Spotlight - February 2019
It’s impossible to avoid the subject of Brexit these days. Tedious though many find it, when it comes to VCTs, it seems a salient issue. After all, VCTs invest in small UK companies, filled with promise but fragile. So it’s worth spending a moment or two pondering what the impact might be of a no-deal (‘managed’ or otherwise), May deal, Malthouse compromise, or whatever the latest ruse is they’ve cooked up to try and cobble together a consensus.
We’ve been asking various VCT managers to tackle this question. This month in Spotlight, we bring you a range of views from Calculus Capital, Foresight, Octopus, Triple Point and YFM. It’s not all about Brexit – they also discuss the new rules and where they’re finding opportunities.
Our VCT seminars last month were another chance to gather intelligence on prospects for the sector. For those that couldn’t make it (or even if you did), I’ve drawn together some things I found interesting, particularly around potential risks to VCTs.
The other article in Spotlight this month focuses on China. We’re now three days into the Year of the Pig, which is historically a very good year for investment returns. However, China faces some important challenges, of which the prospect of a full-blown trade war is the most visible. Managers are not particularly hopeful of a swift resolution on this, but they are seeing opportunities amid the turbulence.
We’re currently confirming dates for our training events in 2019 and you’ll hear more details soon. In the meantime, here’s a couple more dates for your diary. Invesco is holding an Investment Trust Conference on Thursday 7 March, with speakers including Edinburgh and PIGIT manager Mark Barnett. And Morningstar’s annual Investment Conference is coming up on 30 April and 1 May – I’ll be speaking about property and infrastructure.
Finally, if you’re looking to sharpen up your VCT knowledge, our friends at Intelligent Partnership have launched a new online training course on VCTs. It’s quite detailed, including 12 separate modules, and usually costs £195 to take: Spotlight readers can get a £50 discount by using the code AIC50.
That’s all for now – see you next month.
Nick Britton, Head of Intermediary Communications, AIC
Upcoming events around the UK
Please click on the links to book your place.
7 March 2019
Invesco Investment Trust Conference (London)
8.30 – 12.00. Focused on the value of income, this half-day conference at Claridge’s is introduced by broadcaster and journalist Gavin Esler with speakers including Mark Barnett, manager of the Edinburgh and Perpetual Income and Growth investment trusts.
14 March 2019
Morningstar Adviser Forum (Chelmsford)
9.00 – 12.45. Speakers include Nick Britton (AIC), who will discuss using investment companies for retirement income, and Mel Hollman, who will update attendees on the Senior Managers and Certification Regime. See full agenda here.
30 April-1 May 2019
Morningstar Investment Conference
Morningstar’s flagship two-day conference has a varied line-up of speakers including Jonathan Ruffer (Ruffer Investment Company), Marcus Phayre-Mudge (TR Property) and Nick Britton (AIC).
New Year resolution?
Investment company managers on whether 2019 will clear up China's trade woes
The 5th of February marked the start of Chinese New Year, ushering in the Year of the Pig. Pigs are said to be generous and enthusiastic and though they may not stand out from the crowd, they are creatures of action rather than talk.
So how are China-focused fund managers viewing the threat of trade wars, the current state of the Chinese economy and the prospects for their investments? The AIC has gathered comments from managers with significant proportions of their portfolios in the region.
Trade wars damaging but opportunities arise
Robin Parbrook, Fund Manager of Schroder Asian Total Return said: “We remain sceptical of any real let-up in US and China tensions despite Trump’s suggestions that a deal will be completed. As highlighted several times last year, it is clear that US-China tensions are not just about trade, but something much bigger. It involves US perceptions around China’s intellectual property theft, cybercrime, the way China projects its political and financial power via One Belt One Road and China’s desire to dominate key industries via massive state subsidies through Made in China 2025.”
Howard Wang, Fund Manager of JPMorgan Chinese said: “We believe we should see a resolution on tariffs as it is in the interest of both parties. However, the political dimension means we do not have strong conviction. We do think that domestic Chinese equities have discounted a very pessimistic outcome: both a trade war and growth slowdown. Consequently, we are beginning to see value in several areas of the A-share market. Whatever the outcome of current negotiations we believe China and the US will increasingly compete in areas of technological innovation from electric vehicles to artificial intelligence.”
Suresh Withana, Managing Partner of Harmony Capital, the investment manager of Adamas Finance Asia said: “At a macro level, the trade war between the US and China has the potential to cause continued, serious, short-term global disruption. However, this disruption may have unexpected benefits for certain regional economies.
“For instance, companies may seek to shift production from China to other Asian countries. Furthermore, if volatility in public markets continues to prevail, we would expect to see both Chinese and Asian SMEs increasing their reliance on private financing sources as they will still require capital to fund ongoing regional growth opportunities. We believe the most exciting investment areas will be those driven by intra-Asian consumption.”
Dale Nicholls, portfolio manager of Fidelity China Special Situations said: “While Chinese exports to the US as a proportion of their total exports globally have been falling for years as China has expanded its global reach and trading partners, increased tariffs will impact the export sector. Of greater concern is the broader impact on general sentiment and the prospect of delayed investment by Chinese companies in general. Despite the rumoured prospect of new trade concessions and a possible ceasefire between the two nations, we remain vigilant.”
"The trade war between the US and China has the potential to cause continued, serious, short-term global disruption. However, this disruption may have unexpected benefits for certain regional economies. For instance, companies may seek to shift production from China to other Asian countries."
Suresh Withana, Managing Partner of Harmony Capital, the investment manager of Adamas Finance
Chinese growth slowing but expected
Dale Nicholls, portfolio manager of Fidelity China Special Situations said: “China is facing a slowdown, but this is already well documented and the growth rates in China remain the envy of most economies. The authorities’ focus on deleverage has been the main catalyst for a slowdown as this has impacted access to funding and subsequently impacted business and consumer confidence. There has been a slowdown in the rate of growth of consumption, particularly in larger durable goods such as cars. This has not been helped by falling markets and the sense that house prices have peaked. However, retail sales are still showing high single digit year-on-year growth despite the decline in car sales and, even with a general economic slowdown, the medium-term prospects for earnings growth remain strong.”
Mike Kerley, Fund Manager of Henderson Far East Income said: “Chinese growth is slowing although not by more than we would have expected. The rising base ensures that the growth of the past cannot be repeated, while the reforms of state-owned enterprises and the clampdown on non-bank credit will put pressure on growth in the short to medium term. These headwinds are being offset by measures to promote consumer spending and by tax cuts to corporates and individuals. This should be seen as a positive as the government pursues a policy of sustainability, rather than the old model of pump priming through debt-funded investment. Ultimately, the quantity of growth may slow but the quality will improve.”
Robin Parbrook, Fund Manager of Schroder Asian Total Return said: “The scope for China to undertake major stimulus measures is now much more limited – unless they wish to suspend the effective renminbi peg. We expect the Chinese economy to continue to slow in 2019 as a result of the authorities’ desire to rein in excessive leverage and bring shadow banking back to balance sheets. Given the pegged currency, a current account no longer in surplus and a leaky capital account, we view the monetary options as limited assuming devaluation is not considered an option - this would cause market chaos and global deflation.
“We do expect some fiscal measures to boost consumption but given the size of the economy coupled with high housing and auto ownership rates, such measures are likely to have a limited impact compared with previous efforts. Our base case is for the Chinese economy to slow, but with debt effectively internalised, the immediate triggers for a financial crisis are unlikely to happen. However, one of the major tail risks we see for the Asian region, is a messy unwind of the renminbi peg.”
Suresh Withana, Managing Partner of Harmony Capital, the investment manager of Adamas Finance Asia said: “China’s SMEs already face a significant financing gap but we expect any slowdown in the Chinese economy to further restrict access to traditional financing methods. That being said, we would also expect to see some form of government intervention to increase domestic spending to counteract many of the effects of slower economic growth.”
Howard Wang, Fund Manager of JPMorgan Chinese said: “China has been on the path of slower, but higher quality growth for the last several years. Amid uncertainties in US-China trade negotiations and domestic cyclical headwinds, the government has moderated the pace of financial deleveraging. We expect policymakers to continue to ease and to resort to more coordinated pro-growth policies on both monetary and fiscal fronts, to direct liquidity to the real economy and to cushion for growth. The personal and corporate tax cuts, along with more market-oriented reforms around resource allocation, should support domestic demand and private sector productivity. Given the current valuations and bearish sentiment, we are optimistic on the outlook of China equities, in particular onshore China equities.”
Market turbulence producing opportunities
Dale Nicholls, portfolio manager of Fidelity China Special Situations said: “Following a period of market volatility towards the end of 2018, activity in the portfolio has been focused on opportunities that arise during a period of indiscriminate sell-off. Certain sectors are particularly sensitive to market falls, such as insurance and investment companies.
“In many of these types of companies, valuations have dropped to historically low levels that significantly discount their attractive long-term growth prospects. When it comes to insurance, the sector is hugely underpenetrated relative to the West with demand coming from the growing middle class in China. With regards to securities, the long-term prospects in capital markets, particularly for institutions, make securities firms very attractive at these prices.”
Suresh Withana, Managing Partner of Harmony Capital, the investment manager of Adamas Finance Asia said: “2018 was a volatile year for Asian equity markets. However, we continue to see abundant investment opportunities in China and throughout the wider region, particularly in financing companies in the SME sector where there is a significant shortfall of fresh capital available to quality businesses.
“A key regional investment theme that we expect to continue in 2019 is the rise of an increasingly aspirational consumer culture and this should provide increasing SME investment opportunities in healthcare, tourism, consumer and retail businesses and education.”
Mike Kerley, Fund Manager of Henderson Far East Income said: “Around 25% of the portfolio is invested in China, as it is a country that we believe will only grow in corporate stature. Historically, Asia has generally been associated with the mass manufacturing of low-cost products. Now, however, this is changing. For the first time we believe China will spend more on R&D this year than the US and, within five years, we think it may spend more than the US and EU combined. This is most prominent in newer sectors such as electric vehicles, renewable energy, healthcare, artificial intelligence and virtual reality – products and services we will embrace in years to come and have the potential to become part of our day-to-day lives.”
Howard Wang, Fund Manager of JPMorgan Chinese said: “We continue to find plenty of attractive investment ideas in consumer, healthcare, and technology. We have taken the market sell-offs as opportunities to add to quality, structural growth names in internet, software and healthcare services.”
The smaller picture
VCT managers from Calculus Capital, Foresight, Octopus, Triple Point and YFM tell us where they’re finding opportunities among growing UK companies
Uncertainty around Brexit has hit UK markets and raised questions about the UK’s economic prospects, but what effect is it having on the UK’s smaller unquoted companies? Despite a tough year, the average VCT returned 2.7% in 2018 and is up 42% and 163% over five and ten years. Where are VCT managers finding opportunities today and what are their views ahead of Brexit?
On Tuesday 29th January the AIC held a media roundtable on VCTs. John Glencross, CEO of Calculus Capital which manages the Calculus VCT, Ian McLennan, manager of the Triple Point VCTs, and Rodney Appiah, director of Foresight which manages the Foresight VCTs, discussed their recent investment activity, the potential effect of Brexit on smaller companies and their overall outlook for the sector.
John Glencross - Calculus VCT, Ian McLennan - Triple Point VCTs, and Rodney Appiah - Foresight VCTs, discuss the impact of Brexit and the themes in their portfolios.
Their views have been collated alongside comments from David Hall, managing director of YFM Equity Partners which manages the British Smaller Companies VCTs, and Jo Oliver, manager of Octopus Titan VCT.
Brexit’s impact on smaller companies
Ian McLennan, manager of the Triple Point VCTs, said: “When it comes to Brexit, the main concern we are hearing from portfolio companies is around people. Tech-related companies in particular often have a significant number of EU nationals in their team. One portfolio company has reported that they have already seen a 50% reduction in job applications from EU nationals after the 2016 referendum result. In time we expect that this will be mitigated by clarity on the rules around EU immigration for skilled workers, by increased immigration from non-EU countries and by up-skilling UK citizens. On a more positive note our healthcare-related investments are anticipating that Brexit will result in more money being spent by the NHS.”
David Hall, managing director of YFM Equity Partners which manages the British Smaller Companies VCTs said: “There’s a difference between the short and long-term effects of Brexit. The current process is just creating short-term uncertainty. That makes any sort of long-term planning more difficult.
“What we have seen in our portfolio is those businesses who move physical goods across borders step up contingency planning, which in many cases means finding other ways of getting their goods to overseas markets, for example offshore inspections or quality control centres or final assembly outside the UK. These are temporary measures for now but could be made permanent if needs be.
“For those businesses delivering services it’s not quite business as usual, but there is less thought about tomorrow and more about the long term. At this stage the long-term impact of Brexit is unclear, but for those markets outside the EU trading conditions are unchanged so there is less disruption.
“So, the ideal business to invest in is one that doesn’t move goods across borders and has a high proportion of business outside the EU. Generally, this is where many of the growth businesses focus and, in reality, trading within Europe for these businesses also comes with less regulatory hassle.”
John Glencross, CEO of Calculus Capital which manages Calculus VCT, said: “Clearly it would be helpful to have greater certainty. As I look at our portfolio, however, by and large, exporting to the rest of the EU is not an important market. It has always been difficult for small businesses to sell to other European countries. Even pre-Brexit, the US, Asia and Middle East are more important markets. Where uncertainty is biting, however, is in the status of EU nationals who work for UK companies. Their status post-Brexit needs to be settled quickly.”
Jo Oliver, manager of Octopus Titan VCT, said: “Uncertainty isn’t good for any business. However, it does create opportunity for companies that are nimble and adaptable such as early-stage businesses.
“Many of these are deliberately creating companies that can be global from the start, due to enabling technology such as smartphones and cloud computing. Our single greatest concern when it comes to Brexit is the importance of being able to access talent and the UK continuing to be a leader in innovation and entrepreneurship.”
“So, the ideal business to invest in is one that doesn’t move goods across borders and has a high proportion of business outside the EU. Generally, this is where many of the growth businesses focus and, in reality, trading within Europe for these businesses also comes with less regulatory hassle.”
David Hall, managing director of YFM Equity Partners which manages the British Smaller Companies VCTs
Where are managers finding opportunities?
Ian McLennan, manager of the Triple Point VCTs, said: “Triple Point has funded several of the fastest growing tech innovators in the UK, including Capital-on-Tap which itself uses cutting-edge technology to arrange finance for thousands of UK SMEs. We have invested in a digital health company which uses artificial intelligence to assist NHS GPs and dermatologists in the diagnosis of melanoma skin cancer. We recently deployed funds into a rapidly growing company that provides an end-to-end software service to apprenticeship training providers and universities.”
John Glencross, CEO of Calculus Capital which manages Calculus VCT, said: “Calculus is sector and region diverse, focusing on finding and backing great management teams working in entrepreneurial companies successfully selling real products and services. Not all of our investments are focused in and around London and whilst we do focus on healthcare and technology, we do also have investments within energy, media, consumer and industrials.
“Three examples across tech, healthcare and other sectors:
• Weedingtech (West London) - With increasing concerns over the health impacts of chemical herbicide use, Weedingtech has grown significantly and doubled its turnover since Calculus Capital’s first investment in 2016. Users of its herbicide-free, non-toxic weed control foam include municipal authorities in New York, London, Munich, Barcelona and many others.
• Blu Wireless Technology (Bristol) - Blu Wireless Technology is developing the latest ultra-fast internet and wireless-enabled technology. The company was named by the European Commission in 2018 as a ‘key innovator’ for its contribution to research on 5G networks and in the same year won UK government contracts for 5G trials.
• Synpromics (Edinburgh) – A world leader in the technology surrounding cell and gene therapy. Its ground-breaking patentable technology provides the control mechanisms that direct the activity of cell and gene.”
Jo Oliver, manager of Octopus Titan VCT, said: “Our focus is on investing in tech-enabled companies with high growth potential across a diverse range of sectors and industries. One example is the AI-powered language learning app, Memrise, which has grown rapidly to more than 35 million users, while another is Sofar Sounds, which hosts intimate music events in cities across the globe every month.”
Has there been any effect from regulatory changes?
Rodney Appiah, director at Foresight which manages the Foresight VCTs, said: “In a word, no. Foresight continues to adopt a sustainable and pragmatic approach to early-stage private equity investing that focuses on backing UK-wide businesses with proven and defensible business models, steered by strong management teams, operating in large, growing and non-cyclical markets. This approach is tried and tested and has been demonstrated over several economic cycles to be the right one for us and our investors. It has also proven to be a financially successful one with Foresight delivering average returns of 2.9x in realisations for investors since 2010.”
Jo Oliver, manager of Octopus Titan VCT, said: “The recent regulatory changes, enabling the investment of £10m per annum in knowledge intensive companies, is positive for Titan. Most of Titan’s investee companies are knowledge intensive and therefore we can capitalise these businesses from an earlier stage, which enables them to invest in research and development.”
John Glencross, CEO of Calculus Capital, which manages Calculus VCT, said: “The Calculus focus has remained consistent: building diversified portfolios of smaller, UK, entrepreneurial growth companies and creating value for our investors through our multi award-winning funds. The regulatory changes have forced the wider industry to follow the same principles we have followed from day one, twenty years ago.”
Outlook for VCTs
John Glencross, CEO of Calculus Capital, which manages Calculus VCT, said: “Even in the midst of Brexit uncertainty, investment activity remains strong. The UK is emerging as a very entrepreneurial nation, particularly in the areas of technology, life sciences and the creative industries. These industries, by and large, sell globally. The Treasury is very focused on encouraging an entrepreneurial economy and this is helping to support activity.”
Ian McLennan, manager of the Triple Point VCTs, said: “The outlook for the business-to-business software companies that our new Venture VCT invests in remains very promising. Innovation is continuing at a rapid pace and we are seeing a new form of corporate innovation where large, established companies increasingly engage with SMEs and start-ups as a core part of their own R&D plans.
“Thus, the corporate sector, under constant pressure to compete and improve efficiency, is open to early adoption of new software products that improve data and processes throughout the enterprise whether it is for customer engagement, resource planning or for administration and accounting. Our Venture Fund, with its emphasis on working with corporates to articulate their needs and investing in the innovative companies best placed to solve these known challenges, is well placed to benefit from this evolution.”
Jo Oliver, manager of Octopus Titan VCT, said: “Despite the market uncertainty we have seen continued demand for VCTs this year – our AIM VCTs closed in record time and there is continued demand for our Titan VCT.”
Rodney Appiah, director at Foresight which manages the Foresight VCTs, said: “I think there are reasons to be cautiously optimistic about 2019. Despite some economic and political headwinds, UK SMEs remain surprisingly resilient in what is an increasingly globalised market. We are seeing a growing confidence in the UK venture capital ecosystem, a maturing fintech sector, a reshaping of our high streets and a reinterpretation of the world of work due to the increased use of technology and the disruptive nature of the sharing economy. In that environment, Foresight believe our approach of seeking out ambitious entrepreneurs with proven and defensible business models remains an attractive one for investors.”
Where next for VCTs?
After a decade of strong performance, Nick Britton looks at risks to the sector
There are only two investment company sectors that have delivered positive returns for each of the past ten calendar years, on both a share price and NAV basis. One is infrastructure, which perhaps isn’t surprising. The other is VCTs.
Weighted average total return of all VCTs, share price and NAV, discrete calendar years, excluding 30% tax relief. Source: AIC/Morningstar.
It’s worth taking a moment to reflect on that. VCTs invest in small, fragile companies. Many of these will fail. Positive returns depend largely on being able to sell companies on for a profit, over an uncertain timescale.
So why have returns been so consistent? Before we get carried away, we should remember that not all VCTs have delivered ten years of positive returns; it’s only the sector average that has been positive in each year. We should also add that returns were not positive in 2008. Nevertheless, ten years without a loss is surprising when we consider the usual profile of venture capital returns, which are prone to ‘hockey stick’ or ‘J-curve’ effects even in the best-case scenario.
One reason that VCTs have been able to beat the J-curve is their evergreen structure. This is unusual in the world of venture capital, where institutional funds have limited lives. Because VCTs have been around so long, their portfolios are full of companies of different ‘maturities’: in other words, investments are not all made (or exited) at the same time. This helps to flatten out the J-curve and enables smoother returns.
VCT portfolios are also full of companies with high levels of idiosyncratic risk. This doesn’t mean that they can’t be dragged down by a general malaise, as they were in 2008, but it does mean that it’s quite likely that the fortunes of different companies in a portfolio will diverge.
Could anything break this impressive run of performance? At our VCT seminars in Leeds, Birmingham and London, managers considered a number of headwinds.
The subject of Brexit was never far away. No surprise there, given that our Leeds and Birmingham seminars were held in the week of Theresa May’s 230-vote defeat in the Commons, while our London event occurred the morning after MPs had to vote on no less than seven competing amendments aiming to influence the direction of Brexit.
Having listened to eight different VCT managers talk about the impact of Brexit on their portfolios, and read the views of two others, a couple of things struck me. Please note that both are generalisations.
Firstly, it’s not loss of access to EU markets that is the most important worry for VCT managers or their investee companies. This is partly because not all sell into Europe, and even for those that do, it might not be their most important market. (As I’ve said, there are exceptions.)
What has come up again and again, though, is the question of access to the talent of EU nationals. The UK in general, and London in particular, have benefitted from ready access to the talents of an entire continent (and beyond). If the attractiveness of the UK as a place to live and work were diminished, that would be a worry for VCT managers.
New rules bedding in
The other interesting theme to emerge from our seminars is the absorption of the ‘new rules’ into VCTs’ investment strategies. I’m talking about the 2015 age limit and ban on management buy-outs (MBOs), as well as the 2018 ‘risk to capital’ condition. While it’s true to say that these rules have pushed VCTs up the risk scale in general, many managers – especially those doing large fundraisings – believe that the effects on them will be minimal. That’s because they’ve always invested in a way that would be compliant with the new rules.
For those that haven’t, perhaps because they did more MBOs or followed strategies more focused on capital preservation, the new rules have had a number of effects. Fundraisings have generally been smaller. New hires have been made to refocus teams on earlier-stage opportunities. And naturally, investment strategies, including the sourcing of deals, have been reassessed.
Triple Point is an interesting case. The company’s new ‘challenge-led’ strategy aims to mitigate risk by investing in companies that solve the pre-existing problems of corporates (rather than companies with cool products or services in search of a market). But the investee companies themselves are early-stage, making the strategy entirely compliant with the new rules.
Not all of the rule changes are restrictive. For so-called ‘knowledge-intensive’ companies, the new rules are more liberal, with a looser age limit and the ability to raise more money from VCT and EIS.
Mixing it up
In addition to the VCT rule changes and Brexit, our seminars touched on a wide range of other issues affecting portfolio companies – both opportunities and threats. They are too numerous to go through here, and because VCTs’ portfolios are so diverse, perhaps they don’t matter as much to an investor as a VCT manager’s skill in being able to locate, develop and profitably exit their investments.
For example, in Leeds we heard about an eco-friendly weedkiller company, a cremation business, a maker of children’s TV programmes, and a company that helps John Lewis reduce queue times in its children’s shoe department. Clearly, the determinants of success or failure in each of these companies will be very different.
This kind of diversification, together with generous tax reliefs and the ability to access an asset class that’s unlikely to be represented otherwise in clients’ portfolios, are among the key attractions of VCTs. These attractions remain, despite Brexit worries and the challenges of the new rules.
Of course, nothing is guaranteed, and VCTs will always be high-risk. But their 23-year record has demonstrated that the evergreen closed-ended structure is absolutely the right one for this kind of investing, giving managers the maximum amount of control and long-term investors the best shot at a positive outcome.