Tom Hopkins reflects on the ups and downs of the tax-efficient investment market in 2016/17 and, in the light of what on balance has proved a mostly 'up' year, considers what could happen over the coming 12 months
It is hard to think of a tax year that saw more challenges and changes in the world of tax-efficient investment than 2016/17. It was the first full tax year following changes to HM Treasury and HMRC rules.
The result of these changes - including the age of investible companies now having to be less than seven years - has generally seen the overall risk profile of tax-efficient investments increase and the market fragment.
From where we sit at Kin Capital, the highlights of the year were headed by the obvious fact venture capital trusts (VCTs) moved further towards the mainstream, with a near-record fund-raising season.
For their part, Enterprise Investment Scheme (EIS) funds saw total capital raised down on last year - although this was a reflection of supply rather than demand, and more cash was subscribed into growth funds. The official Seed EIS statistics suggest a fairly constant amount raised while the first social investment tax relief (SITR) funds also closed in the tax year, which could provide further tax-efficient product diversification.
Still, the higher risk profile shift and the potential damper it places on investor demand was outweighed by the effects of pension freedom changes and a clampdown on aggressive tax avoidance schemes, as well as investors being more willing to take the additional risk to generate growth returns.
On the supply side, the fall in EIS was probably impacted more by the rule changes than VCTs - hence the contrasting numbers - and certainly VCT supply was aided by late offers with fund managers taking advantage of the demand versus supply issue.
Furthermore, we might have seen the end of some of the larger-scale EIS funds given HMRC's view on ‘cookie cutter' and ‘low risk' companies - for instance, the tax year started with Octopus, the largest tax-efficient firm, exiting EIS over deployment concerns before going on to raise a record amount (£120m) for its Titan VCT. This pattern was replicated at a number of firms, further underlining the issues mentioned above.
VCTs second highest year
According to the AIC, VCTs raised £542m in 2016/17, which compares with £460m in 205/16 and is the second highest level on record. A fair number of funds closed early and some raised in record time. The following analysis from Wealth Club, a firm that offers direct investors access to a range of tax-efficient products, shows the fundraising progression.
Source: Wealth Club
It is worth noting Northern VCTs raised its £13m in under 48 hours while Octopus accounted for 27% of the whole market. And it was good to see some newer funds, such as Pembroke VCT, take advantage of the supply/demand dynamic and raise significantly more than in the previous year.
Additional VCT capacity/competition is a good thing for the industry and UK PLC in general. At the same time, the government and HMRC should be pleased that, following the VCT and EIS rule changes, most of the capital raised in 2016/17 will be deployed into growth businesses.
EIS numbers down
According to research firm Tax Efficient Review, EIS funds' numbers were down. While the data does not capture all capital raised under EIS, it does show the amount raised by the larger fund managers. The data reveals the EIS market fell 18%, which is understandable given the likes of Octopus exiting this segment of the market.
This trend is backed up by the official HMRC statistics that came out last month. These lag by a year - so the official amount raised in 2015/16 was £1.6m, compared with £1.8m in 2014/15. This drop is likely to reflect the end of renewable energy as a qualifying trade in particular.
As noted above, in the short term, the HM Treasury and HMRC rule changes seem to have had the biggest impact on the large scale EISs that were investing into companies replicating the same trade.
HM Treasury (driven to a certain extent by EU changes) wants this capital to go to growth investments and deliver value for money to the economy - in other words, those businesses near the start of their growth, rather than those at a more mature level of development. Again, this is reflected in the HMRC statistics, which showed a potential decline in the number of EIS advanced assurance approvals in 2016/17.
As a result there was an increase in growth investment, which accounted for 45% of the EIS market against 22% the previous year. Once again, this reflects the rule changes and lack of alternative products but it is also more an acceptance that, if clients want EIS exposure, they have to take on more risk. Again, this should be good news for UK PLC.
SEIS and SITR
The official HMRC statistics show SEIS numbers flat but, with the first funds coming out of their SEIS holding period, hopefully this area of the market will start generating returns to investors, which will in turn increase demand.
The first SITR funds closed during the year and, with the investment limits increasing from around £300,000 to £1.5m for sub-seven-year-old social enterprises, it will be interesting to see how that market develops. The first - mostly debt - investments were also completed.
So what next?
The rules for EIS and VCTs are now such that there will be more generalist funds investing in growth deals. How this plays with assets prices remains to be seen as more VCTs and EIS funds will be focusing on earlier-stage businesses. Either way, it is a good reminder of the importance of EIS and VCTs ahead of the patient capital review later this year, which will be reviewing the issue of attracting growth capital into small and medium-sized businesses.
The EIS will continue to be more fragmented and we might see some more asset-focused - as opposed to asset-backed - funds. Investors and their advisers will need to be mindful of the operational risk.
In a similar vein, be aware of asset-backed funds as, in some cases, the asset backing is meaningless if the company is generating losses. You only need to see some of the write downs during the last tax year in some anaerobic digestion EIS investments to understand the value of some so-called asset backing, even in the much feted renewable market.
Media EIS continued to prove popular and, given it is such an important part of the UK economy and it is supported by HMRC, it will continue to grow, which is why there were six funds in the market this tax year, which closed out in record time.
Given the market, nobody can say with total certainty what the various areas of focus will be this year. But with the still-recent rule changes, more tax-efficient funds will be invested into growth companies and they will be supporting UK growth.
The 2017/18 tax year will take in a general election (although at this point it is hard to see any change in government), the first autumn budget and a patient capital review (which will include VCTs and EIS) - all of which could impact the supply and demand dynamics for tax-efficient products.
One thing is for sure - it should be another exciting year for those in and around the sector.
Tom Hopkins is a co-founder and partner of Kin Capital, which provides fund-raising and fund management services to funds operating in government-approved tax-efficient schemes
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