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Angels' delight

Created:

19 December 2007

Written by:

John McLeod

Private equity has gone from being a little-known backwater to one of the most talked about areas of investment and it is now possible for even relatively small investors to get hands-on exposure to this risky-but-rewarding asset class.

Like the high net worth investors on the BBC programme “Dragons’ Den”, you can invest in direct private equity deals as a ‘business angel’, providing not only capital but also business expertise to help add value to your investments. You can even take seats on investee company boards.

What’s more, investing in private equity deals could provide attractive tax relief of up to 60 per cent of your investment, provided the companies qualify for the Enterprise Investment Scheme (EIS). EIS investments allow 20 per cent income tax relief plus sheltering from capital gains tax (CGT), which could save up to a further 40 per cent tax. Unquoted investments can also become exempt from inheritance tax (IHT) after a two-year holding period.

Nevertheless, unquoted investments can be very risky, especially if they are early-stage investments, so it is important to take a diversified approach. You can also invest indirectly through private equity investment trusts, limited partnerships, tax-enhanced venture capital trusts (VCTs) or exchange-traded funds (ETFs).

Private equity on parade

Private equity has outperformed quoted equities over the long term. In the 10 years to the end of 2006, private equity delivered an average annual return of 18.7 per cent a year, compared with the 7.9 per cent annual return from the FTSE All Share index (see table).

Giant private equity groups, such as Blackstone and KKR, have started to have a massive impact on the global economy and stockmarkets. Indeed, much of the merger and acquisition activity which has boosted the UK stockmarket, especially the mid-cap sector, has been driven by private equity deals, with returns boosted through debt.

But the reality of most business angel investment is different from the popular perception of private equity funds. Although some of the large players do have a ruthless approach, based on sacking incumbent managers, slashing costs and saddling companies with high levels of debt, business angel investors tend to work in a more sensitive fashion, focussed on adding value to companies and developing businesses to generate growth.

There are three key differences between private equity investing and investing in quoted companies.

Firstly, the lack of a stockmarket listing means that investors can take a longer term view, without being too concerned about market volatility. That said, private equity is not really a separate asset class from quoted equities, as an economic downturn could hit unlisted companies hard, especially those at an early stage.

Adding private equity holdings to a portfolio can provide a degree of diversification but downside protection is only likely to last in the short term because private equity valuations lag movements in stockmarkets. Private equity is illiquid so companies are only revalued on an occasional basis or if there is a transaction.

The second difference is that private equity offers the prospect of higher returns, as you may be able to invest in companies at an early stage of their growth, capturing greater upside. By contrast, quoted companies are likely to be relatively mature already when they reach the market.

Indeed, private equity investments could actually provide diversification from stockmarkets, provided you were able to identify companies with strong growth prospects whose fortunes are not related to the overall economic climate. For instance, a biotechnology company which managed to discover a cure for AIDS would almost certainly do well, even in a global recession.

Private equity investors often look to float companies on stockmarkets through initial public offerings (IPOs) as way to take their profits. Then again, trade sales to other private equity groups or quoted companies are more common than IPOs and could deliver better valuations. Trade sales are also a useful alternative exit route, as IPOs can be difficult to achieve when stockmarket sentiment is poor.

Finally, a key difference between investing in quoted companies and private companies is the degree of access and control which investors have. Stockmarket investors have to rely on company accounts and occasional meetings, where voting could affect management.

By contrast, private equity investors can have close scrutiny over company accounts. They can also take an active role in directing companies, which could mean adding expertise and even sitting on a company’s board.

Indeed, it can be simpler to remove underperforming mangers, than it would be to effect a change of management in a quoted company. That said, the strength of a management team tends to be a crucial factor in deciding to invest in a company so sacking the managers should be a last resort, rather than the first step.

Tax relief

Accelerated taper relief for investing in unquoted companies gives a useful boost to investors so the proposals to scrap it in favour of a flat 18 per cent CGT rate for all assets is a blow to the private equity industry. Some investors may well take profits on investments prior to 6 April next year in order to avoid an effective tax hike of 80 per cent (if they have already held an unquoted asset for two or more years).

However, unquoted assets will still continue to benefit from business property relief, which means that they are exempt from IHT after a two-year holding period. Business property relief was introduced to encourage entrepreneurs and there is a replacement rule, which allows you to sell one qualifying holding and reinvest in another.

Provided you are in a qualifying asset on death, you should achieve IHT exemption so long as you have held qualifying assets for a total of two years, cumulatively, out of the last five before death. To qualify for business property relief, companies must not be listed on a recognised stock exchange – so private companies which float on the Alternative Investment Market remain exempt – and must be trading companies so investing in cash, shares, property or land are not acceptable.

Furthermore, unquoted companies could also qualify for EIS tax reliefs, which are even more generous. EIS-eligible companies qualify for inheritance tax exemption through business property relief, provided they meet the two-year holding rule.

What’s more, you can also claim income tax relief at 20 per cent on your investment. The investment limit for this relief is £400,000 per person in a tax year so spouses and civil partners could co-invest to receive a tax rebate of up to £160,000 a year (for a total investment of £800,000).

You can also shelter unlimited capital gains by investing in EIS qualifying companies. Sheltering can be achieved provided qualifying shares are allotted within three years of making the gain or up to a year before you realise a gain.

There is a minimum three year holding period to qualify for EIS relief so early disposals would lose your income tax relief and recrystalise CGT liabilities. However, after three years have passed, you could dispose of your holdings in tranches to utilise the annual CGT-exempt allowance.

The annual CGT exempt allowance is currently £9,200 per person and assets can be transferred tax-free between spouses and civil partners so a couple could realise gains of up to £18,400 a year between them before incurring CGT. On the other hand, timing the disposal of unquoted holdings can be much harder than selling listed equities.

Meanwhile, any capital gains made on EIS investments are exempt from CGT themselves. Should your investment fail, you can also offset the loss against gains made elsewhere. Dividends from EIS companies are subject to income tax, however.

To qualify for EIS reliefs, a company must be engaged in a qualifying trade, where the rules are the same as those for business property relief. What’s more, a company must have gross assets of no more than £7m at the time of investment and no more than 50 employees, which is quite restrictive. No more than £2m can be invested in an EIS company in one tax year either.

Unquoted companies cannot be bought directly inside Isas but it is possible to hold them in self-invested personal pension (Sipps), where you would benefit from upfront tax relief and all returns would be tax free. You could not enjoy EIS tax reliefs in a pension, however.

Unfortunately, many Sipp providers do not allow unquoted shares to be held due to the risk of unauthorised tax charges, which could range from 40-70 per cent of the value of your investment. Most providers have taken a cautious stance, even though this risk only applies to company employees.

Some ‘full’ Sipp providers will allow unlisted shares to be held, though, justifying their higher charges by conducting assessments of the eligibility of holdings. Neil Marsh, of full Sipp provider Hornbuckle Mitchell (www.hornbuckle.co.uk), notes: “If you follow the rules, they’re a perfectly acceptable investment.”

You could hold up to 50 per cent of a company’s shares in your Sipp, provided you are not an employee. If you are an employee, you must not hold more than 20 per cent of the shares in total - including stakes held by your family members – and must not enjoy benefits worth more than £6,000 (such as a company car).

Private equity provider Hotbed (www.hotbed.uk.com) has its own Sipp, run in association with Alliance Trust, which allows you to hold unquoted investments. Hotbed allows you to borrow up to 50 per cent of your Sipp’s value to ‘gear up’ your investment.

How to invest

Finding direct private equity investments is not as simple as looking for listed shares or funds, which can be researched on many websites. You may have to join a private equity network and should definitely take advice from your independent financial adviser (IFA) before you commit any money.

Many EIS projects are only offered to friends and family, while others are marketed to IFAs and existing investors. Some EIS offers can be researched online at www.taxshelterreport.co.uk and www.taxefficientreview.com.

John Davey, of IFA Bestinvest (www.bestinvest.co.uk), suggests the current offer from Ingenious Broadcasting as a low risk offer. Pub companies used to be popular low risk EIS investments, as the businesses had asset-backing, but the 50 employee rule introduced in the 2006 budget has hit this area.

You can also invest, either individually or as part of a syndicate, through private equity networks such as Hotbed, Beer & Parners (www.beerandpartners.com) and Envestors (www.envestors.co.uk). Hotbed and Beer offer unitised private equity deals, with minimum investments of £25,000 and £35,000 respectively.

You may well have to wait for a trade sale or IPO to realise your investment so you should be prepared to have your capital locked up for several years - not to mention being aware of the risk of making a loss. However, trading in unquoted companies is now possible through the rapidly expanding ShareMark trading platform (www.share.com).

• A useful guide to business angel investment is also available to download free from the Envestors website (www.envestors.co.uk).

Alternative approaches

Rather than investing as a business angel, there are a variety of other ways to invest in private equity. If you would like to invest with EIS benefits, you could use an EIS fund or portfolio service.

Where EIS funds are classed as ‘approved’ by Her Majesty’s Revenue & Customs, the income tax relief is received at the time of investment, rather than when the underlying investments are made. On the other hand, the CGT sheltering only starts when underlying investments are made and this is also when the two-year clock starts ticking for IHT exemption.

Meanwhile, approved EIS fund managers must invest 90 per cent of their assets in a minimum of four qualifying companies within a year. Unapproved EIS funds or portfolio services could take longer to deploy their assets, which might help if there were a dearth of attractive opportunities in the pipeline or if valuations were going through a period of volatility.

Mr Davey recommends unapproved EIS fund Oxford Gateway 4, which aims for “aggressive growth”, with guidance from specialist advisers. See www.taxshelterreport.co.uk and www.taxefficientreview.com for more on EIS funds and portfolio services.

VCTs hold portfolios of small companies – subject to the same £7m gross assets test as EIS companies – and qualify for 30 per cent income tax relief on new investments, provided you hold the shares for a minimum of five years. All gains and income are tax-free.

Mr Davey advises backing top-up offers, rather than brand new launches, as you gain access to mature portfolios which were able to invest under the pre-2006 gross assets limit of £15m. Furthermore, the managers can pay out dividends quickly, swapping new cash for the 30 per cent of their portfolios which does not have to be invested in qualifying companies. His favourite top-up offers are for Baronsmead, run by a highly regarded team, and Noble, where the manager can protect against market downside through a put option on the US Russell2000 index.

For more on VCTs, see www.bestinvest.co.uk, www.taxshelterreport.co.uk and www.taxefficientreview.com.

Private equity investment trusts do not attract tax relief but are far less restricted than EIS companies and VCTs, as there is no gross assets test for investments and there is no minimum holding period for investors. They can be traded instantly and can be held inside Individual Savings Accounts (Isas), thus avoiding CGT and higher-rate income tax on dividends.

However, the current credit crunch could make it harder to borrow to boost returns and cautious managers are currently holding 19 per cent of their assets in cash, on average, instead of gearing up to invest. The market is also showing caution about the sector, as the discount to net asset value is 18 per cent, compared with a one-year average of seven per cent.

Rob Harley, of Bestinvest, thinks the best returns are likely to come in the mid-market MBO space so he recommends HgCapital and SVG Capital.

Simon Elliott, of broker Winterflood securities, backs both those trusts too. He also points out that venture capital has not seen the same boom as MBOs so there could be value and some diversification there. He suggests 3i and Prelude as trusts with greater exposure to venture capital.

As an alternative to investing in a private equity investment trust, you could use an ETF which holds private equity companies. ETFs are index-tracking funds which trade on the London Stock Exchange but are not at risk from widening discounts and are exempt from stamp duty. They have lower charges than most actively-managed funds and can be held inside Isas.

At the moment, there are two UK-listed private equity ETFs: iShares S&P Listed Private Equity and PowerShares Global Listed Private Equity. See www.londonstockexchange.com for more details.

You can also invest in private equity limited partnerships, which are closed-ended funds that are not listed on stockmarkets so must be held for fixed terms of, say, 10 years. Limited partnerships tend to have high minimum investment levels, typically around £500,000, and cannot be marketed to private investors so you must invest through your IFA.

One interesting current offer is the European Special Applications Fund (www.e-synergy.com), which will invest in projects coming from the European Space Agency’s 10,000 research affiliates. Meanwhile, Aureos (www.aureos.com) runs limited partnerships investing in private equity companies in emerging markets. Aureos is currently raising money for China, Central Asia, Latin America and Pacific Islands private equity funds, with an African fund due to launch in 2008.

Case study: CInergy

CInergy raised £700,000 in July to expand international sales of its customer retention system for telecoms operators. The deal was arranged through the Envestors network and funds were raised from private investors and an institution.

Oliver Woolley, of Envestors, explains that the process began in the autumn of 2006, when Envestors “spent around six weeks with the company, working to get them fully investment-ready”. This involved finalising the investment proposition and agreeing a valuation, as well as conducting due diligence on the company.

Due diligence is vital to give investors peace of mind, including checking a company’s management team for criminal records and bankruptcies. Where possible, trade references are sought, as well as feedback from customers to see what they think of the products or service.

The next step was to present the company to investors at an event in October 2006. This resulted in interest from both private investors and an early-stage fund, which led to some complication in how the deal would be structured.

On the one hand, the private investors wanted to enjoy the tax benefits of the EIS. On the other, the fund manager wanted to have “A” shares, which would give the fund preferential rights.

Mr Woolley comments: “It’s not uncommon for these issues to arise – getting everyone to point in the right direction can be quite a challenge but it’s our role to help in this. Eventually, the private investors decided that they would all prefer to go in on the same terms as the fund and forego their EIS relief.”

In the end, CInergy raised £450,000 from business angels and £250,000 from the fund. Mr Woolley notes: “The company has gone on to win a major contract, which has pleased all investors – it’s been a very positive result.”

In terms of an exit route, the intention is to go for a trade sale or an Aim-floatation within three years or so. The private investors and the fund are protected by tag-along and drag along rights, which were written into the investment agreement.

Tag-along rights protect minority shareholders by insisting that they should have the right to sell their stake at the same time as a majority shareholder. Tag-along rights also entitle minority shareholders to be involved in any negotiations prior to a sale.

Drag-along rights protect majority shareholders by ensuring that minority shareholders have to sell at the same time as them, on the same price and terms. This could be important, as some buyers may be looking for complete control of a company, without minority shareholders.

Case study: Epistem

EpiStem, a biotech spin out from the Paterson Institute for Cancer Research, raised £3m in a round of funding to coincide with its initial public offering (IPO) on Aim in April. The funds were received from a total of 33 venture capital sources, ranging from individual private investors to Venture Capital Trusts. This included £425,000 raised via the Beer & Partners business angel network.

Beer & Partners investors who got in at the pre-IPO stage paid 124p a share, which was also the IPO price. The company floated with a market cap of £8m and the price has now risen to 167p.

In other words, the pre-IPO investors have made a theoretical profit of 35 per cent against the price they paid seven months ago. Of course, most will want to hold onto the shares until they have passed the three-year holding mark, as they would not want their investments to lose the tax relief they enjoyed by investing under the EIS.

Mike Weaver, of Beer & Partners, notes: “The success of this collaborative approach to fund raising and flotation has contributed to an expansion in the number of projects offered by Beer & Partners in later stages of growth.”

EpiStem has already established over £1m in annual revenue from major drug companies and is close to identifying potential therapeutics for cancer care and new stem cell based biomarkers. The opportunities that are opened up by this type of research are comparable to those generated 20 years ago by work on blood cells.

Case study: Independent Pharmacy Care Centres

Independent Pharmacy Care Centres (IPCC) delivered 90 per cent growth for a syndicate of investors in just 15 months when the company exited via a trade sale to Lloyds Pharmacies earlier this year.

IPCC was set up in Stockport in 2001 and raised an initial £2.5m by way of a private placing the following April. A further private placing raised a similar amount by the end of 2003, enabling it to reach a total of 23 pharmacies, mainly through acquisitions in the North of England.

In June 2006 it went to Beer & Partners looking for a further £3.3m. This was provided by a syndicate of seven equity investors registered with the network, in a deal structured by the Glasgow-based Beer & Partners associate, Clive Thomson.

This additional capital helped the company boost its total number of outlets to 35, which employ 375 staff, and gave the £26m turnover business a valuation of £43.3m. Less than a year later, Lloyds Pharmacies announced its intention to acquire IPCC in a £60m deal, including debt.

Beer & Partners investors got in at 230p per share in March 2006 and were taken out in July 2007 at 438p per share. Investors lost their EIS tax relief, as the holding period was less than three years, but this was offset by the handsome profit achieved.

Long term returns

* private equity funds at all stages from start-ups to large deals - excludes private equity investment trusts, VCTs and business angels

Source: British Private Equity and Venture Capital Association/PriceWaterhouseCoopers. Figures to 31 December 2006

Top-performing VCTs

Sources: www.taxefficientreview.com and www.bestinvest.co.uk, figures to 23 November

*excluding VCTs launched since the 2006-7 tax year, as the period since launch is too short to show meaningful performance

Table: Top-performing private equity investment trusts

*positive figures are premiums

Source: www.trustnet.com, figures to 23 November. Net asset value (NAV) total return performance figures are calculated using fully-diluted (where applicable) daily estimated NAV figures from Thomson Financial Datastream and with gross income (dividends) reinvested.