Belinda Thomas, Partner at Triple Point
Despite significant changes introduced over the past few years to the types of companies in which Venture Capital Trusts (VCTs) can invest, this type of investment remains a highly attractive option for those looking to diversify their portfolios and capitalise on tax-efficient schemes. According to the Association for Investment Companies (AIC) last year VCTs raised £728m – the highest amount for ten years.
The changing backdrop to VCTs, driven by the adoption of EU state aid rules in 2015, the 2017 Budget and Patient Capital Review has meant that VCT managers are now required to invest in early-stage companies that have been trading for less than seven years.While this could provide higher returns to investors, there is also a greater degree of risk that needs to be carefully assessed. Furthermore, in an attempt to bring VCTs back to their original purpose of investing in true entrepreneurship, managers are no longer able to invest funds in significantly asset-backed companies or support management buy-outs.
As a result of these changes, many managers are taking a far closer look at their investment strategies and are developing ways to innovate and ensure that they have a strong pipeline of potential investments so they are able to identify the next high potential high growth company and limit their downside exposure. A number of different models are emerging from this shake-up. We are seeing a shift to both ends of the spectrum, with some VCT managers either becoming increasingly sector-specific and using their expertise to develop niche strategies, while others are becoming more generalist, casting their net across a wide number of sectors to ensure their portfolios remain well spread.
Some managers are focusing on developing a strong regional presence to enable them to work more closely with management teams to monitor their investments. Meanwhile, others are focusing on developing their network among business advisers, growth consultants and entrepreneurs to more effectively screen potential investments and focus on businesses with a proven model, which is perhaps one of the more interesting approaches that is emerging.
Research shows that more than forty percent of failures among early stage companies arise from problems in the initial phase when market demand is tested. If there is no market need for a product, the product itself has been found to be flawed, or the business model itself does not work, there is a high risk that the company will fail. Companies have often found these problems difficult to address, potentially exposing investors to a greater level of risk from the outset and leading, at best, to lower returns, or at worst, even losses within a portfolio.
The ‘challenge-led’ approach, however, works by investing in companies that have demonstrated proven solutions to the real business issues faced by large corporates, and which already have a customer base, or market demand for their product or service. This approach addresses many of the risks associated with investing in earlier-stage businesses as the market demand will have already been established and the business model has already been proven. The investment therefore will help the company more quickly transform from a start-up to scaleup, rather than be used to develop or market a product, or test the demand.
Although changes to the regulatory landscape initially prompted some concern among both managers and investors, the result could be an evolving, and more successful VCT industry, which offers both growth companies and investors a better chance of success. This new philosophy is already being established and is enhancing the possibility for start-ups to make a successful transition to scale, while mitigating some of the risks surrounding early-stage venture capital.
As investor demand for VCTs increases and funds themselves are more restricted in the companies in which they can invest, those with the most entrepreneurial strategies will become the most sought after. Given the changes to the investment landscape, investors need to look beyond the past performance of VCT managers and focus instead on how they are innovating and identifying investments in the most exciting young businesses, while also finding ways to limit the risks and deliver the future returns that investors require.
Triple Point has already developed its own variant of this challenge-led approach and, through its Venture Fund has created a strategy which proactively helps early-stage business increase their chances of success. By developing close ties with a number of established corporates and then identifying the companies that have demonstrated an ability to solve their business critical issues, this strategy addresses one of the most significant risks facing early stage venture capital and enhances investors’ chances of securing a robust return on their investment.