By Matthew Moynes, Assistant Director of Investor Relations, Calculus Capital
Synonymous with UK venture capital investing is the attractive tax incentives provided by HMRC which help stimulate the flow of investor capital into this important asset class. This effective risk mitigation tool can often mean the integrity of the EIS and VCT investment structure can fall under enhance scrutiny, with some questioning whether the ‘tax tail is in fact wagging the investment dog’. That is why throughout this article there will be no further mention of the tax advantages underpinning the UK venture capital investment landscape, and instead the focus will be on its role as an important asset class within a modern day, risk managed, diversified investment portfolio.
There is a certain blueprint for building investors a diversified discretionary managed portfolio which has been widely adopted by most Wealth Managers (WM), Private Banks (PB) and IFA’s. The terminology may be slightly nuanced, but the fundamental principles remain consistent across the industry. Create and implement a strategic asset allocation to align with the varying risk profiles and appetites of investors. The ‘60/40 portfolio’ has long been established as the rudimentary benchmark for investors seeking moderate risk. The theory is simple, you can tap into capital appreciation through a 60% allocation to equities and secure portfolio income and mitigate risk with the remaining fixed income exposure. But the modern methodology used by most asset allocators now goes much further than this simple split. Beyond the traditional core asset class of equities, fixed income and cash, an investors long term needs and objectives can now be mapped out against sub asset classes which may include Developed Government Bonds, Investment Grade Bonds, High Yield & Emerging Market Bonds, Developed and Emerging market equities and Commodities. So why and where should UK venture capital fit into a clients diversified investment portfolio?
Why UK venture capital?
It is very important that potential investors appreciate and understand the key differences between traditional asset class exposure and that of venture capital. It is becoming increasingly common practice for WMs, PBs and IFAs to use ETFs to execute on their strategic asset allocation for specific risk profiles across their discretionary managed portfolios. There are a number of reasons for this. Firstly, the passive investments style of ETFs has led to substantially cheaper fees, giving investors instant exposure to equity or fixed income indices at very low Annual Management Charges. Additionally, the mechanics driving the ETF trading structure often leads to enhanced liquidity, meaning tactical asset allocation changes can be implemented swiftly across a large portion of clients holdings. For example, this means if a WM decides they are potentially overexposed to Developed Market equity due to a change in the macroeconomic landscape, the daily liquidity of an ETF allows for a very quick reduction in the portfolio’s exposure to this asset class. The reason this is all mentioned is to highlight how vastly different this is to a client’s holdings in unquoted companies through either a VCT or EIS. Front and foremost this is an illiquid asset class, where investors rely on third party managers to return their capital. Then from the perspective of costs and charges, the overall fees align closer to the higher fees of more traditional Private Equity funds.
So why take on the additional liquidity risk and pay higher fees? Well for starters, the potential upside through capital growth accessible through these smaller, unquoted, risk to capital assets completely eclipses that of their publicly listed counterparts. Those investors willing to soak up additional risk may gain exposure to a growth trajectory not accessible through traditional asset classes. From a holistic portfolio perspective, venture capital offers further diversification from the cyclical and defensive securities held across equity indices and long only funds. This diversification is also relevant from a portfolio income perspective. The dividends paid out by VCTs offer an alternative source of portfolio income to that of traditional fixed income assets. But why the additional fees? The venture capital market can be very competitive and tricky to navigate. Third party asset managers like Calculus Capital apply extensive resources and expertise to filter out the deals offering the best potential upside to investors and provide an incredibly high level of post investment support and engagement. The relationship between a Venture Capital manager and the selected portfolio companies goes well beyond just a provision of capital, it centres around forming a value creating partnership which allows these smaller, unquoted companies to leverage the Manager’s market connections, expertise and experience and ultimately reach their growth potential. The nature of venture capital investing also allows the investor to develop a level of intimacy with the portfolio companies as they track their growth journey, the likes of which is much harder to achieve through the more traditional fund structures operating with a far greater number of holdings.
The adoption of an Environmental, Social and Governance (ESG) rating criteria by most mainstream funds has been driven by investor demand and expectation. There is a strong case to say that both EIS and VCT products offered a form of sustainable responsible investing before the wider industry truly embraced this investment philosophy. The recent Sustainable Financial Disclosure Regulation (SFDR) requires that all European domiciled funds produce and ESG screening score to reflect their adoption of the responsible investment criteria. Given the nature of the companies targeted and the proactive support provided to the management teams of investee companies to help improve and strengthen governance, if a similar screening policy was applied to the legacy holdings of EIS and VCT products, there is compelling evidence to suggest they would score very favourably.
Where does it fit?
Private Equity has long been considered a staple component of the investment portfolio of Institutional and Ultra-High Net Worth investors. Often attractive returns and portfolio diversification is achieved through a unique investment structure consisting of Limited Partnership Agreements, Committed Capital, Capital Calls, Waterfall Distribution models and various extension periods. Despite some PE Managers recently adapting their investment structures to accommodate retail investors, this largely remains inaccessible to traditional High Net Worth and Sophisticated investors. However, for those investors with appropriate risk appetite and product set knowledge, venture capital makes a compelling addition to a modern day, risk managed diversified investment portfolio which can further enhance risk adjusted returns.
The UK is very lucky to have venture capital schemes which offer generous tax relief and incentives, but risk profile permitted, this is a product set that should be considered within most multi asset class portfolios on the merit of its growth potential and diversification properties. If nothing else, let’s hope this article takes strides towards squashing the fallacy that you should always fill up your pension allocation before you even consider looking to venture capital.