harder to invest.

“VCTs have not traditionally paid big dividends when they have made exits. It’s going to be interesting for a few years to see if VCTs pay larger dividends when they have a good exit. My view is that you shouldn’t necessarily look to who raises the most, but for who might be sensibly carving a position in the market and might have an appropriate deal-flow.

“It’s not always those who shout loudest who deserve the most attention.”

The VCT industry will also be limited by its “incredible consolidation”, says Glencross, which he described as “sad”.

“You need to keep the industry fresh, but there are no new entrants,” he says. “I don’t think size is necessarily a wonderful benefit. I think it may be that size can start to be an impediment, although if you are big, you are obviously well-established.”

One other issue the VCTs will have to contend with is greater scrutiny f fund charges, something that is being looked across all investment asset classes.

There are two different types of VCT charges, one that charges the company an investment fee and others who take a fee from the deal value.

Glencross says the management fees are around 1.5% to 2% a year and the high charges are because VCT investing is “not like picking a set of investments from the Euro Top 500”.

You have to proactively work with it to make it successful, both to take out unnecessary risk, and to capture as much upside as possible

“This is real investing, both finding good investments, and doing your due diligence, documentation, everything,” he says. “We all talk about making investments, it takes five years to see a growth investment deliver value.”

He says he banned the word ‘monitoring’ at Calculus as “you cannot monitor a growth investment”.

“You have to proactively work with it to make it successful, both to take out unnecessary risk, and to capture as much upside as possible,” he says.

“Most managers will take a fee from the deal total, which is a private equity industry norm. When it’s taken from the company; if you are taking a 30% investment in a company with good growth prospects, the other shareholders are unlikely to be willing to pay your deal fees in that, and therefore you are in danger of not getting access to the best opportunities.

“Also, generally, people that do are investing in smaller investments and are taking a larger stake and make the company pay.”

“It doesn’t matter whether it comes from the company or the investment total, it’s essentially all the same pot,” says Glencross.

“Other fees are fine within reason and are industry parameters. You can’t equate this with a form of investing with quoted equity funds which, essentially mirror the FTSE index, this is real investing.”

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