Investors who want to tap into venture capital and the kind of start-up businesses out there that might be crucial post-pandemic have various UK options. The author of this article examines the terrain.
The economic hurricane caused by COVID-19 is hitting asset values. Sure, listed equity markets have recovered from their lows, but the overall financial market position is fragile. This raises questions about whether business assets can be bought at a sharp discount, opening up prospects for a gain later on. How does venture capital fit into this, and what sort of considerations should VC investors have in mind? After all, VC is meant to be a “patient” form of investing, with time horizons of a decade or longer. To answer that and other questions is Moray Wright, CEO and co-founder of Parkwalk. The firm is a growth fund investor.
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“And why do we fall, Bruce? So we can learn to pick ourselves up.” The words immortalised in Christopher Nolan’s epic Batman trilogy, which I’m sure many of us have indulged in once again during this period of lockdown, reflect in some ways the current sentiment across the investment landscape - particularly in venture capital - but there is a light, even from the bottom of the coronavirus well.
VC delivers increased returns post-crisis
When we last fell in 2008, VC delivered increased returns, as entry points reduced by 20 per cent to 50 per cent. Since then, we have seen a near tripling in valuations for Series A/B/C and quadrupling in Series D valuations during 2014-2019. VC valuations generally lag listed market corrections but as we are seeing with examples such as Monzo - expected to suffer a 40 per cent drop in its value after a fundraising round later this month - it hasn’t taken long for this crisis to impact venture capital.
But for those investors deploying capital now into growth businesses this means there is an opportunity. According to data from Numis, returns from VC investments made in 2020-2022 will exceed those of recent years due to the combined effect of lower valuations and a drop in the cost of companies’ marketing and salaries, creating a golden ticket opportunity for new fund managers without portfolios and with lower blended entry prices, to invest in these companies.
After the 2001/2008 crashes, realised multiples from in-year investments increased by 1 (2008) to 1.25 (2001) turns. Given this data, it seems strange that the government’s Future Fund saw double the demand (vs capacity) from VCs given that it is a Convertible Loan Note (CLN) solution - surely for investors now is the time to be taking risks and investing in equity not debt?
Historically, it has not been easy for retail investors to access VC investments but Enterprise Investment Scheme (EIS) Funds and Venture Capital Trusts are an option (with the benefit of 30 per cent income tax relief).
But the advantage of EIS investments, over VCT funds, is that they are forward-looking in terms of valuations, and are not able to invest in convertible loan notes (ie it has to be equity). Therefore, they are ideally positioned to take advantage of any valuation adjustments. The same is not true for VCTs, where an investor is effectively buying into historical valuations.
VCTs and EIS investments are high risk but EIS has loss relief so for an additional rate taxpayer, this reduces potential exposure to loss to just 38.5 per cent of the original capital invested. The government is effectively underwriting a large chunk of the risk.
So EIS investors are able to take advantage of the risk/return dynamics but mitigate the risk more effectively. And investing in an EIS Fund now, depending on the EIS manage, will result in a large part of the funds invested in this tax year, for the option of the income tax relief to be carried back and offset against 2019/20 tax liabilities.
Shift in focus
COVID-19 has also shifted the focus of investors, as science and technology will be central to our new economy, building solutions to threats both known and unanticipated will be at the forefront of investment decisions as we emerge from the pandemic. In a post-crisis economy, we expect to see further government support for this asset class. And the sectors such as life sciences, AI, quantum computing, advanced materials, genomics, cleantech, MedTech and big data will be in greater demand.
For instance, according to Pitchbook analysis on the UK’s venture capital landscape, healthcare, biotech and pharma start-ups attracted substantial amounts of capital in the last decade, and we have already seen expertise utilised to help fight COVID-19. These healthcare venture investments need time before delivering returns and support from investors now more than ever.
These newly emerging technologies, drug discovery and wider
healthcare products start life at an R&D level and the
companies spun out from the university level research and
development. VCs such as Parkwalk, focusing on R&D intensive
businesses, should be in the crosshair of all investors,
especially whilst valuations are as low as they are.
Still an appetite for ESG
Despite the pressures this pandemic has placed on financial institutions, there is still an appetite for ESG. Alpha FMC’s latest Product Trends Survey highlights that the majority of UK asset managers are facing demand from their client base for ESG products and integration, with 59 per cent reporting a “substantial increase” in calls for specialist ESG products.
I have long argued that R&D-heavy businesses - firms that deliver the step-change technology required to deliver global ESG requirements and position the world for a post-pandemic era - actually deliver the most impactful returns.
Across our portfolio we have a wealth of companies helping in the fight against the pandemic, such as Entia, spun out of Imperial College London. Entia has an innovative self-testing blood analyser and digital health solution for home monitoring. The existing product has been repurposed so certain “at risk” patients don’t have to go into a hospital where they might catch the virus.
Institutional investors who genuinely want to generate a step change in the required impact returns, as well as potentially the financial returns, must be willing to take on a higher degree of risk by looking at earlier stage businesses and the companies helping in the fight against coronavirus.
For retail investors wanting to take advantage of ESG attributes, in a favourable valuation environment enhancing returns, with a portion of the risk underwritten via tax mitigation, now could be the time to invest equity into EIS qualifying growth businesses.