Better Alternatives: Patient Capital Review effect on venture capital schemes

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Despite the UK being home to one of the world’s most dominant financial centres, it ranks only 13th in the OECD in terms of number of scale-up businesses based in the country. Put another way, fewer than 1 in 10 firms that receive seed funding in the UK go on to get fourth round investment, compared to nearly a quarter in the US.  In order to strengthen the UK as a place where innovative firms can obtain the long-term ‘patient’ finance they need to scale up, the UK Prime Minister announced in November 2016 that HM Treasury would be conducting a “Patient Capital Review” (PCR).  The final recommendations of the PCR will be presented to the Chancellor ahead of the Autumn Budget 2017 and are set to identify the barriers to growing firms accessing long-term finance.

Included in the PCR is a review of the venture capital schemes that make up the tax-efficient sector.  The government has professed preference that tax-efficient investments should be more focused on growth enterprises, rather than asset-backed investments.  Hence, the current apprehension within the investment industry that tax advantages for venture capital schemes (including the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS)) may be removed come November 2017.  But would such a ‘big stick’ approach realise the UK Government’s goal, or are there other means available that could also provide scale-up businesses with access to long-term finance?

Limited tools for government

In its Consultation Report, the Treasury has acknowledged the success of existing tax advantaged venture capital schemes, noting that EIS is highly praised in particular by business angels as having supported significant amounts of new investment since its inception.  Nevertheless, the report notes that, “Longer term, there appears to be capacity for greater retail investment, although there does not appear to be significant latent capacity to increase levels of effective investment through existing channels such as the Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCTs) reliefs.”

The report also observes that tools can at times be limited for governments in the support of venture capital, noting in particular the unsuccessful UK High Technology Funds launched at the peak of the dot.com investment boom: “At the time of a National Audit Office analysis in 2009, funds launched in a similar period had an average Internal Rate of Return of minus 5.2%, but the High Technology Funds underperformed further, making an equivalent return of minus 9.7%.” Since then the Treasury has learned from these lessons and the introduction of Enterprise Capital Funds where the treasury, through the British Business Bank, co-invests alongside private investors has proved a more effective risk aligned structure.

 A question of access
The access of scale-up firms to long-term capital means of course that investors likewise need easier access to scale-up firms.  We would argue that there are other methods in which this access could be encouraged that do not involve a radical shake-up of the existing tax incentives, including:

• Digitisation of schemes: Alternative assets are growing in popularity, but still remain difficult for investors to access because much of the investment process and related tax benefit structuring is still paper-based.  The processing of tax-relieved investments could be shortened, for instance, by HM Revenue and Customs (HMRC) using digital technology with companies qualifying for EIS/SEIS approval, claiming receipt of investment, and issuing investors’ certificates; likewise with investors’ claiming tax relief through their tax returns.                    
  

• Maintaining current SEIS, EIS and VCT schemes: With smaller rule changes in support of a continued move away from asset backed and capital preservation schemes, the role and purpose of these tax efficient schemes remains valid and retail investors have demonstrated their appetite to invest in early stage businesses over many years.

• <Co-investment incentives: Because the government recognises that retail investors have a capacity to play an increased role, encouraging their access to Later Growth Investment and Development Investment phase opportunities should be pursued as an avenue for progression.  Unlocking additional funding from retail investors is key but these greater sums are likely to prefer being directed towards lower risk, later stage businesses ie a different profile to SEIS and EIS qualifying companies. To achieve this, incentivising and enabling retail investors to co-invest alongside professional fund managers (for Venture Capital (VC), Private Equity (PE) and Enterprise Capital Funds (ECF) funds) would increase funding into these later phases and match existing trends for investors to provide co-investment into venture capital funds.
  

  Currently, a partial barrier to increased capital is the long-term, illiquid nature of VC/PE/ECF funds, combined with their high levels of regulatory burden as Non Mainstream Pooled Investments.  Many retail investors are unwilling to invest into these long term structures and lock up their capital for 10 years or more. If, however, investors were easily able to access investment opportunities into the same deals that the funds were investing into, and receive returns on a deal-by-deal basis, this would substantially increase the chances of unlocking later-stage capital.  Some form of additional tax benefit accessible by co-investing alongside professional fund managers in these late stage deals would transform the market and go a very long way to achieving the government’s stated objectives.

Crucial questions

The government’s rationale behind the PCR is to be commended, not in the least because there is a possibility UK start-ups could be cut off from the European Investment Fund (EIF) after Brexit negotiations.  Given the fact the EIF had supported 27,7000 UK SMEs by the end of 2015, the creation of a viable national replacement is crucial.  An increase in long-term investment, namely to the final Development Capital Investment phase of the growth and investment cycle, needs to therefore be addressed. 

But given the government’s own admittance that some of their ‘big stick’ approaches do not always work, would a sweeping change of current tax-incentivised investing prove successful?  Or could a more prudent approach be taken by examining and altering the other existing barriers to access, such as plodding paper-based systems and unproductive barriers for retail investors wanting to co-invest with professional fund managers to increase late-stage funding?  Stay tuned for 22 November when the Autumn Statement is due to be announced.  

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