Issue 53
Risky Renewables: the bulls vs the bears
Venture Capital Trusts: the experts’ guide to the tax-year end sale
Say hello, wave goodbye? Small-fry trusts face struggle to survive
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Say hello, wave goodbye?
Venture Capital Trusts
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LEADER
Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investing for Growth Europe is home to many outstanding businesses, from ‘hidden champions’, industrial companies dominating attractive niches to luxury brand businesses which benefit from heritage and provenance, and younger, disruptive, internet-enabled businesses. We believe that the best way to create sustainable and growing returns for shareholders is by investing in such innovative and adaptive businesses, regardless of geographical location or sector. For those investing in our European investment trust, the Baillie Gifford European Growth Trust plc, the investment trust can invest in companies of €500 million and above. This gives the portfolio managers a pool of about 1,150 companies, out of which they can select the 40 or 50 companies which we believe are most likely to deliver outstanding growth over the next five to ten years. Having recently become the portfolio managers for this investment trust (previously known as The European Investment Trust plc), we have been radically reshaping the portfolio to take advantage of the opportunities we see. Over the next two or three years, we also expect to invest in unlisted companies valued at a minimum of €500 million, enabling us to invest in Europe’s most exciting growth companies, listed or not. However, we will not invest more than 10 per cent of the trust’s portfolio in these private companies. We are not looking to invest in embryonic businesses or ideas, but in established businesses choosing to remain private for longer. Businesses like these tend to be asset-light and do not require much capital, while owners often find it easier to create long-term value without short-term shareholders. Baillie Gifford has been investing in unlisted companies since 2012. We believe that unlisted companies like these are better held within the structure of an investment trust than a fund. Our shareholders can trade in the trust’s shares at the market price whenever they wish, while the closed-end structure of an investment trust means that there is never any need for us to sell any of our holdings to fund redemptions. So far, only around 10 per cent of the world’s unicorns – private companies valued at over $1 billion – have come from Europe, so it still has some catching up to do. Yet when we speak to companies in Berlin and Stockholm, we can see that the mindset is changing. Small can be Beautiful Looking at the European market over the past 30 years, it is niche industrial businesses that have delivered the best returns, companies such as ASML, whose lithography systems allow light to be projected through patterns to make blueprints for manufacturing semi-conductor chips, or Beijer Ref, whose environmentally-friendly fridges and freezers play a key role in reducing CO2 emissions in supermarkets and other commercial premises. The internet has made it much easier for smaller companies. The old theory that economies of scale were the most important thing no longer holds. IMCD is a good example of a capital-light business, and has been run by the same chief executive officer and chief financial officer since it was set up in 1995. A Dutch company, it markets and distributes speciality chemicals, which are used in cosmetics, food, drink, cars, detergents, paints and medication, a growing market as more chemical companies outsource distribution. Adapting to Change We tend to like family-backed businesses, such as Atlas Copco, and NIBE, a leading manufacturer of heat pumps. NIBE has been run by the same owner for 30 years. These Swedish companies’ business models depend on buying other family firms, and that depends on those owners being prepared to sell. We have seen that family-run Swedish businesses with a long history of successful acquisitions tend to be welcome purchasers. Europe also has a rich provenance in leading brands such as Gucci, owned by Kering, and Cartier, owned by Richemont. We have been impressed by the way in which both companies have nurtured their brands. Although Adidas is a more mass-market brand, it has its own valuable heritage, while L’Oreal, another strong European cosmetics brand, has stayed ahead of the times, using digital sales and marketing effectively. As investors, we care most about the long term. It is important for us to be able to trust the people running the businesses we invest in, and the know that they want to pass on the business to the next generation in even better shape than it is today. Despite the negative headlines, Europe is a fantastic region in which to seek out such companies.
MORITZ SITTE Investment Manager Moritz joined Baillie Gifford in September 2010 and is co-manager of the Baillie Gifford European Growth Trust. He graduated BSc in Business Administration in 2009 and went on to complete an MSc in Finance and Investment in 2010.
STEPHEN PAICE Investment Manager Stephen is Head of the European Equity Team at Baillie Gifford and co-manager of the Baillie Gifford European Growth Trust. Stephen graduated BSc in Financial Mathematics in 2005 and joined Baillie Gifford in the same year.
Investors may be cautious about investing in Europe. Economic growth is uninspiring, its politicians even more so. Europe lacks a technology giant and its lacklustre stock market is dominated by large, bureaucratic multinational companies in sectors such as financials, consumer staples and even healthcare. Baillie Gifford is not buying these companies, however. We are investing in a small number of innovative, proactive companies that happen to be domiciled in Europe. Let us explain.
SPONSORED STATEMENT
Continental Blend – The Case for European Companies
The Baillie Gifford European Growth Trust invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up. The trust’s risk could be increased by its investment in unlisted investments. These assets may be more difficult to buy or sell, so changes in their prices may be greater. The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research. Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions. Baillie Gifford & Co Limited is authorised and regulated by the Financial Conduct Authority (FCA). The trust is listed on the London Stock Exchange and is not authorised or regulated by the FCA. A Key Information Document is available by visiting www.bailliegifford.com
The value of your investment and any income from it can go down as well as up and as a result your capital may be at risk.
A Capital Idea for Growth
Investors may be cautious about investing in Europe. Economic growth is uninspiring, its politicians even more so. Europe lacks a technology giant and its lacklustre stock market is dominated by large, bureaucratic
Divining what will happen to power prices over the next 30 years as a result of the clean energy revolution seems absurdly difficult
Who knows what the future will bring? Right now investors are struggling to gauge the economic impact of coronavirus in the second half of the year. Amid that short-term uncertainty, divining what will happen to power prices over the next 30 years as a result of the clean energy revolution seems absurdly difficult.
Gavin Lumsden, Editor
Power plays
Will the rollout of wind and solar power lead to virtually free energy, an amazing concept for generations of consumers brought up on carbon fuels? Or will the proliferation of renewable power create new sources of demand that supports green energy prices? It’s an important question for investors in renewable infrastructure funds. In a relatively short time these dozen or so investment companies have established themselves as important providers of dividend income. However, those payouts and their premium share price ratings will be threatened should bearish predictions from the likes of Bloomberg New Energy be provoked accurate. In our first feature Jennifer Hill takes stock of an alternative income sector where sentiment has suffered due to fears that funds are cannibalising their growth prospects by contributing to the sharp reduction in the cost of energy. Uncertainty is inherent to venture capital trusts (VCTs), subject of our second feature, from both an investment and legislative point of view. That’s why experts recommend investors set a time horizon of at least seven years. And, as you probably know, the investment trust sector is littered with lots of interesting funds. However, many are too small and are struggling to capture investors’ attention. Those with a market value of under £100m face a doubtful future if they cannot find a strategy for growth and a story with which to excite investors.
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Next Generation of Progress
The Future of Food
The value of your investment and any income from it can go down as well as up and as a result your capital may be at risk. The food supply chain, as it stands, is unsustainable. With a world population of 8 billion people (forecasted to rise to nearly 10 billion by 2050), growing affluence and consumers with a strong preference for convenience, it is becoming ever harder to meet global food demands. Technological advances, however, are helping a few companies to reimagine how food is produced, prepared and distributed to help make the food chain fit for purpose for future generations. Among the companies held in the Scottish Mortgage portfolio, there are those that are predicting food requirements, automating inefficient practices and optimising how consumers receive their food. From helping farmers determine what seeds to plant, utilising natural support systems to improve efficiency levels, through to the possibility of robots delivering food to your door, these companies are revolutionising how and what we eat. Starting at the beginning of the food production process, Indigo Agriculture uses microbial coating on seeds to increase crop yields and help farmers to make a living, while reducing the environmental impact. The company also works with farmers to gather data on the success of crops, to drive further incremental improvements. In an industry where climate change is having a big impact, Indigo uses technology to analyse images of the earth from satellites to figure out what is growing where and what the conditions are. This insight allows Indigo to monitor the world’s food supply and determine where to focus its efforts to greatest effect. The company has a significant growth potential, even if it only succeeds in supplying a small percentage of the world’s crops grown today. Once food is produced, it typically makes its way to customers via supermarket shelves. However, with more and more people wanting greater convenience, but also healthier and more responsible food choices, companies such as HelloFresh, offering a meal-kit subscription service, take the hassle out of the dreaded food shop. Each week, HelloFresh provides customers with new meals, delivering the exact amount of ingredients required with clear instructions on how to cook, helping to lower the amount of food waste per household. With over 2 million customers worldwide and access to vast amounts of data, the company can determine customer preferences, including what recipes, ingredients and meals each household enjoys. This information allows HelloFresh to optimise its supply chain management – if it is delivering 1 million meals tonight and knows it needs 100 tonnes of carrots, the company can buy them in bulk and negotiate a better price. Another change in dining preferences is that people want to eat restaurant-style meals, but in their own homes, often with friends. This trend underpins German-born company Delivery Hero, which has one of the largest networks of restaurants in the online food ordering and delivery space. It partners with more than 150,000 restaurants around the world and currently delivers over 1 million orders a day. Its daily target is 10 million. As Delivery Hero scales its network, its focus remains on keeping both its restaurants and customers happy by personalising the service they receive. By tracking data on restaurant performance and customer satisfaction, the company can see when customers receive the wrong food, if an order is not delivered, or if a certain dish leads to very negative customer reviews. By gathering all the data across its network, Delivery Hero can help its restaurants tailor their menu offering, improve food quality and build a loyal customer base. Taking food distribution to another level, Meituan Dianping is the largest food delivery company in China, managing over 30 million orders a day. In China, there is a more of a culture of people entertaining, eating out and having food delivered, rather than cooking for themselves. Many people order three meals a day. To meet this demand, Meituan has a delivery fleet of over 500,000 drivers, who can complete an on-demand delivery within an average of 30 minutes, thanks to its AI-enabled ‘Super Brain’ engine that figures out the fastest delivery route for an order within 0.55 milliseconds. But the company is not stopping there. In an attempt to cut costs even further, work is underway on developing a fleet of autonomous, food delivery robots, which can even use elevators. This trend is already influencing the way new homes are designed in China. Watch this space.
The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates. Investing in emerging markets is only suitable for those investors prepared to accept a higher level of risk. This is because difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment. Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions. Baillie Gifford & Co Limited is authorised and regulated by the Financial Conduct Authority. The investments trusts managed by Baillie Gifford & Co Limited are listed UK companies and are not authorised and regulated by the Financial Conduct Authority. A Key Information Document is available by visiting www.bailliegifford.com
Against the backdrop of an overstretched food chain, companies in the Scottish Mortgage portfolio are taking technological advances to the next level. A new generation of businesses are reshaping our world and what is possible as they endeavour to future proof the food chain.
Check out our website – citywire.co.uk/investment-trust-insider – for your daily dose of news, interviews and comment on your favourite investment funds.
INSIDE TRACK
Investment trust directors debate the fallout for their sector from the problems at Woodford Patient Capital Trust last year.
VIDEO
Woodford Scandal: the lessons investment trusts should learn
Fund manager who took Martin Currie Global Portfolio to top of its sector last year discusses his approach.
Zehrid Osimani: coronavirus disrupts but doesn’t supply long-term shock
A short beginner’s guide to the specialist investment companies focused on small, unquoted businesses.
Gavatar: what are venture capital trusts (VCTs)?
Ian Cowie: the 21st century’s top 20 investment trusts so far
COMMENT & ANALYSIS
Liberum’s Dozen: income and growth trust picks for 2020
2019: top 10 surprises & upsets from a stunning year for trusts
James Carthew: Scottish Mortgage seeks 1.3% of the very best global companies
TOP NEWS
Trust Watch: chance to buy a ‘cheap’ Scottish Mortgage
Ian Cowie: the emerging market trust I’ve bought to shoot the lights out
Renewable funds could plunge 40% on ‘cannibalisation’ threat, say JPM analysts
Ian Cowie: it’s time to add a new Japan trust as Shin Nippon goes off the boil
Morningstar downgrades Nick Train’s funds over capacity concerns
Tesla surge takes it past Amazon to be Scottish Mortgage’s number one
Jupiter fund slumps as bets against Tesla and Scottish Mortgage misfire
Investment trust managers pick their top themes for 2020
New Year Tips: Winterflood overhauls investment trust recommendations for 2020
Scottish Mortgage: Tesla shares could double from here
Lindsell Train wobbles as Train’s bestseller status wanes
Witan switches Lindsell Train from UK to global mandate
Risky Renewables: now Jefferies questions dividend cover if power prices plunge
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Key Points:
Renewable infrastructure investment trusts are among the few closed-ended fund sectors to have sustained high share price ratings despite the wider market gyrations of recent years. Investor demand for uncorrelated sources of income has unsurprisingly seen frequent fundraising activity and at times exceptionally high premiums over net asset values.
Until recently, shares in renewable infrastructure investment trusts were trading at all-time highs, reflecting investor enthusiasm and flows into the asset class. However, a string of negative broker notes has cast doubt on the sustainability of returns and caused their premiums over net asset value (NAV) to drop. The average premium share price premium fell from 16.6% to 14% in late January when JPMorgan Cazenove kicked off a run of bad news for the sector, and has since slipped to under 13%. Analysts Christopher Brown and Adam Kelly said trusts risk becoming ‘a victim of their own success by cannibalising their own revenue base’. Growth in carbon-free energy is expected to push the cost of electricity sharply downwards over the next two to three decades. Based on a forecast from Bloomberg New Energy Finance (BNEF), an independent forecaster owned by financial media giant Bloomberg, they said listed renewable energy funds face a 33% drop in asset values. And because of their elevated share prices that could translate into a 43% fall in their stocks. BNEF is pencilling in a 4% annual decline in UK baseload electricity prices in real terms to £19/MWh by 2040 and £15/MWh by 2050 – an outlook that contrasts starkly with the forecasts used by renewable energy infrastructure trusts, which Brown and Kelly estimate at 0.6% annual growth for the next 20 years to an average of around £52/MWh by 2040.
Jefferies analyst Matthew Hose followed up the Cazenove note by pointing to the scale of recent electricity price declines – a year ago, UK baseload summer 2020 prices were around £53/MWh, but ended 2019 at £39/MWh and a month later were £36/MWh – and the possibility of a deeper de-rating in the sector. ‘What makes the situation more interesting is that the funds’ exposure to power prices within their underlying portfolios has been increasing over time,’ he said. ‘This is generally a function of the gradual erosion of future subsidy cash flows, the introduction of subsidy-free projects and increases in assumed asset lives. ‘It is easy to forget the situation in late 2015/early 2016 when the funds (Greencoat UK Wind [UKW] aside) traded on small discounts, we suspect due to the level of UK power prices at the time,’ Hose said in a note to investors. A more pertinent risk, according to Hose, stems from the impact of falling power prices on near-term cash flows and the ability of trusts to pay covered dividends.
by Jennifer Hill
RENEWABLE ENERGY
However, the most bearish prediction to date on UK power prices – significantly below the current forecasts used by funds to calculate their net asset values – has rattled investor sentiment, sending share prices and premiums sharply downwards.
We look at the potential power price ‘cannibalisation effect’ and the counter-arguments to it. Who are the renewable energy trust bears and bulls, and which trusts still merit investors’ consideration?
01
Reality check
Stifel analyst Iain Scouller expects the current reporting season to act as a ‘reality check’ for the sector with lower inflation, a cancelled corporation tax cut and falling yields all ‘lurking’ alongside energy price declines. The retail prices index measure of inflation stood at 2.2% in December – well below the typical 2.75 to 3% used by renewables trusts when valuing their portfolios. That’s significant because any government subsidies the funds receive are linked to the cost of living. Higher inflation will increase their cash flows and hence their valuations. Corporation tax is another key input for the discounted cash flow method of valuation, which discounts the future cash flows of an asset by an appropriate rate to arrive at a net present value for the asset. The Conservative government’s shelving of a corporation tax cut from 19% to 17% stands to decrease projected discounted cash flows and reduce renewables trusts’ NAVs per share. While it is easy to see the attraction of yields of 5%-6% at a time when 10-year government bonds yield just 0.6%, the increase in trusts’ share prices has forced yields down to lows. UKW, a fund focused on buying wind farms in Britain and the first renewable energy trust to launch in an oversubscribed flotation in March 2013, now has a sub-5% yield. With around 50% of revenues linked to market power prices, compared to 33%-40% for the other six big funds in the sector according to an analysis by Stifel, it is among the most sensitive to short-term price movements. It has held up relatively well amid the turn in investor sentiment since the start of the year, which sent share prices in the sector sharply downwards, though they have partially rebounded. Bluefield Solar Income (BSIF) has been particularly impacted despite 60% of its revenues being linked to subsidies or fixed agreements. Analysts at Numis Securities, which is broker to BSIF, said this looks unjustified given the quality of its earnings, driven by a strong acquisition pricing discipline by the manager. ‘Given the high performing and conservatively valued portfolio, BSIF remains a core “buy” [for us] with a covered dividend of 6.1% after debt amortisation, compared with the peer group weighted average yield of 5.1%,’ said analyst Colette Ord. She believes premium ratings are sustainable across the sector given the attractive yields on offer. While future share issuance is likely to provide a more attractive entry point – ‘in principle, it is better to buy shares in these trusts on issues as you can usually get them at a cheaper price,’ said Darius McDermott, managing director of Chelsea Financial Services – analysts and investors still see merit in picking up shares on the secondary market. We asked a number of them to detail their bullishness on the sector on a scale of one (most bearish) to ten (most bullish) and their top pick.
James Carthew, QuotedData Renewables Rating: 8/10
While James Carthew, head of investment company research at QuotedData, thinks power prices will come down, he doesn’t think the drop will be as dramatic as BNEF expects. It appears an outlier in its forecast with others, such as Baringa and Poyry, being less bearish in their outlooks.
‘One comment we have heard that makes sense is that renewable energy funds would just stop investing if they didn’t think the returns were available,’ said Carthew. ‘Another thing to bear in mind is that the shifts from petrol/diesel powered transport to electric vehicles and gas-powered heating to electricity means a lot more demand for electricity. ‘I also think that the yields offered by these funds will remain attractive relative to bonds and interest rates for a long while yet.’ If he had to pick a single trust in the sector, it would be JLEN Environmental Assets (JLEN), which benefits from having a very diverse portfolio and relatively lower proportion of its revenues linked to market power prices (36% according to Stifel).
Cantor Fitzgerald analyst Markuz Jaffe puts himself on a ‘moderately optimistic’ seven out of ten. ‘Whilst a premium of 10%+ may be unpalatable, the carrying value of assets held by these companies is often conservative versus open market transactions, particularly for those benefiting from government-backed subsidy revenues,’ he said.
Counter-arguments to the power price ‘cannibalisation effect’ include prices reaching a floor if returns for new-build solar/wind capacity became insufficient and governments or other regulatory bodies imposing minimum pricing to protect returns and incentivise ongoing investment in carbon-neutral power. ‘Underpinning this is the fundamental need for power markets to balance, with the alternative being power shortages and blackouts – costly from both an economic and political viewpoint,’ said Jaffe. He likes SDCL Energy Efficiency Income (SEIT), a newcomer having been launched in December 2018. Its portfolio includes large-scale energy efficient light installations and combined cooling, heating and power units. Revenues come from availability-based contracts so are not linked to subsidies or power prices, making this a ‘complement for climate-aware investors who are already exposed to subsidised renewable generation assets’.
Markuz Jaffe, Cantor Fitzgerald Renewables Rating: 7/10
John Newlands, founder of Newlands Fund Research, points to opposing forces at work: widening support for renewables on the one hand, supported by the UK’s aim to become carbon neutral by 2050, and a backdrop of reduced subsidies on the other.
‘The attractions are clear to relatively risk-averse investors, especially if they need income, noting the wider backdrop of low interest rates of all kinds,’ he said. ‘Having said that, old knackers – you can say wizened veterans – like me have never been convinced of the long-term merits of such funds compared with generalists such as Witan (WTAN), F&C (FCIT) or Scottish Mortgage (SMT) that are capable of generating high singe figure annualised total returns over literally decades. ‘If I had to pick one though, I’d go for something like the Renewables Infrastructure Group (TRIG), with a top-flight management company and diversification both geographically and by energy source. ‘Unlike many peers it has the ability to chop and change between solar, onshore and offshore wind and battery storage as markets and governments change.’
John Newlands, Newlands Fund Research Renewables Rating: 6/10
Relative to the bond market renewable energy trusts ‘still offer compelling value for diversifying assets’, said Architas investment manager Solomon Nevins. The multi-manager has used renewables trusts in its Diversified Real Assets fund since it launched in 2014, but has been taking some profits, taking the allocation to 4.5% from a high of 6% at the start of 2019.
Nevins is unsurprised by the shaky start for the sector in 2020. ‘The market has finally latched onto the power price risk that comes from a growing renewable energy sector,’ he said. ‘With very low marginal operating costs there’s no incentive to halt production in a low price environment, which had historically been the case in an energy market dominated by fossil fuel production. We have held these concerns since the sector’s inception so taken power price forecasts with a pinch of salt.’ He prefers social infrastructure, upon which he rates his bullishness as a seven out of ten. His pick in the sector is HICL Infrastructure (HICL), which he recently added to the Diversified Real Assets Fund after the Labour party threat of nationalisation diminished.
Solomon Nevins, Architas Renewables Rating: 5/10
Darius McDermott is managing director of Chelsea Financial Service, which has been researching venture capital trusts (VCTs) for the nearly 20 years. He has invested personally in them for 15 years and has built up a portfolio of six, which he adds to annually.
Venture capital trusts (VCTs) are big business in the run up to the tax-year end as investors seek to capitalise on the attractive tax breaks they offer. Funds raised in prospectus offers so far this tax year stand at £350 million (including offers that have already closed), figures from investment platform Bestinvest show. There is £252 million remaining capacity not including over-allotment facilities, which could in theory add another £230 million. A wide field of 18 offers are open from 23 underlying VCTs. These include some nascent portfolios, such as Blackfinch Spring, Foresight Williams Technology, Puma Alpha, Seneca Growth Capital and Triple Point 11 Venture Shares, which are ‘frankly struggling to raise cash’, said Jason Hollands, head of Bestinvest’s VCT service. To help readers navigate the VCT universe this tax-year end, we have gleaned the most pertinent information from him and three other expert panellists.
What is the background to VCTs?
HR: VCTs were first launched in 1995 as a way of helping introduce investment into UK smaller companies. They are structured just like an investment trust – they are listed on the main list of the London stock market and have a board of directors, chairman, memorandum, articles of association and a listed price and have to produce annual and interim reports and accounts. Like an investment trust, a VCT will seek to raise a certain amount of capital from investors over an offer period. Once it has raised the money it seeks, the manager of the VCT then sets out to invest into VCT qualifying companies.
our panel
Hugh Rogers has been involved with VCTs since 2001. He researched them at Bestinvest from 2001 to 2006 and joined broker Shore Capital in 2009 where he promoted VCTs and EIS offers to financial advisers. He returned to his research roots in 2019 as a director of Tax Efficient Review. He doesn’t invest in VCTs personally to maintain utmost independence but is keen to educate private investors and financial advisers on their benefits.
Jason Hollands is a managing director at wealth manager Tilney. He heads the VCT service at Bestinvest, Tilney’s direct-to-consumer platform, which has been researching the VCT market since its inception in 1995, publishing detailed reviews of offers and operating a star ratings system. It has a full-time analyst covering VCTs and other-tax efficient schemes. Hollands holds a number of VCT investments and values the tax-free dividends they generate.
John Newlands is founder of consultancy firm Newlands Fund Research. He has notched up 24 years’ experience in the investment companies universe. He describes himself as ‘lukewarm generally’ on VCTs for a number of reasons, which he details in this feature.
DM: There are four types of VCT. Generalist VCTs cast a wide net to find investment opportunities in companies at various stages of development, in all different sectors. These are arguably the most popular form of VCTs. Specialist VCTs invest in companies within one specific sector. These are not as common as they have been in the past. AIM VCTs invest in companies which are, or about to be, listed on the Alternative Investment Market (AIM), the junior stock exchange. At the lower risk end of the VCT spectrum, limited life VCTs aim to invest capital and then wind up within five to seven years. This is a guideline time horizon and not a guarantee. HR: It’s a myth that VCTs have to invest into seed capital or start-up businesses. They don’t – they can have assets and established revenue streams – but there are strict rules regarding what is and isn’t a VCT qualifying business, including that it can’t have can’t have any more than 250 employees. A large VCT that has been trading for many years could have upwards over 50 VCT companies within it. So, they are diverse investments and they can also hold an element of cash and more liquid investments to aid liquidity and diversification.
In which types of companies do VCTs invest?
DM: VCTs offer attractive tax breaks. You can receive 30% income tax relief on investments of up to £200,000 per year. However, in order to receive and keep this there are three conditions: 1. You must buy new VCT shares not those on the secondary market; 2. You must have paid the equivalent amount, or more, in income tax that year. So, in order to claim back £15,000 from a £50,000 VCT investment, you must have paid at least that in income tax. If you have only paid £10,000 in income tax you can only claim that back. 3. You must hold shares in the VCT for at least five years to keep the income tax relief; if you sell before this point, you will have to pay it back. Other tax benefits include no income tax payable on dividends [these can either be taken or, if the VCT has a dividend reinvestment plan, reinvested to achieve further 30% income tax credits]; no capital gains tax payable upon the sale of the VCT; and gains within the VCT being free from corporation tax.
What are the tax breaks?
HR: VCTs are approaching their 25th anniversary and they have survived a succession of chancellors and economic cycles, but that doesn’t mean they haven’t had to change and adapt to many rule changes over the years. Most recently, the Patient Capital Review came into effect in 2017. This redirected the investment focus away from asset-backed companies towards the pure growth capital companies that VCTs were originally designed to support. It meant that VCT managers could no longer invest in companies which traded out of a property, such as a garden centre or childcare facility, where the value of the property represented the value of the trading business. VCTs now have to invest in the equity of third party businesses.
Have the rules changed much over the years?
DM: VCTs carry a higher risk than many other forms of investment. The value of an investment in a VCT may go down as well as up and investors may not get back the full amount invested even after taking into account the tax reliefs, which are subject to change. JH: Fund size is important – neither too big nor too small. Most VCT offers include a facility to extend the size of an offer – an over-allotment facility – once the initial target is reached, but these are not always called upon. That’s because finding the right deals – origination – is key. VCTs must invest at least 30% of cash raised within one year and 80% within three years. In the world of listed companies any fund manager could choose to invest in Unilever or Sage. When it comes to unquoted companies, not only do VCT managers have to find deals, but the company has a big say in who they decide to take financing from. JN: I have three main health warnings to offer. First, there can be a massive disparity between the best and the worst, therefore even more research than usual is justified. Secondly, the frankly swingeing initial charges on VCTs can sometimes be reduced or even avoided by purchasing via platforms or wealth management companies. Thirdly, be aware that these funds are like lobster pots – much harder to exit than enter, so a long time horizon is advisable.
What risks should investors consider?
HR: An investor who wants to exit will need to sell their shares on the secondary market. There is little trading in VCTs on the secondary market. Consequently, wide discounts can open up between the net asset value and quoted share price. VCT managers often have buy-back policies designed to police the discount, but there is no guarantee of them buying up secondary shares.
How do investors exit VCTs?
HR: In reality, investors should approach VCT investing with a seven to 10-year timescale in order for the underlying companies to show what they can do. The minimum investment size for most VCTs is relatively low, often around £3,000 or £5,000, which means it’s easy even for smaller investors to split their investment across two or three to help mitigate risks. By spreading their investment, investors can diversify across different types of VCTs and managers who focus on different parts of the VCT capitalisation scale.
How can investors mitigate risk?
HR: Investors who have maxed out their pension contributions often turn to VCTs to boost their tax-efficient investments. They can develop a rolling pot of VCT investments, which kicks off some healthy tax-free dividends from five years onwards. JH: For the right investor, VCTs can be a really usual part of an overall tax-efficient investment strategy on top of core allowances such as ISAs and pensions, but while I am an investor myself they are not suitable for everyone and I get alarmed when I hear talk about them being an alternative to a pension. A typical VCT investor will be someone already fully maximising ISAs and pensions, who is subject to the higher or additional rates of tax and who has a substantial portfolio of mainstream investments, with VCTs representing less than 10% of an overall portfolio.
Who are VCTs suitable for?
Venture capital trusts are listed on the London Stock Exchange, just like investment trusts
VCTs have hired investment analysts to assess more start-up and unquoted companies
JH: That was the second wave of changes. The first, in November 2015, put an age cap on the businesses that can receive VCT or EIS funding (now they must normally not be more than seven years old) and refocused VCTs on providing development capital to younger businesses by precluding them from purchasing shares off an existing owner. This gave a major advantage to VCTs with mature, legacy portfolios of less racy holdings backed when the rules were less restrictive. Mature VCTs are evolving in risk profile as new deals are undertaken in accordance with the current rules, while in the meantime the legacy positions provide relative stability and exits from these should reward investors with special dividends. The rule changes also make traditional VCT categories less relevant. For example, the Baronsmead VCTs, which formerly focused on management buy-outs at unquoted companies, now have more exposure to AIM companies than unquoted businesses. Most AIM VCTs are increasingly doing unquoted deals – for example, Unicorn AIM is 18% unquoted – as it is hard to find new AIM stocks that are less than seven years old. You therefore have to look at VCTs with two sets of eyes: what’s the quality of the mature portfolio and the track record on this, but also does this manager have the right skills and expertise to do the new, earlier-stage types of deals? A number of groups have effectively hired new teams to lead the new deal process.
Investors should view VCTs as seven to ten-year investments
HR: The Patient Capital Review has put the established ‘growth’ VCT managers back in the spotlight – Northern, Proven, Baronsmead and Draper Esprit are all proving popular as they’ve not had to redefine their investment strategies to adapt to the new rules. Albion and Mobeus are also in that category, but have already closed their fundraising for this year. JH: Of the current crop of offers, those with the highest rating from Bestinvest are Amati AIM, the Northern VCTs, the ProVen VCTs and Octopus Titan. DM: VCTs we like that currently have open offers are Pembroke VCT, which invests in high quality retail and hospitality businesses, ProVen VCTs, which has a strong track record in growth capital investing and was arguably the least affected by the rule changes, and Amati AIM, an established portfolio of AIM companies that provides ballast for more recent growth investments.
Which VCTs should investors consider?
VCT OFFERS
Over 70 investment trusts have market values under £100m and are at risk of being left behind as the sector expands.
Wealth management firms that are the main buyers of investment trusts are increasingly reluctant to consider smaller ‘closed-end’ funds with market values under £100m. A survey by Winterflood Securities of delegates at its annual investment trust conference in January found just 42% were prepared to buy trusts below this threshold. This was less than the 55% who said so last year and down from 71% in 2013 when the broker first asked the question.
Small-fry trusts face struggle to survive
73 TRUSTS UNDER £100M
That is because they are increasingly viewed as too small to make it on to the watch lists of wealth managers that are the main buyers of investment trusts today.
Broker Winterflood Securities has urged the companies to come up with a strategy for growth if they want to have a long-term future.
Left behind
Big wealth management firms dislike small investment trusts because there are not enough shares in the market for them to buy on behalf of their clients. As wealth managers have consolidated into a handful of very large firms, such as Brewin Dolphin, Investec and Rathbones, they have become increasingly professional in the way they operate their businesses. Most have centralised ’buy’ lists compiled by research teams in their head offices from which their portfolio managers can choose. In order to ensure the private investors they serve get a consistent and comparable service, they require big ‘liquid’ trusts with sufficient shares to trade on behalf of all their eligible customers. The Winterflood survey also highlighted the growing demand for larger trusts with 14% of respondents preferring trusts with market capitalisations of over £200m, compared to just 3% in 2016. Bigger investment trusts not only have the capacity to support larger trades, they also have the advantage of lower costs to benefit investors. As a percentage, their annual ongoing charges tend to be smaller as much of the costs of running a trust are fixed and can be spread across a bigger pool of assets on a fund over £100m. The ‘spread’ or gap between the ‘offer’ and ‘bid’ prices at which brokers buy and sell trusts also tends to be narrower for larger investment trusts, making it less costly to trade in an out of them.
Despite the existential challenge they face, there are some interesting and worthwhile funds among this list of small fry for long-term, private investors to consider.
The problem for the 73 ‘small-fry’ investment trusts listed below is that the lack of wealth manager interest is already affecting their shares. Many, such as ScotGems (SGEM), a £40m global smaller companies trust run by Stewart Investors, trade at substantial discounts to net asset value due to a lack of investor demand. Of course, there can be good reasons for this neglect. ScotGems, for example, is a relatively new trust that was slow to invest its money. A lacklustre start was compounded recently by a change in the fund managers. Other smaller trusts have had their misfortunes. Performance at the £41m Downing Street Micro-Cap (DSM), another new entrant of recent years, has suffered due to problems at some of its portfolio companies, while sentiment towards AEW UK Long Lease (AEWL), a £60m real estate investment trust, was damaged last year when its biggest tenant went into administration and the board sacked the fund manager AEW UK. Several of the funds on this list are in the slow process of winding up and returning money to shareholders, such as RDL Realisation (RDL), formerly known as Ranger Direct Lending; the two Better Capital private equity funds; emerging markets focused Ashmore Global Opportunities (AGOL) and CatCo Reinsurance Opportunities (CAT), which was hurt by the spate of hurricanes and wildfires in the past two years.
02
On their way out
While the boards and fund managers of many of these trusts have their work cut out in improving performance and communicating better with investors, there are lots of worthwhile funds on the list for private investors to consider. Individual investors, making long-term buy-and-hold purchases for their pensions, can be more tolerant of a lack of liquidity in an investment trust. And small trusts are not always unattractive. The £79m R&M UK Micro Cap (RMMC) and £71m Miton UK MicroCap (MINI) both have mechanisms to regularly return money to investors to ensure they do not get too big for the very small companies in which they invest. Wide discounts cannot always be blamed on the trusts. Crystal Amber (CRS), an activist investor, and Marwyn Value Investors (MVI), a specialist smaller companies fund, have both seen their discounts widen due to forced selling by fund manager Neil Woodford when his business collapsed last year. Some, like Mobius (MMIT), a £98m emerging markets smaller companies trust run by a team headed by the veteran Mark Mobius, and the £91m JPMorgan Multi-Asset Trust (MATE) or the £80m Ashoka India Equity (AIE), are new having launched in 2018 and probably have a good chance to win investor support and grow. Other long-standing trusts may have been left on the shelf but can make worthwhile investments for patient investors who have done their research. Among trusts in this category are the BMO Managed Portfolios - Growth (BMPG) and Income (BMPI) - which are ‘funds of funds’ run by trust picker Peter Hewitt offering investors a one-stop shop if they want it. At £86m, Henderson Opportunities Trust (HOT) is the smallest of three trusts run by James Henderson and Laura Foll at Janus Henderson. Appropriately enough, it focuses on smaller companies more than the Law Debenture and Lowlands equity income trusts they also manage. Although performance in recent years has been held back by the managers’ ‘value’ investment style, it could do well if domestic UK stocks continue their post-election rally. David Horner and David Taylor’s Chelverton UK Dividend (SDV) is a £44m racy, higher-risk smaller companies trust that nevertheless has its admirers for good long-term returns and attractive dividend yield of 4.6%. Lastly, the £79m Miton Global Opportunities (MIGO) deserves a mention as fund manager Nick Greenwood also invests in investment trusts, although unlike Hewitt he focuses on overlooked and special situation funds, many of them on this list, recognising that the emergence of a ‘two-tier’ investment trust sector can provide opportunities for investors prepared to do some digging.
03
Special situations
Simon Elliott, Winterflood
Simon Elliott, head of investment trust research at Winterflood, said the declining level of support for smaller investment trusts among such a key investor group raised fundamental questions over their long-term future. ‘While some of these are in managed wind-down, we believe that it is essential for those ongoing vehicles to have some plans to grow if they wish to continue to remain relevant to the wider investment community,’ he said.
by Gavin Lumsden
Investment Trust Insider is published by: Citywire Financial Publishers, First Floor, 87 Vauxhall Walk, London SE11 5HJ. Tel 020 7840 2250 Fax 020 7840 2251
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