Slowdown offers capital prospects

Many smaller companies in search of funds have to turn from banks to other providers when markets are volatile. At such times venture capital trusts can be highly attractive to investors.

There is a dichotomy at the heart of the current retail investment market. High volatility, fears of recession and the drain in global liquidity have hampered confidence. It is not surprising that savers want to hold on to their money, but history shows that investing in a slowdown is the best way to secure good long-term returns, particularly in venture capital and private equity.

It is a truism that small, unquoted companies need to either grow or die and that if they are not growing they are shrinking. A bumpy economy therefore exacerbates this and makes them highly volatile. Expansion capital is essential for this class of business. Sadly, though, banks are not equipped to fund that kind of volatility, particularly during a downturn.

Bank finance is based on the assumption of a stable business case and steady growth. In a competitive British market, these command tight financial rewards, generally of base plus 2%.

In other words, all a bank wants to do is lend money to a business and have it paid back.

This means that in good times there is a danger that banks lend on overly-optimistic assumptions, while in bad times their potential upside is not matched by their risk.

This increases the likelihood of the bank turning off the lending tap. Their business model is not equipped to take a venture capitalist’s view over the business cycle, or to benefit from the commensurate returns that a venture capitalist can command.

Quite simply, banks will tend to take a shorter-term view because their rewards are not sufficient to justify the efforts made by the typical venture capitalist in nurturing their investments.

Banks are tightening up and either not providing funds for growth or squeezing their companies as they underperform in difficult markets.

It is at times like this that a provider of total finance (both debt and equity) can replace banks and take a diametrically different view. This is because they retain an equity upside in the business as well as providing the core debt requirement.

Deal sizes of between £1m and £10m are more immune to the credit squeeze because investors do not depend on banks co-operating on debt. This also benefits the businesses they invest in, since they provide stable longer-term finance that sees companies through the business cycle.

So there is a clear need for venture capital finance during a slowdown, but is the performance there to justify it to investors?

Research from the British Venture Capital Association (BVCA) shows that returns from private equity funds launched, after the technology bubble burst, in 2001 and 2002 have generated yearly returns of 28.3% and 26.6% respectively. Compare this with 14.9% for funds launched when the boom was at its peak in 2000. Fundraising in a recessionary environment is therefore potentially attractive for investors.

Not surprisingly, though, this runs counter to the risk aversion behaviour adopted by retail investors. The Investment Management Association’s figures from the end of last year demonstrated this, with Cautious Managed being the most popular sector for investment during 2007, accounting for £1.6 billion of total net sales.

Paradoxically, although preserving cash is a priority, investing in a venture capital trust (VCT) in this sort of market, with a 30% discount, could be very appealing.

In general, the decrease in tax relief for VCTs that has taken effect in the current tax year – from 40% to 30% – has encouraged investors to focus more on investment returns as opposed to tax breaks. Shareholders enjoy the tax breaks but, once they have them, tend to forget about them. They then concentrate on their investments and dividends, which is the right way of looking at it.

It takes four to five years for a VCT portfolio to mature and for the dividend stream to become consistent. In this context, VCTs should be treated as long-term investments that create sustained income, while the tax break should be treated as a bonus. Indeed, many shareholders treat VCTs as complementary to pensions.

The purchasing power of generalist VCTs in the credit squeeze has created a potentially excellent year for those buying shares in these issues. A portfolio starting in a dip rather than at a high can compound the returns even more over the longer term.

This year will present more opportunities from entrepreneurs seeking investment to take their businesses to the next level. If the banks do not show faith in them, VCTs might, and that can only be a benefit to shareholders.