With merger regulations now in force, the venture capital trust industry looks set for consolidation as it reaches its tenth anniversary, yet some problems still need to be ironed out.
The venture capital trust (VCT) industry is approaching its tenth anniversary and is showing the first signs of becoming a more mature market.
In recent months we have seen the transfer of the Advent funds and the removal of Classic Fund Managers by Downing as evidence of this greater maturity. Now we have the long-awaited merger legislation in force to help the market develop further.
The nature of the VCT market is such that there are a relatively large number of small trusts. The potential for merger benefits is therefore high. For example, the merger of two trusts with different advisers provides cost savings on management fees as well as board remuneration and administration charges. Another obvious potential is created where one fund manager advises a number of VCTs (perhaps raised in different tax years).
Economies of scale will be immediately available if these VCTs merge to form one trust - not to mention the additional portfolio diversity provided by a larger investment pool.
In principle, any consolidation should be good news for VCT investors. However, in practice, we need to ask whether the industry is ready to take advantage of the merger rules in the way that they are intended.
The aim of the legislation is clear: to provide benefits of cost and efficiency for shareholders through meaningful consolidation among the large numbers of smaller trusts. The legislation is very much geared towards share for share exchanges. And, while there appears to be little opportunity to realise cash, there is a relatively minor restriction on the amount that can be used for share buy back programmes, so making a merger look more attractive in most cases.
First, the cost of mergers needs to be considered. VCTs both benefit and suffer from having a full stock exchange listing. This gives them a share price quote so that full listing rules apply to a merger. This can be particularly onerous in cost terms for smaller VCTs as any costs will tend to be fixed rather than scalable.
Potential future cost savings could be almost wiped out in some cases. It is arguable, therefore, that those trusts that would benefit most from merging are the ones most difficult to merge.
Second, there is the question of shareholder approval. The new legislation requires a 75% majority of the shareholders in any VCT hoping to merge to approve the transaction. Historically the proportion of shareholders that vote on any resolution is low.
But until shareholders are more likely to vote on merger resolutions, there may be a degree of reluctance on the part of VCT boards to risk the cost of even bringing the resolution to their shareholders.
The easiest mergers should be where a number of small trusts share the same investment adviser but all have separate boards, stock market listings and charges.
In these cases, bringing these trusts together should mean instant cost savings through board rationalisation, reductions in audit fees, management fees and other overheads.
But there is a significant barrier to this type of merger. A VCT is limited to investing no more than £1m in any one company in a single tax year. At present, advisers with more than one VCT will typically use their multiple trusts as co-investors in the same company. This means that sometimes as much as £3m to £4m is invested in that company but spread across four or five VCTs. This is very efficient for the adviser and provides cost benefits to the investors in all trusts as it brings down the overall transaction costs. As a consequence, VCT boards may again consider the benefits of merging outweighed by the disadvantages.
More pressure to raise the investment limit is clearly needed, in particular because this upper limit has not been raised since the creation of VCTs. This has been significantly devalued since then by inflation. Yet there appear to be no plans to raise the limit in the near future.
A number of issues that need to be resolved before the first mergers can take place. Once board directors and shareholders work through these problems and mergers take place, all those involved should benefit. As the industry matures consolidation should create a self-fulfilling quality control function, so that only the highest quality trusts survive.
• Mergers of VCTs could cut costs and provide a longer investment pool.
• Costs of a merger might make this a less viable option for smaller VCTs.
• Investment limits need to be raised but there are no plans to do this in the immediate future.