Kin Capital in Professional Adviser

Because the Patient Capital Review is two months late there is a danger some decisions might get rushed through for the Autumn Statement. Tom Hopkins co-founder of Kin Capital explains.

Since the Brexit vote the hugely influential European Investment Fund (EIF) starting to turn off the taps. The government has released the Patient Capital Review (‘PCR’) in an attempt to review how the UK is supporting growth businesses, or, to use the new buzzword, ‘scale-ups’ both now and in the future.

There are essentially three key questions, here.

  • Is there an equity gap for entrepreneurial businesses?
  • If so, where is it?
  • How can the UK government plug it – especially given the EIF situation.

The EIF is a European Union agency, effectively funded by member states. It has been an important backer of British venture capital and accounted for more than a third of investment in UK-based institutional venture capital funds between 2011 and 2015.

More than that, it is an ‘anchor’ investor, which is vital for a successful fund-raise as it allows fund managers to build a book around the EIF commitment to the fund. Therefore, replacing the EIF is crucial for the UK government and hence it is reviewing solutions, and this includes the venture capital schemes (SEIS, VCT, EIS and SITR) which make up the tax efficient industry.

As a side-thought, perhaps the title ‘tax efficient’ for the sector probably doesn’t help the people in power understand what these scheme are actually doing for UK Plc.

Certainly is worth saying again that following the 2015 changes to the rules which cover the government’s venture capital schemes – more capital than ever is flowing from these schemes into growth businesses.

Gone are the days of fund managers raising £100m and carpeting Cornwall with solar panels, with the investors getting their 30% income tax relief and also benefitting from the investee companies receiving government’s renewable feed-in tariffs.

A strategy that was extremely scalable for fund managers and delivered for investors, but didn’t do much for growth businesses (although one could argue it kickstarted the UK’s green revolution).

Now the ‘growth and development’ and other qualifying rule changes mean that more EIS and VCT funds than ever are being invested into jobs, new products and the economy at large. This, of course, is a positive development.

In 2013 I wrote an article for Tech City News bemoaning the lack of follow-on capital. I said that while the government had done much to promote the growing entrepreneurial culture in the UK its job was only half done, and to finish the task meant increasing the ECF programme and redirecting the venture capital scheme capital. Last year, the government announced a further £400m for the ECF programme and the 2015 rules changes mentioned above have directed the flow of funds.

Baby with the bathwater

So all well and good? Well, not quite. The issue is that the PCR is reviewing the venture capital schemes based on old data and there is a danger that the baby will get thrown out with the bathwater.

The consultation paper rightly questions the value of the historical low risk schemes but the comparative cost of the schemes fail to take into account the rule changes.

For instance, VCTs look costly (£0.90 – £1.22 cost per £1 of additional investment) but that is due to the fact that historically the majority were investing in stable management buyouts business which produced a steady tax-free dividend back to investors. This is no longer allowed and VCTs are investing into higher risk growth businesses.

EIS cost comes out better at £0.57-£0.73 but again will be distorted but legacy investment strategies that are no longer allowed, eg renewable energy. At least the report small print does flag that costs should be considered against outcome.

For instance, Parkwalk EIS fund did an analysis of its portfolio companies – the amount paid in PAYE and NI was double the amount of EIS tax relief in one year only. Actually, the payback period for UK Plc was just six months which is a great investment in anyone’s books.

The good…

Some sectors would seem to be more in favour than others and the PCR consultation paper again highlights the government’s recognition of the importance of university spin-out companies in building the ‘knowledge economy’. These are the sorts of businesses in which the UK has a competitive advantage and needs to maintain this post-Brexit.

In 2015 the government made its first carve-out for ‘knowledge intensive’ businesses, making the EIS rules more generous for these businesses. And we may see further concessions in terms of qualifying criteria, to increase the numbers of companies deemed ‘knowledge intensive’…and it’s not out of the question that the the amount of tax relief for these types of businesses is increased. Parkwalk EIS which raised £50m last tax year invests only in these types of businesses so could be set to benefit.

But it is important not to forgot about non-tech companies as they create plenty more jobs. Pembroke VCT’s portfolio of consumer business companies, for example, has created thousands of jobs, with the likes of Five Guys going from 0 to 60 sites nationwide in three years.

Advisers and investors might be wise to stick to growth investors whose investment strategies have not changed over the last couple of years due to rule changes and who in the eyes of the government growing UK Plc.

The bad…

It is interesting to note the ‘Patient Capital’ definition at the beginning of the report – ‘make a return from substantial growth of a business rather than through short-term profits from low risk projects’….’supports entrepreneurs to bring disruptive innovation’…’led by ambitious entrepreneurs who want to build large-scale businesses’.

The consultation paper estimates half of EIS funds had a capital preservation strategy, though historically by quantum of cash I’d put this number at 75% although this is changing.
However, the report is fairly clear in what it thinks about ‘capital preservation’ strategies that effectively turn a venture capital tax relief into a modest investment return. While the rule changes in 2015 have addressed some of the issues the paper makes it clear that the remaining ‘low risk’ schemes are in the sights.

So advisers and investors need to think carefully about what sort of products they are backing…the question they need to ask is “Is this product on which I am getting tax relief also bringing genuine benefit to UK plc?” Those that produce synthetic tax planning products are going to find it harder to justify what they are doing and investors are likely to be more sceptical.

The ugly…

Is this the beginning of the end of BPR products. As the paper points out BPR was introduced to help family businesses pass on firms to the next generation. It was not designed for an investor to hold 0.00001% of a private company providing bridge property loans. The PCR estimates this pool of capital to be £4bn per year and whilst this includes AIM listed investment strategies which are supporting growth businesses, a sizable chunk could not be classified as ‘patient capital’.

While BPR / BR is not included as an approved venture capital scheme it is a tax relief that is seen as part of the tax efficient market, and its growth over the last few years has now put it firmly on the government’s radar.

There is a danger that the government change the rules so that this tax relief is redirected to family businesses, so, say, beneficiaries have to hold the shares for x number of years post investment. Regardless, this is one tax relief that is most at risk of a rule change and so advisers should be wary.

Fistful of dollars

Undoubtedly, the venture capital schemes can play an important part of the patient capital solution and I hope that comes through in the responses to the consultation. There is already talk of £800m plus VCT supply this tax year and demand might match it. Likewise more and more people are willing to take risk for a growth return under EIS. So there will be plenty of capital available to growth businesses from these schemes now that the new rules are in place.

And whilst the paper mentions, and some would question, the rich getting a tax break for making these investments that misses the point – these schemes have done more than people realise to stimulate entrepreneurship, and hence growth and job creation and ultimately tax receipts. Plus until institutional investors are willing to take the risk then only right that tax reliefs remain in place.

The venture capital schemes are there for the government to use and work alongside the UK’s new EIF. It should use them not lose them and take advantage of the funds raised to grow UK Plc.

The original article can be found in Professional Adviser here