Despite the economic gloom affecting the bulk of the UK stock market, small-caps continue to thrive. ‘Smaller companies offer very attractive growth opportunities, even if the economy is slowing,’ observes Stuart Veale, managing director of the private equity firm Beringea. ‘It is not the same as it is for larger companies as they rely more on the whole economy. Small rapidly growing concerns in dynamic markets are showing good growth and we are investing.’

Veale oversees the firm’s highly successful ProVen series of venture capital trusts (VCTs), two of which won the VCT of the Year award from What Investment’s sister title, Growth Company Investor, after producing bountiful rewards for investors in the past few years. At present, ProVen has £36.6 million of available funds and recently pumped £1.25 million into online travel aggregator Isango and £1.75 million into security solutions provider Optic Vision.

Bridging the gap
The point of these specialist vehicles, which were launched in the 1990s and have lucrative tax incentives for investors, is to bridge the so-called ‘equity gap’ between banks, government grants and business angels, and more formal venture capital financing.  According to research by Business XL magazine, there is currently £1.02 billion of VCT money available for investment in growing UK companies. On top of this figure, even more will soon be accessible from the £116 million – and more – that has been pulled in so far by new and still-open funds.

Once funds have been raised, VCTs are obliged to invest at least 70 per cent of their cash within three years, so VCTs that were launched in 2006, for example, might be closer to parting with their money than others. Furthermore, the trusts can only invest a maximum of £1 million in any one qualifying venture.

As the principle of the scheme is to ensure funding exists for ambitious, but high-risk, UK ventures, the government has chopped and changed the rules regarding the size of company it sees as the crucial recipients. Originally, any qualifying business could not receive investment if its gross assets exceeded £15 million. This provided a large swathe of options in the smaller company space for VCT investment.

In 2006, then-Chancellor Gordon Brown revised this rule so that any money raised by VCTs before 6 April 2006 had to be invested in firms with gross assets of no more than
£7 million before investment (and no more than £8 million thereafter). Last year’s Budget saw further alterations, with the stipulation that newly raised money must only be put
into companies with fewer than 50 employees and that the ceiling of new VCT funds in any one venture cannot exceed £2 million.

Entrepreneurial activities
The reason for the changes is to keep VCTs focused on backing entrepreneurial companies that fit into the ‘qualifying business activities’ (see page 36). While some market observers believe that any changes to the investment criteria might hamstring longer-term activity, our research indicates that entrepreneurs have no need to worry about this for now.

This is because the majority of the pool of VCT cash was raised prior to 6 April 2006 and so can be invested in ventures with up to £15 million of gross assets. So, if a business has gross assets of £7 million or less – regardless of how many people it employs – all of this money is potentially available to it, as well as the £116 million that has so far been drummed up by 2008’s funds.  

Fitting the bill exactly is another recent plunge into the unquoted depths from Beringea, which backed the £7 million management buy-out of Oxfordshire-based Path Group, a distributor of consumer electronic accessories. Two of the ProVen VCTs financed the deal, adding two new non-executive directors to the board.

However, despite this recent incursion, Veale says the ProVen funds’ focus is now on growth capital investments rather than management buy-outs and buy-ins: ‘The companies we are looking at are relatively small, operating in a good market and are either growing particularly fast or occupying a niche. We are interested in all sectors, but a common theme of our investments is that they all have strong management teams and a good competitive advantage.’

Plenty of cash available
Despite their successful record, ProVen are not necessarily the most eye-catching to potential investees. Others have more cash,  for example.

Octopus Protected VCT is third in our list of cash-swamped trusts. Simon Rogerson, chief executive, can boast that Octopus’s many arms of VCT funds represent a whopping £250 million, in which Business XL calculates there remains £97.9 million available for further investment.

However, Rogerson says he is in no hurry to splurge. ‘Yes, we are sitting on a lot of cash but we’re happy to keep doing that. The economic situation has caused values to come down a little, but we think they will come down more so we’re being patient.’

He and his team divide their strategy and VCTs in three ways. The ventures team, via the Titan 1 and 2 VCTs, is focused on small, early-stage, unquoted companies, investing up to £2 million. Then three Eclipse VCTs back management buy-out deals of between £5 million and £20 million, and the Protected and Apollo VCTs provide mezzanine finance of around £1 million to £4 million. A recent deal saw the backing of an MBO of nuts and bolts maker HydroBolt.

This company had a lot going for it, explains Rogerson, as the company was well established and profitable, with good turnover, and ‘its exposure to oil and gas means it is well protected from potential economic woes. We invest in things that we think will become big businesses. In these economic times people have a natural scepticism of businesses that are very focused on consumers.’

A cold wind blows
The wider economic landscape is, of course, a concern for fund managers. Patrick Reeve, managing director of Close Ventures, whose funds have generally recorded strong performance and whose Close Technology & General VCT is the fourth most cash-rich, says values at the smaller end of the market are not falling but ‘we are beginning to see a little bit of distress in the current economic climate’.

And so in some sectors this is starting to affect how companies are priced. He adds, ‘Valuations are starting to be a little more aggressive, particularly in certain areas – small management buy-outs, technology less so, I think, but consumer-facing companies are being viewed more critically.’

But Beringea’s Veale has a slightly different view: ‘Businesses get an idea of what they are worth, so even when the cold winds of an economic slowdown start to blow they are reluctant to change their valuation.’ While some VCTs may be playing a waiting game, one thing is clear: literally millions of pounds have to be invested over the next 18 months.

Oliver Haill is head of research at Vitesse Media. This article is taken from the VCT Report 2008, published by Business XL magazine