By Oliver Warren, Investor Relations Associate
Since April 6 last year, £580m has been invested in VCTs, a record amount at this stage and a more than impressive show of confidence in the UK’s early-stage ecosystem during a period of considerable upheaval. With investors looking to alternative asset classes like venture capital for returns, pension contributions tightening and an increase in dividend tax rates, it is likely that this figure will only increase year on year.
There is, however, a growing need for diversification. With the average individual investment at £32,000 annually this relatively small portion of an investor’s portfolio is often used to top up the same VCTs. In the 20-21 tax year 52.9% of non-AIM VCT money went into just 4 VCTs out of the year’s 18 offers. This is well reflected in the previous two tax years as well. Investors and advisers alike are inclined to revert to the old adage ‘if it’s not broken why fix it’.
It appears the very idea of modern portfolio theory and diversification, which is so widely applied across risk rated portfolios, is being broadly ignored when it comes to a VCT allocation. Investing in an asset class where reliable names hold sway and size infers safety this is perhaps unsurprising, however at an investor level concentration risk is unknowingly rising to levels that would typically set alarm bells ringing.
Furthermore, VC portfolios tend to experience concentration risk more acutely than funds with listed equities as a small portion of underlying companies grow exponentially whilst the failures drop out, skewing the portfolio’s weightings towards a handful of holdings. Afterall, the UK has one of the most competitive venture capital landscapes globally so large raises are more likely to contribute to cash intensive follow-ons than newly discovered start-ups.
Following on from the rule changes in 2015 and 2017 VCTs are now more in line with ‘risk to capital’ investing, which means that exciting growth orientated companies are the sole focus. The long running bellwethers of the market will slowly dispose of their asset backed and MBO companies and buy early-stage growth companies. This shift in what’s ‘under the bonnet’ has forced investors to increase their appetite to risk. Gone are the days when VCTs operated capital preservation strategies and were looked at solely for their tax reducing merits. They are now a staple part of a sophisticated investors portfolio offering a ‘risk on’ approach and a low correlation to traditional markets. When adjusting for this heightened level of risk and volatility diversification should adjust accordingly.
Benefits of investing across multiple VCTs
So why would an investor split or alternate their annual VCT subscription? Well, for just the same reasons they would typically invest across a couple of UK Equity Funds, it is standard practice when implementing a strategic asset allocation across a blend of third party asset managers
VCTs have different sets of goals and with those different strategies and styles. They invest in a wide range of sectors from technology to healthcare and media. Whilst generalist VCTs have a ‘go anywhere’ approach the managers tend to have sector specific expertise encompassing a few particular areas. By diversifying across a wide spectrum of the UK’s most successful industries steady returns can be achieved even when one sector is adversely hit. During the pandemic this divergence in sector performance was thrown into heavy contrast as the consumer and retail space came to a grinding halt, whilst the life sciences witnessed a renaissance alongside the continued acceleration of technology companies. The Calculus VCT predominantly invests in the latter two sectors alongside the creative industries, which offers strong synergies and a tilt towards one of the fastest growing areas of the UK economy, and happens to be a relatively untapped by our peer group.
VCTs are also more inclined, unlike investment trusts focussing on listed equites, to have a geographic focus to certain parts of the UK. Company deal flow tends to be more localised and post investment the ongoing management more active, requiring close communication, seats on the board and continual oversight. Proximity is broadly recognised to offer long term benefits. Diversifying with a regional predisposition can therefore provide valuation improvements as well as other useful advantages.
Lastly, VCT managers tend to look for companies at different stages in their growth trajectory. Some might target established, revenue generating businesses, led by proven management teams, others may look for early-stage entrepreneur led companies with higher growth potential. A blend of both approaches dampens down volatility improving both income stability and the probability of capital growth. Investors should assess this alongside the potential of each portfolio and their ability to make new investments for future growth. It would be prudent to look at whether the VCT has a mix of mature investments ripe for sale -the ultimate objective for a VCT is to achieve profitable exits, thus sustaining the dividend stream. In 2021 the Calculus VCT achieved 7 exits with an average return multiple of 2.3x.
As the last few years have shown venture capital makes a compelling addition to a modern, risk managed portfolio, putting UK investors in a particularly fortunate position. We have a range of listed investment companies, with tax reliefs, concentrating solely on the space. However, in an economic environment of seemingly endless growth and increasing asset prices we need to start treating this allocation like any other. Diversification across a number of high-quality generalist VCTs paying attractive dividends is now, with everything considered, the only sensible strategy.