Despite the fall in fund flows into VCTs, they still offer an excellent way of accessing a diverse array of growing companies
Interest in venture capital trusts (VCTs) in the months leading to the end of the tax year (2001-02) was significantly lower than in previous years. Estimates put the total raised during the last VCT season at around £113.18m, some 58% short of the figure targeted.
The fall in funds flowing into the VCT sector is mostly a reflection of fewer investors having capital gains to shelter this year rather than the investment environment for private equity managers.
VCTs are still seen as primarily tax planning vehicles, offering CGT deferral and a 20% income tax rebate with capital and income distributions free of tax.
While these incentives are attractive, investors should not forget about the attractions of the underlying investment, particularly at a time when there is a trend to diversify portfolios away from quoted equities into other asset classes, such as private equities.
Unquoted company deal flow is buoyant at present. There is generally less competition to win mandates and the typical entry prices for private companies are cheaper than they have been for some time.
With prospects of an economic recovery, now could be the best time to invest in private equity, particularly when some commentators forecast quoted equity returns to be muted.
There is also evidence of private companies outperforming quoted companies in the business marketplace. In particular, entrepreneurial management and shorter lines of communication have allowed smaller companies to be much nimbler in their chosen markets, and this has often resulted in them gaining market share quickly from their larger competitors.
Over the five-year period to 2000/01 unquoted companies' sales rose by 27%, more than double that achieved by FTSE 100 companies. In addition, sales growth was just under two times higher than that for FTSE Mid-250 companies.
Overall during the five-year period, the average private equity backed firm increased annual sales revenue by 57% from £14m to £22m. As a result of increased sales, exports by unquoted companies grew by 27%pa compared with a national growth rate of just 4.4%pa (source British Venture Capital Association) Consequently, investment in unquoted companies is now a big part of the UK economy. In 2000, over £8bn was invested in 1,523 companies. Investment in start-up companies rose by 37% and in early stage companies by 141% to £175m and £528m respectively (source BVCA).
This growth in business has been reflected in the returns of private equity funds. According to the BVCA, the returns of private equity funds raised between 1980 and 2000 measured to the end of December 2000 were 26.4% over five years and 20.4% over ten years. During both periods, these returns outperformed the FTSE 100 and FTSE All-Share indices. In terms of opportunities within the Alternative Investment Market (AIM) for VCT managers, these may be slightly more limited. Managers can only invest in new issues and are therefore entirely at the whim of the volume of companies coming to the market ' and for the next three years, there is serious some doubt about the volume and quality of new issues.
Consequently, it is imperative that VCT investors' portfolios are not restricted to any one venture capital category, such as AIM. Key to sustained outperformance will be the fund manager's ability to fish from the biggest pool of companies. Such portfolios are only accessible via generalist VCTs.
Although AIM VCTs can offer investors a number of attractive stocks, they are probably too restrictive in the current market. Generalist VCTs can cherry-pick the best companies from a variety of investment situations and while this may well include AIM stocks, crucially the manager will mostly look at unquoted situations, where private companies need expansion finance or perhaps want funding to help with a management buy-out.
This lack of restriction allows the generalist fund manager to pick best of breed from each venture capital category.
Despite the reduced fund flows into VCTs this year, our ability to capitalise upon the current opportunities within the venture capital market will not be affected due to the number of additional private equity funds we manage.
Specifically, Aberdeen is one of the biggest VCT providers in the UK, managing private equity portfolios with total assets in excess of the £500m. The ability of our VCTs to co-invest, together with our other private equity funds, in transactions requiring in excess of £1m allows them to collectively access larger deals. This achieves a broader spread of risk than would be the case if they were to invest individually, only in smaller transactions. For example, so far Aberdeen Growth Opportunities VCT has raised £8.3m and it is intended that there will be at least 30 qualifying investments held in the portfolio at any one time. Consequently, the average initial cost of each holding would tend to be in the range of £2580,000 to £300,000. Unquoted companies requiring financing equal to £280,000 tend to be small and in early stage development with a high risk of failure. These circumstances can arise for a number of reasons, including simple bad luck, but a recurring theme is an over ambitious business plan and/or a senior management team who aren't quite up to the mark.
The business and management of risk can generally be more easily mitigated by investing in more proven, later stage businesses and sectors with known or predictable demand. These tend to require greater amounts of capital than smaller, early stage companies.
In larger, later-stage transactions, it is typically much easier to assess the ability of senior executives. In a Management Buy Out (MBO) opportunity for example, it is normal for the team leading the buy out to have been in control of the business for some time before the proposed transaction.
However, access to MBO deals generally requires a larger investment from a venture capitalist, which is why co-investing amongst funds can be so beneficial.
Once an investment into a company is made the investment managers' job is far from over. Small to medium-sized unquoted companies often require management assistance as well as capital investment. In many circumstances it is important for the managers to have the expertise to provide commercial, accounting, legal and corporate finance support to investee companies.
The portfolio management team continuously tracks the performance of investee companies, advising on strategy and managing the realisation process. In addition, a non-executive director will normally be appointed to the board of each investee company.
Unlike quoted equity managers, they can often sell shares at the press of a button, exiting from a private company takes time, particularly agreeing a time to exit consistent with the aspirations of the management team.
Before making an investment in a private company, the fund manager will estimate the likely timescale to exit, and the future potential value of the company at that time. This allows a reasonable calculation of and also the level of return.
However, the prospective returns available from effective private company investment make all the hard work worthwhile. For instance, a £2.3m investment into a company producing pre-packed sandwiches in July 1996 produced realised proceeds of £4.3m in December 1998.
The 87% return produced is superior to the performance of both the FTSE 100 and FTSE All-Share, and over three-quarters of UK equities during the period, including well known names such as Barclays Bank, HSBC and Shell.
Despite the fall in fund flows into VCTs, potential investors should not be put off. Assuming coinvestment support is available, VCTs can operate perfectly well almost regardless of size and remain are an excellent investment vehicle to gain exposure to the wide range of excellent investment opportunities found within the private equity arena.
They bridge the funding gap for smaller growing businesses and at the same time, offer the investor access to a diversified range of companies with exciting potential rewards in the long term; not forgetting the various tax benefits.
Unquoted company deal flow is fairly buoyant at present.
There is evidence of private companies outperforming quoted in the business marketplace.
It is imperative that VCT investors' portfolios are not restricted to any one venture capital category.
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