There is an old investment adage that brave investors should put their money to work at the sound of gunfire. What may look like bravery if you are an individual investor, however, can look very much like recklessness if you are managing someone else’s money.
Fund managers by nature are more circumspect and the kind of uncertainty we are facing now – trade wars, the general fear of recession and, of course, Brexit – makes one feel the opposite course of action, of sitting on the side-lines, might be more appropriate. The overriding focus for any fund manager should be on delivering a positive outcome for the investor. They have placed their faith in the manager’s ability to invest sensibly at all stages of the economic cycle.
This is particularly the case with a venture capital trust (VCT). While they are a tax-advantaged product, VCTs should not be marketed on the basis of their attractive tax breaks alone. What fundamentally guides their managers is they are seeking to create value for all their clients, both old and new.
The rules surrounding state-aided funding
The restrictive nature of the rules surrounding VCTs means their managers need to be very careful about the amount of money they raise. It is a fair guess at present that demand for VCTs is outstripping supply. Yet to feel comfortable about issuing a new offer for subscription, managers first need to be confident they can invest any new capital sensibly, wisely and in compliance with the many and various VCT rules.
By virtue of the rules surrounding state-aided funding, the type of companies VCTs invest in are typically at an early stage in their development. Understandably, this is the ‘quid pro quo’ of the attractive tax breaks – HMRC wants evidence that funding leads to significant job creation and that tax breaks are effectively more than paid back through growth in income and corporation tax receipts. In other words, HM Treasury wants to be sure it is getting its money’s worth.
Clearly, investment in early-stage companies involves particular and very real risks. While start-up companies might have very exciting prospects and be run by highly motivated and entrepreneurial management teams, they remain inherently more risky investments.
How to invest in early-stage companies
There are certainly a lot of small companies around, and managers will obviously want to try and partner with the ones that are most successful. Many successful VCT-qualifying companies are deciding to stay private for a little longer than might have been the case in the past, which is leading managers to do a higher proportion of their initial investments in unquoted businesses.
In early-stage investing, it is massively important to get in at the right price – that is to say, when the valuation is most attractive. This is particularly relevant in the world of venture capital investing, where early-stage investee companies might require multiple funding rounds before achieving break-even and where the time horizon to successful exit is inevitably longer.
As an example, we have investments within the portfolio that we have held for well over a decade and which in the early years often struggled to make a meaningful contribution to overall performance. In recent years however, many of these have become substantial and highly valuable businesses. When a business starts to gain momentum, the return on investment can start to become really significant, which is why patience and paying the right price for an initial stake are so important.
Companies staying private for longer
A good illustration of this phenomenon is Hasgrove, which started life as a digital marketing and corporate communications agency, listed on AIM and subsequently went through a number of good and bad years before ultimately deciding to delist from AIM and divest itself of all its volatile and unpredictable business activities. By 2013, Hasgrove was a private business again in which we had decided to retain a sizeable stake. Hasgrove (Interact) is now a thriving, cash-generative and healthily profitable business.
Another example would be Interactive Investor. We all know how well the investment platform sector is doing, especially in view of the successful flotation of AJ Bell in November 2017. Although Interactive Investor currently remains a privately held business, it is rapidly becoming an increasingly credible competitor to the likes of Hargreaves Lansdown and AJ Bell, following a series of successful acquisitions that have enabled it to generate real scale in assets under administration and customer numbers.
Both Hasgrove and Interactive Investor now feature within the top 10 of our most valuable holdings and each is likely to add further value as they continue to build on their success. As it happens, they are both examples of an increasing trend for successful private companies to stay out of the public realm for longer.
Now, there are obvious and logical reasons for the emergence of this trend – most of which are related to the economic and political turmoil surrounding Brexit. Capable management teams running successful private businesses are questioning the wisdom of a public listing, particularly if there is no pressing requirement to provide liquidity.
In these uncertain times, management and owners are choosing to defer embarking on an expensive and possibly disappointing IPO exercise. Equity markets are also currently volatile due to the political and economic backdrop and you can easily waste an awful lot of time speaking to corporate finance experts and institutional investors when you should actually be focusing on successfully navigating your business through a stormy and uncertain period.
The compelling arguments for seeking a public listing will no doubt return in due course but, in the meantime, we are able to enjoy the advantage and flexibility offered by being able to invest in companies that operate in either the public or private arena.
Liquidity in VCTs
The notion of patient capital has taken a few knocks of late and this has, perhaps naturally, led to an increase in squeamishness regarding investment in more illiquid stocks. This concern can and should be addressed.
A portfolio approach to investment gives investor access to a wide range of companies across a diverse range of sectors that would be extremely difficult to replicate as a private, retail investor. An established and maturing VCT offers investors exactly such an opportunity while also allowing the opportunity to access an existing pool of assets from day one, which has the potential immediately to deliver upside, while mitigating against the risk of total loss on investment by virtue of its diversification.
Chris Hutchinson is manager of Unicorn AIM VCT
