Venturing into the jungle of private equity

Entrepreneurial firms aren't beyond the reach of the small investor, says Christine Stopp
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The Independent Online

Budget changes to Venture Capital Trusts (VCTs) will make these schemes more attractive to larger investors. Up-front income tax relief was doubled to 40 per cent and the annual investment limit doubled to £200,000. These are incentives which may leave the smaller investor cold - but VCTs and other types of fund investing in the same area are worth considering for those with modest sums to invest.

Venture capital - investing in unquoted and often small new businesses - has always had a high-risk, specialist image. But the private equity sector, which includes venture capital funds, grew by an average 16.2 per cent a year over the 10 years to the end of 2002, the latest year for which figures are available, according to the British Venture Capital Association. This long-term record, say the experts, argues for its inclusion in private investors' portfolios.

The two main tax-privileged ways to invest in private companies are VCTs and Enterprise Investment Schemes (EISs), where the Budget increased the maximum annual investment from £150,000 to £200,000. The key difference between the two is that VCTs invest in a portfolio of unquoted shares, while an EIS invests in one company. That means that VCTs have the virtue of spreading risk around several businesses, which can be listed on the Alternative Investment Market.

Apart from absolute performance, one argument for private equity is its long-term ability to perform in the face of a downturn in quoted markets. In other words, including these assets among your investments could actually reduce risk rather than increasing it. On the other hand, valuing private companies can be difficult for even the most experienced manager.

David Cutler, an accountant who has been on the boards of several investment trusts, recounts how he advised the owners of one company to sell at any price. They persuaded a well-known private equity fund to pay more than twice what the board reckoned it was worth. And George Galazka's experience (see case study) shows that you need to know what you are doing.

Private equity can mean anything from investing in fledgling hi-tech companies which will not be profitable for several years to putting money into a management buyout by the senior executives of a large and profitable company. What these have in common is the intense element of involvement in the company by the fund manager, who will usually take a seat on the board and keep a very close eye on day-to-day progress.

VCTs are at the riskiest end of the spectrum. David Thorp, a Baronsmead investment manager, looks for companies which are planning a period of fast growth. A successful investment might typically have £1m in pre-tax profits when he invests, and £3m when he sells. Mr Thorp's successes include the active-wear retailer Fat Face and the blinds manufacturer Thomas Sanderson, which he sold for three times its purchase price. "The downside is that when you fail it means a 100 per cent loss. We don't always get it right, but we are right more often than we are wrong", says Mr Thorp.

Why can unquoted companies buck the trend and make returns for investors when listed companies are losing value? "We are the ultimate stockpickers," says Mr Thorp. "We don't have the herd instinct of the rest of the fund industry. We may get 30 good prospects in a month and only invest in one, and each company takes three to six months to research. Once we have invested we are in contact at least once a week."

The performance figures reflect the importance of knowing what you are investing in. VCTs, which invest in very small UK companies, have a far patchier record of growth than venture and development capital investment trusts (VDCITs), which have no special tax advantages but which can invest without restriction in small and large companies and different geographical markets. One of the strongest is Schroder Ventures International Investment Trust, a fund of funds whose performance is a result of being almost wholly invested in buyouts. It also has a wide geographical spread, with only 19 per cent in UK companies and 35 per cent in multinationals.

The sector giant, at a market capitalisation of just under £4bn, is 3i Group, an enormous and highly diversified fund which is Europe's leading venture capital provider. 3i is the fund which institutions look to as a play on the small companies and technology markets, and its share-price valuation tends to echo that of these sectors.

Following a strong run it is in our table as one of the top five performers in the VDCIT sector over one year, though it is not generally perceived as one of the sector's most exciting performers. In an entrepreneurial industry, it is seen as too much of an institution. "3i is the training ground for the rest of the industry. Too often the better talent tends to go elsewhere", says Nick Greenwood, analyst from investment group iimia. "It looks a bit expensive at the moment. I would prefer a smaller company such as HgCapital."

Investors who would like to sample the venture capital effect but are nervous of being fully committed to a specialist fund could consider a general investment trust. A number of trusts, including names such as F&C, have been increas- ing weightings in the private equity sector.

One fund which has been particularly successful is Caledonia Investments, which showed share price growth of 62 per cent over one year to 30 March. Caledonia is a former shipping company which switched to investment trust status and is much admired by industry analysts. It holds at least 50 per cent of its portfolio in quoted companies or cash, and will take stakes in unquoteds of between £10m and £25m in capitalisation.

Another type of venture capital opportunity which is accessible to the smaller investor is the Enterprise Investment Scheme (EIS). EISs have a number of broad similarities with VCTs, but their risk profile is a good deal higher as they invest in single companies. The minimum investment tends to be £5,000 or £10,000 compared with £3,000 in a VCT.

A number of the companies on offer as EISs are property-backed, which reduces the risk of the company disappearing with no remaining assets, but they should still be considered a very high-risk investment. Current offers with a property element include Capital Pub Company 2, which invests in a chain of pubs in the Greater London area, and Childcare Corporation 7, which operates in the nursery childcare sector.

At the still more risky end of the spectrum EISs include film and TV companies and a cod-farming operation. Film company EISs are "off the scale as far as risk is concerned", says Bestinvest analyst David Porter. "A fun investment if you are really interested in films, but you should put your money in and not expect to see anything for it, except perhaps seats at the premiere."

A number of these schemes close on 5 April, but anyone interested may still have a chance to get cash in for the current tax year if they move fast on Monday. Details of the funds on offer are available on the Bestinvest website (see Further information).

An important consideration for all venture capital investors is the exit strategy. If you buy quoted shares or conventional investment funds you can buy and sell easily. With unquoted investments it is much harder, and particularly so for an individual investor in an EIS scheme who wants to realise his investment after three or four years. The common exit routes are flotation, which presupposes that the company has been successful enough to warrant it, or a trade sale - a takeover of the company you are investing in by another company. With some schemes, "you'll be lucky if you get there", warns David Porter.

In the view of Bestinvest, the Budget changes to VCTs mean that the optimum strategy for maximising up-front tax relief will be to sell after three years. This means that "it will be vital for VCT managers to have in place clear exit strategies", the company says.

'Returns have been mixed, but I'm happy to hold on'

George Galazka, formerly a senior executive with an international bank, took early retirement five years ago.

"I gave up corporate life to spend more time doing things which interest me. I have a private pilot's licence and am also keen on horseracing," he says.

He now keeps in touch with the world of work by acting part-time as a non-executive director, but his other main preoccupation is managing his investment portfolio as a source of income - "making sure my resources cover my lifestyle", as he says. Since 1995 Mr Galazka has held around 7 or 8 per cent of his equity assets in venture capital, principally in VCTs (see box). "Returns have been mixed, to be blunt," he says, but he proclaims himself "happy to hold at this stage".

The tax breaks available in a VCT have been an added attraction to this type of vehicle, and he has been satisfied with his long-term holdings in two of the Baronsmead funds. "They are a competent team who have produced quite respectable performance and are also exemplary in engaging in dialogue with shareholders," says Mr Galazka.



* Venture capital: investment in small, start-up companies, usually with a high risk attached.

Private equity: investing in unquoted companies - some of which may be very large, with a different risk profile to a high-tech start-up.

* Seed capital: investment made at the concept stage of a new business venture.

Start-up capital: money put in during the first three years of the company's life.

Development capital: finance for an established company which needs to expand.

Management buyout: purchase of a business from its owners by the company's existing management.


* Enterprise investment schemes (EISs): a high risk tax incentive scheme which allows investment in a single company. Tax incentives include a 20 per cent tax rebate on the cost of the investment, deferral of capital gains tax on the sum invested, and no capital gains tax on gains within the scheme. A loss made in an EIS can be offset against gains elsewhere - a benefit not available with a venture capitalist trust.

* Venture capital trusts (VCTs): funds set up under special legislation to invest in small UK start-ups. They carry attractive tax breaks which help compensate for the level of risk. There is up-front income tax relief of up to 40 per cent. Dividends and capital gains made on the sale of shares as well as capital gains made within the fund are free of tax. The tax breaks mostly benefit large investors, but you can invest in a VCT with as little as £1,000 or as much as £200,000.

* Venture and development capital investment trusts (VDCITs): straightforward investment trusts, without the tax breaks of VCTs, but with greater investment freedom. They can invest in private equity, including larger and non-UK companies. Most investment trusts have savings schemes which allow investments from a £500/£1,000 lump sum or £50 a month.

* Non-specialist investment trusts: investment trusts in generalist sectors that hold part of their portfolio in unquoted investments. This can be a good and relatively low risk way for smaller investors to gain some exposure to private equity.

Direct investment: putting money directly into a business, although the risk is high and the minimum investment is in the tens of thousands. This type of deal is usually set up by a lawyer or accountant acting for one or more clients, often experienced business people who can become involved in the management of the fledgling company.

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