Boom Time

VCTs were established by the last Conservative government to encourage investment
in new UK businesses, with subscriptions for new shares in VCTs offering lucrative
tax benefits to tempt investors. However, falling stock markets between 2000 and
2003 meant that fewer investors needed to shield capital gains from the taxman. This
led to a big fall in VCT demand post 2001, and prompted a change of stance from the
Chancellor, who despite scrapping the deferral of capital gains tax, increased the
income tax rebate to investors in VCTs from 20% to 40% for the two years to
2005/06. This led to soaring demand, with investment sales in VCTs for the tax year
ended 5 April 2005 hitting £500 million.

Despite the Chancellor praising VCTs for the positive influence on growing
businesses and confirming his intention to ensure the long-term sustainability of the
VCT market, it would appear he intends the margin of relief for 2006/7 and
subsequent years to revert to 20%. The venture capital industry is trying to ascertain
the potential implications on the VCT market as we speak.

Most VCTs aim to invest the majority of assets in qualifying companies, including
those whose shares are traded on AIM and OFEX. New issues on AIM have
continued to boom throughout 2004 and 2005 with in excess of 870 admissions to the
market (40% of total admissions since the market’s launch), so investment
opportunities are potentially strong.

Nevertheless, how many companies will be tempted to come to AIM prematurely to
take advantage of this one-off opportunity? Certainly, competition between VCTs for
good AIM and unquoted company investment opportunities is strong, as funds fight to
woo the most promising businesses. This combination of financial boost and the
‘three years to invest’ time constraint imposed on the VCTs could cause significant
problems. Unless they undertake appropriate due diligence the market could become
the next bubble attracting the appalling publicity that has dogged the financial
services industry for so long. With an upper ceiling of £1 million to invest per
company, and accordingly less available to spend on due diligence, the opportunities
for rigorous due diligence are limited.

Market Implosion

VCTs became unfashionable investments when the financial markets imploded in
2001. The combination of a limited requirement for a vehicle for individual investors
to roll over disappearing capital gains, and the poor performance of the many VCTs
that invested in emerging tech stocks, contributed to the funds falling out of favour.

Yet, according to stockbrokers Charles Stanley, despite widespread belief, VCT fund
performance over the past few years has not been bad. Indeed, on average, ignoring
any initial tax relief and taking into account the three-year period in which a VCT will
invest, the performance has been acceptable in relation to that of the general market.

Too Soon?

With competition between VCTs for investment opportunities fierce, how many will
end up making poor decisions simply to find a home for the money?

Of course, for those investing in new AIM stock, it is reasonable to expect that the
sponsor has undertaken due diligence prior to putting the prospectus together.
However, being realistic, there are many small companies coming to AIM with a very
small market capitalisation. They are opting to get investment from VCTs because the
money is available now and so few private equity funds work in the sub £5 million
investment area. These companies are likely to have no liquidity in their shares, and
they face the higher costs associated with being a quoted company – from increased
corporate governance to extra auditing. Is AIM really the right place for these
organisations? If not, how many AIM VCTs will suffer from their willingness to
support this trend?

Flexible Due Diligence

With many VCTs looking to raise funds, the manager’s track record will be key. For
those VCTs eschewing AIM in favour of private companies, the risks can be higher.

There is, therefore, a clear need for due diligence, particularly for small private equity
investments, though with a ceiling of £1 million per investment, VCTs cannot
possibly afford to undertake an in depth, all encompassing due diligence process. A
typical budget of up to 2% on due diligence does not stretch far. Even for those VCTs
opting to work together in a syndicate, while potential funds available for due
diligence are larger, there is still pressure to minimise due diligence costs. VCTs need
to be smart about targeting investigations, opting for highly focused due diligence
which addresses key business drivers.

From a check on working capital assumptions or the sustainability of margins to the
validity of forecasts or even the quality of senior management, such targeted due
diligence, undertaken by a third party expert, is highly effective.

Due diligence may result in advice not to make an investment, or more often the
process will raise concerns or issues with the potential investee’s assumptions, or
forecasts, that will result in a change in the terms of investment.

The due diligence process also looks at the ongoing support required by the investee
company. What support will a company require to meet its objectives and deliver
returns to the VCT? From additional management expertise and management controls
to raising further funds, both VCT and investee gain a clearer picture of the short to
medium term requirements. In addition to making better up-front decisions on
investment quality and expected rate of returns, carefully targeted due diligence will
enable VCTs to be better prepared to assist the company post-investment to meet its
objectives.