Gross Assets of Investee Companies

Brooks Newmark raises concerns about targeting venture capital trust (VCT) investment in smaller companies - thus exposing VCT investors exposed to greater risk - whilst simultaneously cutting the incentives that investors will receive.

Mr. Newmark: I begin by drawing attention to my entry in the Register of Members' Interests. Although I have never invested in a venture capital trust, I have, over the past 15 years, been both a venture capitalist and an angel investor. I hope that I can bring some of my practical experience to bear on this debate, especially in the context of amendments Nos. 6, 7 and 8. I will not address amendments Nos. 9 and 13, because my hon. Friend the Member for Fareham (Mr. Hoban) thoroughly covered those issues.

Yesterday, we established that one of the themes of this year's Finance Bill is the Government's ongoing attempt to fix things that are not broken and to fudge those that are. The Bill's treatment of venture capital trusts is no exception to that trend. VCTs have clearly demonstrated that they are performing well in the market and seem to vindicate the Government's attempt to address the "equity gap" through targeted market intervention.

We need look only as far as the figures given on the website of Her Majesty's Revenue and Customs for the total investment in VCTs. After a peak in 2000-01 of £450 million, investment plummeted to only £70 million in each of the years 2002-03 and 2003-04. That was the situation facing VCTs at the time that the Finance Act 2004 implemented the new income tax relief scheme. In the following year, investment reached £520 million and has surpassed £700 million in the last financial year.

When the Treasury Committee conducted its inquiry into the success of the incentives it heard that

"there is very clear evidence"

that the incentives had reversed "a dramatic decline" in VCT investment, and had led to a

"significant uplift in the amount of capital that VCTs have been able to raise."

The Government should be congratulated on that; it is beyond dispute. However, I do dispute that the reduction in the gross asset value of companies eligible for VCT investment is the appropriate way to refocus tax incentives on the equity gap.

Not only are the Government moving in the wrong direction on this issue, but they are also moving in two directions at once. Part 1 of schedule 14 will alter the level of risk that VCT investors are exposed to by targeting VCT investment in smaller companies. That is the Government's stated aim. However, part 2 of schedule 14 cuts the incentives that investors will receive. The two parts must be considered together because if any of part 1 remains in the Bill, it will have a knock-on effect on the need for the incentives offered in part 2 of the schedule.

As one industry analyst has said, the Government's proposal

"has changed the risk and reward profile of VCTs significantly".

Another comments that the change

"appreciably alters the risk-reward profile of private-equity investment by personal taxpayers."

Since bad news comes in threes, let me offer one further comment:

"The reduction to company size greatly increases the level of investment risk. Smaller companies are normally, by their nature, more risky."

That is the point that I made to my hon. Friend the Member for Fareham. That problem has long been foreseen.

In 2003, the Treasury conducted its own analysis of the likely consequences of tinkering with the balance between risks and return. It concluded:

"If there were clear evidence that this would reduce the attractiveness of investment in VCTs, there might be a case for enhancing tax reliefs at the same time as tightening the scheme's focus."

Reducing the gross asset value of eligible companies was always considered to be an alternative to altering the structure of incentives.

Three years later, the Treasury is determined to pursue contradictory objectives by increasing risks and cutting incentives at the same time. The position is simply not sustainable. Instead of fundamentally altering the balance between risk and return, the Government should be ensuring greater investor protection. Bearing in mind that there are already a healthy number of business angels available to provide seed capital for high-risk start-ups, I question whether it is appropriate to encourage individual investors into higher beta investments in companies with a gross asset value under the proposed new limit.

This concern is growing in currency. In November, the chief executive of the Financial Services Authority told the Treasury Committee that, despite having issued warnings to investors and VCT providers, the FSA

"need to be perhaps a little smarter on how we convert the data we put on our website into the information that goes into the hands of the population."

The Government have a responsibility to keep a grip on the balance between the risks and rewards offered by VCTs. Changing both sides of that equation at the same time is imprudent.

Nevertheless, I recognise that there has been some justified concern that VCTs are not operating in the way that was intended when they were set up 10 years ago. Foremost among those concerns is the one about the practice of parallel investment, in which two or more VCTs under the same management act together to invest beyond the £1 million investment limit imposed on each separate VCT. As Lucius Cary, the founder of Oxford Technology VCTs, has said, although that behaviour

"may be technically legal, it is pushing the boundaries and undermining the original objectives of the legislation."

Clearly, VCTs clubbing together to take part in larger management buy-outs is a problem, but it is a problem that was foreseen. The Treasury's report into the equity gap, which dated from before the changes included in the Finance Act 2004, examined the issue of regulating concert parties in order to assist early-stage investment. The report suggested that

"the scheme rules could place restrictions on VCTs forming part of an investment syndicate that collectively invests beyond the £1 million upper investment limit."

If the Government remain concerned by parallel investment, Ministers should confront the issue head-on and not seek to address it by the roundabout route of restricting the gross asset value of eligible companies.

I want to return to my substantive objections to the changes proposed in part 1 of schedule 14 and to my reasons for arguing that they should not stand part of the Bill. Based on my experience as a practitioner, I believe that restricting the gross asset value of eligible companies to £7 million before investment and £8 million immediately afterwards does not focus on the real equity gap. If anything, the limits have been moved in the wrong direction and the probing amendments tabled by my hon. Friend the Member for Fareham are modest in seeking to preserve them at the current level.

There are an abundance of business angels who are capable of providing seed capital-that is generally provided for companies with gross asset values of £1 million to £3 million-to kick-start small businesses. The real difficulty that businesses continue to face is in accessing second-round financing. That is the issue. Many individuals who came to me when I was in the business before I came into the House would complain that there was a lack of access to capital once companies got above roughly £5 million. We should address that gap between £5 million and £25 million.

Further restriction of the gross asset value of eligible companies would be retrograde. I appreciate that this is not part of the amendment, but we should be looking to raise the limit to £25 million instead of slashing it. Recently, in another place, Lord MacGregor of Pulham Market said of the existing gross asset value limit:

"There is clear evidence that it is companies above that level which need the venture capital investment. The limit has not . . . been indexed, and it needs to be looked at again."-[Official Report, House of Lords, 16 March 2006; Vol. 679, c. 1410-11.]

The Government have indeed looked at the matter again, and drawn the wrong conclusions again. That is a judgment based on my experience in the industry. The change in gross asset value in schedule 14 is too sudden and significant to be undertaken without greater industry consultation and I urge the Government to reconsider their decision.

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OTHER INTERVENTIONS IN THE DEBATE

Mr. Brooks Newmark (Braintree) (Con): Does my hon. Friend recognise that moving to lower asset values and smaller companies will mean a much greater inherent risk to those investing in such companies?

Mr. Hoban: My hon. Friend is absolutely right. When companies have lower asset values there is an increase in the level of risk, which will prompt investors to consider the risk-return ratio and think about whether their likely returns from VCTs in the future are sufficient to warrant that investment being made. The Government need to monitor that carefully to ensure that having turned the tap on in VCT funding by increasing the tax relief, a matter to which I will return in later amendments, the consequential changes in the Bill of reducing that relief, increasing the holding period and reducing the gross assets limit, will make VCTs less attractive to investors, thus depriving smaller businesses of the funds that they need to expand and grow. My hon. Friend was quite right to highlight the importance of risk and its role in assessing these investments, and the relationship between small businesses and risk.

...

Mr. Newmark: One of the problems that we face is that the private equity industry, which was alluded to, is, in effect, moving further up the food chain and the elements involved are getting bigger and bigger. The funding gap is indeed at the lower level, which is where business angels are needed and are playing a role. The point made by the hon. Member for Wolverhampton, South-West (Rob Marris) was irrelevant to the amendments; it had to do with taxation. We are concerned with gross asset values. By shrinking where we give the incentives for investors to go in-by lowering that limit-we are going to make it far more risky and far less attractive for individuals to go into that part of the market.

Mr. Breed: I entirely agree with that. We will see that reduction in the figures next year if these proposals go through. The Government are trying to engineer a reduction because they are looking to try to save some money in relation to this scheme. That will be a false economy. Opportunities will be largely missed because private equity funds are not going to be as prevalent as they have been in the past few years. There is no suggestion that there is a shortage of businesses looking for such capital. Indeed, there is probably more demand than there is current supply. If it were the other way round, there could be an opportunity to say, "Well, we do not need so many incentives." However, significant numbers of businesses-even at that lower level; let alone the development level-are looking for the sort of private equity that they require to expand.