VCT guide

43 42 RESEARCH AND DUE DILIGENCE RESEARCH AND DUE DILIGENCE LIQUIDITY - Liquidity at an investor level is concerned with how readily and at what discount an investor can liquidate their investment outside of any pre-determined realisation strategy. VCTs’ shares are not widely traded and they often trade at a discount to their Net Asset Value (NAV). VCT managers do often offer share buyback schemes to enable divestment, but these are usually at a discount to the underlying asset value and are not guaranteed. ANTICIPATED DIVIDENDS/RETURNS (WHERE STATED) - Advisers should assess how returns (without tax reliefs) are generated and take a view on the likelihood of those returns being achieved in different economic conditions. HMRC COMPLIANCE AND MONITORING - Failure to adhere to the rules could result in the VCT losing its approved status, which would result in a clawback of tax relief for any investors who have held their shares for less than five years. Most VCTs have appointed professional advisers to monitor the VCT and the investments it makes. VCT PROSPECTUS, FACTSHEETS AND ANNUAL REPORTS - These documents contain key information about the offer as well as the VCT as a whole, the parties involved, investments held and past performance. KEY INFORMATION DOCUMENT (KID) - A three- page overview of a fund's main features including its objectives, summary risk indicators, charges and performance scenarios. However, some commentators, trade bodies and VCT managers have expressed concerns over the methodology behind the risk ratings in KIDs, as they generally (and controversially) give VCTs very low risk ratings (see page 33). PORTFOLIO STRATEGY - The investment strategy of a VCT defines what it will invest in, such as what sector investee companies are involved in, how established they are and whether they are quoted on AIM. It will also discuss the sector and subsector (there is a range of general and specific VCTs). These factors will determine the potential risks and rewards that the VCT is exposed to. PORTFOLIO COMPOSITION - Is the portfolio of investments concentrated or diversified? The level of diversification across underlying investments varies, but advisers should assure themselves that it is in line with the investment objective and is commensurate with the nature of the underlying investments. Other areas of research and due diligence on VCT investments could include: Discounts and premiums When investment company shares are traded on a stock market, the share price may be higher or lower than the NAV. The difference is known as a discount or premium. • Buying shares at a discount means you pay less than the NAV. • Buying at a premium means you pay more than the NAV. UNDERLYING INVESTMENTS It is important to understand: • The nature of proposed underlying trades • The investment stage • The industry sectors they are in • The risks they are exposed to • The level of returns they can generate and how they are generated • How quickly they return to cash or how liquid they are • The manager’s experience investing in the proposed trades. Advisers should also evaluate the anticipated deal flow and deal pipeline for the VCT and assure themselves that the manager is able to deploy the VCTs they raise in line with the proposed investment strategy. The VCT rules generally restrict companies that can receive VCT funding to smaller companies that have been trading for seven years or less (ten years or less for KICs, although a KIC also has more flexibility regarding when this ten-year point starts – see page 25 for more information on KICs). In commercial terms, this means that the companies in a VCT portfolio are all ‘early stage’. But, within this classification, there are various stages of fundraising depending on the development stage of the investee. The funding stage definitions are not fixed, but are typically: Seed: Seed rounds are among the first rounds of funding a company will receive, generally while the company is young and working to gain traction and build a product from an idea. It is likely to be pre-revenue. Series A: The company may have some established revenues and is typically pre- profit. At this stage, it is seeking to identify the commercial viability of its product or service (product-market fit). Series B: The company may be making small profits but is looking to scale and has growth aspirations outside current revenue streams. Therefore, the funding round is an indicator of risk, with earlier stage funding likely to be higher risk, but lower cost. This brings the opportunity for higher returns, but also greater potential for losses. It is not unusual for VCT managers to diversify across funding stages. Some also reinvest in the same company at a later stage as it develops and proves its value. It is also worth noting that follow on investment, by any party, can dilute the shareholding of earlier stage investors if they are not prepared to invest in the new round of funding. Shares issued to a VCT can’t have anti-dilution rights. Consequently, each time equity investment is taken by the company, new shares are issued. As a result the total number of shares in issue increases, meaning that an existing shareholder who does not invest in the new round (which would increase the number of shares they hold) will hold a smaller percentage of the new total number of shares.