The regulations on venture capital trusts (VCTs) are due to expire in April 2025, and their directors are already lobbying for changes. A 10-year “sunset” clause was agreed in 2015, when the UK was part of the EU, so will that spell the end of VCTs?
That’s hardly likely. At a recent shareholders’ day hosted by British Smaller Companies VCT, it was pointed out that the sort of businesses in which VCTs invest are new and growing wealth creators, which have the ability to learn fast and adapt as circumstances change, so it’s in the national interest to encourage them. The UK has a particular problem here because of its overcentralised government and centralised banks. Local authorities lack the resources to support local businesses in the way that applies in many other countries, and traditional banks tend to be inflexible and cautious. Banks expect to see positive cash flow projections and accumulating profits, and while they’ll lend to cover short-term losses, they don’t see their role as funding lossmaking early-stage businesses in the hope that one day they’ll become profitable. The risk is too high – after all, on average, about one in five of all new businesses are said to fail in their first year.
This funding gap was recognised in the Patient Capital Review, published in 2017, which led to the government saying it would provide more than £20bn in growth finance to innovative firms over the next 10 years. Besides establishing the British Business Bank, which relies on the private sector to identify and invest in growing businesses and then co-invests alongside them, the role of VCTs was seen as vital in scaling up fledgling companies that have proved to be viable. Typically, these companies will be micro-managed by passionate founders and worth less than £4mn. For them to grow into companies worth over £10mn requires more funding and professional governance. A coherent management structure has to be set up, and the founders have to trust in team-based decentralised decision-making. The need to reinvest for growth might mean that they remain lossmaking for several years – perhaps as many as five or more.
Generalist VCT managers provide funding in return for acquiring shares in the company and placing someone with the needed expertise on the board. They also use their network of contacts to help fill key positions. But it’s high-risk, so they have to be selective. They subject potential opportunities to a rigorous vetting process involving face-to-face meetings, company visits, financial and legal diligence and, most important of all, assessing the top management. The initial checking process might whittle every 100 opportunities down to about 20; the more intense scrutiny that follows might reduce this to just one. Even then, some of those taken on will disappoint. Anyone investing in a VCT has to accept that there will be some failures, hopefully more than offset by the occasional spectacular winner.
The case for VCTs is that, if they did not exist, they would have to be invented. By backing innovative small companies, jobs are created, which contribute to economic growth. What reservations, then, might the government harbour?
First: reduced tax receipts for the UK Treasury. Investors in new VCT issues receive tax-free dividends and capital gains and can offset 30 per cent of the amount invested against their income tax liability. Demand for them has increased as pension tax reliefs and allowances have been tightened, so are VCT reliefs too generous? Probably not. The Treasury can expect long-term benefits from the value that VCTs add to the economy, while investors face many disadvantages. Initial share price erosion is common, and fees are high – all that intense due diligence and the monitoring afterwards has to be paid for. VCTs have to be held for five years or longer, and selling them relies mostly on each VCT buying back its own shares. A recession would stress-test their resilience – expect some of their investee companies to suffer losses of earnings. Now is not the time to make them less attractive.
Secondly, the current regulations require expanding companies to hold their headcount down to less than 250 full-time employees and keep their gross assets to below £15mn if they wish to continue to qualify for VCT funding. They cannot be funded by more than £5mn in any 12-month period, with a cap of £12mn over their lifetime. VCT managers say that relaxing these constraints would enable them to make a greater contribution to the UK economy, and to back this up, they point out that even within the EU, the UK could have applied the EU state-aid constraints (designed to protect the single market from unfair competition) less strictly.
But that’s a double-edged sword. If the UK was to relax VCT regulations to encourage more investment, some might question why they were made so restrictive in the first place. A looming recession might provide a suitable political smokescreen.
