09/09/2011

By Modwenna Rees-Mogg, Founder and CEO of AngelNews

The news this week is that YFM’s British Smaller Companies VCT will be paying out £7.5m to investors in a special dividend generated from the partial realisation of Go Outdoors Limited and a final dividend for the year ending 2011. This comes on the back of solid dividends over recent years resulting from the previous 14 successful realisations. The cost of the realised investment in outdoor clothing retailer Go Outdoors was a mere £50,000 in 1998. Who says VCs can’t deliver angel level returns!

YFM - one of, if not, the largest VC investor in the UK today

YFM is the largest true VC investor in the UK today by volume of investments, with well over 250 in its portfolio. Arguably it is also the most successful early stage VC in the country in terms of exits, with over 110 positive realisations to date for investors. As well as managing two strong VCT performers, it runs a range of other funds, with a total of £375m under management, with 50 staff operating out of six offices across the UK. In itself, it is a bit of an entrepreneurial venture – the management team led by David Hall undertook an MBO in 2003 from their previous owners. It made sense to catch up with David, but more about that in a moment.

There is always much debate about the UK Venture Capital scene, and as readers will be aware we take a special interest in the Venture Capital Trust part of the market, because it is of direct relevance to c.100,000 British tax payers invested in one or more of the 100+ VCTs currently quoted on the London Stock Exchange and many of whom are within our readership.

Too often, the debate around VCTs ranges around the tax breaks they offer and how cleverly the rules can be interpreted by fund managers to create a new VCT vehicle that minimises the risks and maximises the tax breaks.

It is all the more satisfying therefore when one of the top performing generalist managers pulls off a great feat, such as the British Smaller Companies dividend, thus proving the efficacy of the VCT model not because it offers a tax break, but because it delivers stellar returns for investors, still tax free, whilst remaining evergreen and thus leaving more on the table for investors in the future and cash in the bank for further investment into UKSME Ltd.

The British Smaller Companies VCT is the top performing VCT over 10 years

British Smaller Companies VCT is the top performing VCT of all over 10 years according to data provided by Financial Express Analytics. More attention needs to be paid to it, its sister fund British Smaller Companies VCT2 and particularly the team behind both.

The net asset value (NAV) you see in that table is impressive. In simple terms it means that the British Smaller Companies VCT has protected the initial investment made by its shareholders AND it does not take into account the 77p of dividends that will have been paid out at the end of next month. Not many VCTs can make that claim.

£7.5m of dividends to be paid out to British Smaller Companies VCTs next month and there is still cash to spare!

So back to that dividend…
The £7.5m was paid out to shareholders on the register last Friday, on 22nd August. Clearly, I should have bought some shares in the VCT after last year’s VCT & EIS Investor Forum when it became blatant how successful YFM has been at growing dividends over the years!

I asked David why the VCT decided to pay out a dividend and not retain the cash for further reinvestment, just because it had got a partial exit.

“We believe the market underestimates shareholder appetite for dividends, especially for VCTs where many investors rely on the tax free income they receive,” he told me “and it’s their money after all.”

“The VCT has achieved many positive realisations over the years and cash is currently sitting at 40% of Net Asset Value, so we will have a nice war chest for investments post the dividend payout.”

Clearly and not least because the VCT is quoted, David does not make any promises about the future dividend stream that is likely to flow from his two VCTs, but if their track record is anything to go by, with years and years of consistent general dividend growth, out with this special dividend, I can assume that shareholders can expect more good years to follow. And I am looking forward to the announcement by YFM Private Equity about this year’s new fundraisings for its VCTs.

The formal launch of the new British Smaller Companies EIS Fund will be announced this Autumn

When I asked David about this, he told me that as well as doing “top-up” fundraisings for the VCTs this year, which will be announced shortly, YFM Private Equity will also be launching the first British Smaller Companies EIS Fund. It will adopt the same investment strategy as the VCTs and will co-invest according to a pre-agreed allocation agreement alongside the VCTs and, if appropriate, the other funds, they manage.

“YFM Private Equity is moving into EIS Fund management because of investor demand from its existing retail investor base.”

British Smaller Companies VCT shareholders have asked YFM to launch a £10m EIS fund with the same investment strategy as the VCTs.

“Shareholders have asked us to launch an EIS Fund – the fund will be targeting a first close at £10m – because they like our investment strategy, but want to be able to access the different tax breaks an EIS fund offers, especially around IHT relief and because of the higher income tax breaks they get. For us it will give us a bigger war chest to pursue our investment strategy of backing great management teams in UK based businesses.

“Both EIS Funds and VCTs are perfect investors in a large variety of UK businesses and we are seeing dozens of great opportunities in everything from software to hi-tech manufacturing. Each year we make around 20 investments. Having additional funds will mean we can do a few more and/or back those we like with additional cash.

This will mean we disseminate risk in the portfolio further, which will be good news for investors and they of course will get an immediate uplift from the income tax breaks.

“We have a 25-year track record of investing well. Our VCT investors have repeatedly (on a five year cycle) voted to continue the life of the VCTs which effectively makes them evergreen. This means we can take a long-term view and time realisations in the portfolio to optimise returns, not because of an artificial deadline imposed because a fund is heading towards being wound up. In the case of Go Outdoors we have already been in for nine years and we are unlikely to fully exit for many more as the prospects are still very exciting. The norm is for us to be invested for about seven years – so a 10-year fund model is not ideal, but a VCT/EIS Fund one is.”

Go Outdoors has performed remarkably well and there is more to come. And its not the only gem in the portfolio.

“What’s the story of Go Outdoors?", I asked.

“We invested in one £2.5m turnover shop in 1998 and with our support the business has grown to a business with dozens of shops across the country with something like £120m turnover. Over the last three years, the business has even been able to pay its shareholders dividends, whilst still growing significantly. The VCT recently received £300,000 in dividends for the go’s last trading year, and we have now had this partial realisation for £6.5m as 3i has come in as an investor. We plan to stay in for a while yet, as we think there is more growth in the value of our remaining stake to be had.”

“Go Outdoors has been the deal that pricked the interest of the press and others, but its just one of a chain of great companies we have backed in all sorts of sectors ranging from quality UK based manufacturing and engineering through digital media to retail. I think the entrepreneurs like our aligned approach and so we tend to get offered good propositions and we have learnt how to work with management teams on delivering long-term growth. It helps that we do not put them under pressure to give us a quick exit I am certain. Because we always hold onto a healthy cash reserve we are in a position to provide more funding if necessary and we can enter the market and pick up great deals at times when others can’t.”

As we chatted David mentioned a number of exciting deals. One that sounds particularly good is Deep Secure which is doing clever things in security software around military applications. I suspect the northern roots of YFM also make it particularly good at spotting unusual but exciting opportunities in specialist manufacturing – safety valves for the mining industry and the like. He also shot a warning bolt across my boughs saying that there is a bit of a bubble developing in the specialist manufacturing market at the moment, so it pays to know what you are investing in. “We like high margin manufacturing businesses that have been around for a while and learnt what to do and how to do it in different economic climates. We also avoid over-gearing our investments so they are protected when times get tough.”

From software to digital media and manufacturing, the British Smaller Companies portfolios, have them all covered

David said how it helped to have offices across England, especially in the regions. “We are deeply networked across the UK and so tend to hear about good opportunities early on and because we are local, we are on hand to help when needed. At the moment there is lots of demand for our money because the banks are still not being that helpful and there’s also a chunk of businesses which are over leveraged and cannot refinance elsewhere, so they come to us.

The YFM investor base is also more widespread than some with our northern base we have a higher proportion of investors based outside the South East than others. This is due in part because of its presence across the country. We are visible to investors and they meet us at networking events all the time. Of course we also have our formal AGMs and more general networking events with investors,
but I think it helps that they meet YFM people all over the place.

YFM does not have a downer on London though and its second largest office is based in Berkeley Square. David is there at least one day a week. “London is a big, big driver of the UK economy, but how I see it is like this. If a company can succeed in both London and the regions it is going to be far stronger and get further than if it can only thrive in one of them.”

I think you can tell a lot from a company’s marketing messages and it comes across loud and clear from YFM that it’s their ability to get an exit which really makes them tick. The special interim dividend from British Smaller Companies VCT clearly sends out a loud message of “this is what we do best” quite apart from the financial benefits. Good on them. It’s the exit that matters in Venture investing, not the entry – something angels especially tend to forget.

YFM is a supporter of the Government’s strategy for enterprise investment

David is keen on where the Government is going in terms of its support for enterprise investment.

“I welcome the thrust which is directing VCTs and EIS more towards growth companies. That’s good news for British enterprise. The up front tax breaks make both very attractive from an investor perspective, but I think that the message we would like to send is that there are even better returns to be had if you back a fund manager who is good at growing businesses over a 5-10 year time frame. That’s where the really big rewards for investors can come – as shown by our special interim dividend.”

I wrapped up the interview by asking David why YFM is so confident that it can successfully invest in the part of the market that others have found so impossible that they have simply left.

“I guess like one or two others in our peer group, that we are confident that our experience will guide us in what we do in the future. We stick to the knitting and our team has been investing through 4 or 5 full economic cycles now, so we know what to expect – probably even better than the teams we back think. The UK economy is still very vulnerable, but the best stars always emerge at times like this. You just have to have the confidence to spot them and then run with your beliefs – oh yes and never try to second guess the top or the bottom, but definitely invest on the way down and sell on the way up if you can.”

Overall, I think that much of YFM’s success is due, to the fact that, whilst it is certainly a Venture Capital investor (aka it does want an exit!), its approach is probably more akin to the way a large corporate would pursue an investment in a new division, product or country. In fact when I looked back at my notes of my interview with David, it’s the word “business” that crops up repeatedly – not “venture” or “investment.” YFM takes the long view and goes about building intrinsic value in the business, rather than just flipping a deal as a bit of clever financial engineering. The result is that there is more choice over when and how to exit and when it comes there is something worth selling. There are lessons to be learned for us all, from this approach.

If you would like to know more about the British Smaller Companies VCTs and its new EIS fund, please contact Tracey Parker on 0113 294 5000 or email tracey.parker@yfmep.com