The unwillingness of banks to lend has opened up new opportunities for venture capital trusts (VCTs). Jenny Lowe reviews the prospects for these growth-orientated, tax-efficient vehicles

There are some beneficiaries of the credit crunch, and the contraction of bank lending has opened up new opportunities for venture capital trusts (VCTs) to back growing businesses. Since the credit crunch began, we have seen large financial institutions crumble and lending dry up almost completely, making it a very difficult time for smaller companies.

But for these growth-orientated businesses, there is a lifeline available in the form of VCTs. The general outlook is a positive one, with many VCT fund managers believing that the economic slowdown has, in fact, increased investment opportunities.

Richard Power, manager at Octopus Investments VCTs, explains, ‘It has been the perfect storm for smaller companies, in that banks have been pulling back on lines of credit, creating a major impact on funding for small companies.

‘The Alternative Investment Market (AIM) is awash with investment opportunities in the form of small, growing companies that are feeling the double squeeze of banks withdrawing funding and the reduction in AIM VCT cash available to invest.’

Encouraging enterprise
VCTs were introduced in 1995 by the then Conservative government in an attempt to encourage investors to back smaller, higher-risk growth companies. In order to achieve this they offered generous tax breaks, including the ability to defer capital gains tax (CGT) on the full amount invested in a VCT.

However, since their introduction, the rules have changed several times, and although CGT deferral on initial investment is long gone, VCTs still offer key tax incentives in the form of a 30 per cent income tax rebate on the initial investment – providing you hold your VCT shares for at least five years – tax-free dividends and no CGT liability when you come to sell your VCT shares.

Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC), enthuses, ‘VCTs allow you to gain exposure at a relatively low cost to a professionally managed portfolio of privately owned companies, and AIM- and PLUS-traded shares. They also make an important contribution to the economy by investing in smaller, potentially high-growth, businesses that promote innovation, industrial change and modernisation of working practices.’

While this may sound like the perfect tax-efficient, recession-beating investment product, opting for a VCT does have a downside. As VCTs invest in small, often privately owned, companies you need to bear in mind that they are higher risk than funds that include more established firms. 

‘VCTs do have significant tax benefits for investors – income tax relief on the initial investment when buying new VCT issues providing you hold these shares for at least five years, plus tax-free dividends and tax-free capital gains,’ says Brodie-Smith. ‘So it is important that investors take a long-term view and are prepared to hold VCT shares for at least five years. However, you shouldn’t invest in a VCT solely for the tax benefits – it is important to look at the investment case too, as you would with any other investment.’

Backing a winner
With the tough economic times forcing banks to withdraw funds, VCTs are well placed to do deals to provide the much-needed capital to small, growing companies in their early years.

Stuart Veale, managing director of global private equity and investment banking firm Beringea, explains, ‘Companies raising equity finance now have lower valuation aspirations, allowing VCTs to negotiate more attractive investment terms than have been possible over the past two to three years.’

‘The economic slowdown may well provide good opportunities for VCTs to invest in quality companies at a reasonable price,’ agrees Brodie-Smith. ‘As well as providing capital, VCT managers have a hands-on approach and provide essential advice and support to develop smaller companies.’

And Mark Wignall, chief executive of Matrix Private Equity, agrees that a slower  economy has created opportunities to buy into smaller companies at lower valuations: ‘The slowdown in economic growth and highly volatile markets has fed through to ideal conditions for buying into companies at much lower prices. With their consistent, long-term investment programmes, VCTs are well placed to meet strong demand at much more attractive prices.’

He continues, ‘In 2009, VCTs will become a mainstream source of finance for smaller companies to grow, and to finance change of ownership. Set against the high street banks’ traditional commanding market share, this change will create a huge new flow of opportunities for VCTs to consider.’

New funds drying up?
However, some sector specialists are concerned that fundraising will become an issue in 2009.

‘Most VCT managers are agreed that achieving decent levels of VCT fundraising
in the current tax year is going to be a big challenge,’ notes Donald Maclennan, partner at Foresight Group. ‘VCTs are ideally placed to help the government in its objective of maintaining the flow of capital to small and medium-sized companies, and we may need to look to government to improve the attractiveness of VCTs to investors to allow VCTs to meet this role effectively.’

One positive note is that, earlier this year, HM Revenue & Customs (HMRC) announced that it will meet back claims of VAT for VCTs, a move that will allow these trusts to recover an estimated £30 million.

There are currently seven generalist VCTs raising new money, along with a couple of more specialist vehicles (see table below), the largest being TP5 VCT Plc at £50 million.

But in addition to new fundraisings, recent figures reveal that there is an estimated £1.02 billion of VCT money available for investment in companies that qualify in the UK; and on top of this, a further £116 million is expected to be made available shortly. The manager of a VCT has three years to invest at least 70 per cent of its funds in qualifying investments, and these funds can be put into cash, gilts or bonds in the interim.

VCTs are structured in a similar way to conventional investment trusts, and are listed companies in their own right. In order to qualify for VCT investment, a company must be a trading company based in the UK with gross assets of less than £7 million at the time the investment is made and fewer than 50 employees. It can receive a maximum investment of £1 million and must have raised no more than £2 million from venture capital sources within the previous 12 months.

Plenty of options
Maclennan reports that ‘2009 will be a very busy year. We have had a healthy intake of opportunities on the environmental infrastructure side of our business for many months now, and more recently we have seen an increase in our management buy-outs and growth capital investment activities.’

And Stuart Veale agrees that the investment environment for small UK companies remains positive despite the current market uncertainty: ‘2008/09 will be a strong vintage year for VCT investment. Entry prices have reduced significantly from the high levels we have seen in the past few years, in part due to banks’ unwillingness to provide SMEs with financial support, allowing VCTs to invest in promising businesses at attractive valuations.’

He also acknowledges that ‘The performance of smaller companies, like the ones VCTs invest in, depends much more on the health of the specific sector in which they operate than the output of the whole economy.’