Review: Downing FOUR Generalist VCT

Downing FOUR VCT plc is creating two new share classes for subscription in the 2016/17 tax year – Generalist, and Healthcare.

Downing FOUR was created in 2015 by merging four other VCTs that were managed or advised by Downing. At that time the newly created VCT had net assets of approximately £60 million. To date the share classes have operated a ‘planned exit’ strategy, aiming to exit investments and return funds to shareholders. By contrast, the new share classes will be 'evergreen' in nature, aiming to provide ongoing tax‐free dividends and a longer-term return to shareholders.

This share class – Downing FOUR VCT Generalist – will focus on a combination of earlier stage revenue generating businesses, later stage profitable firms and asset-backed businesses.

Highlights

  • New £20 million share class (with a £10m over allotment facility)
  •  Focus on growth investments – including asset-backed businesses, a particular specialism of Downing
  • Monthly investment option
  • Unusual share buy-back option at 0% discount to NAV (subject to liquidity and regulations) 

The manager

This VCT is one of several managed by Downing LLP, the London-based investment group founded by Nick Lewis. The group has been managing investments since 1986 and have over £200 million under management (as at November 2016).

Downing’s 35-strong investment team is led by partners Chris Allner and Jonathan Boss. The latter is the lead manager of the Downing FOUR Generalist VCT. There is a strong specialism in asset-backed deals with over £140 million of asset-backed investments made since January 2015 including sectors the managers will consider for this VCT: children’s nurseries, wedding venues, data centres, leisure centres and pubs.

Target return and strategy

The targeted dividend of the Downing Generalist VCT is 4% from year four, not guaranteed.

The VCT will invest in growth firms, however importantly some of these businesses may own substantial assets over which Downing can take a charge and thus potentially benefit from some downside protection.  

Despite the changes to VCT rules – which for instance excluded renewable energy assets from VCT investment – Downing believe they can deliver a lower risk VCT. Many of the investments will be made into businesses developing new sites. Pubs, data centres and wedding venues are obvious candidates. These types of business expand by opening in new locations. Construction, refurbishment, and development are required before these new sites reach a mature trading level. For this reason, banks and other sources of finance are often unwilling to lend. Downing invests in this gap.

One important factor is that the VCT cannot simply invest in an already trading business, as was the case previously before the rules changed. Now, effectively a “buy and build” strategy is banned. Existing management teams can be backed, but only in new ventures.  For example, if investing in children nurseries, an existing building has to be converted or a new one built. The business can own the freehold premises though.

The property or premises from which the business operates can be fundamental to the investment proposition. It can provide significant downside protection. For instance, let’s take the example of a pub. In simple terms the value is twofold. Firstly, there is a value derived from the commercial activity of selling food and drink. Secondly, there is a value in the building. Should the sales of food and drink dry up – rendering that side of the business worthless – investors could still have some value in the property as a buffer.

Jonathan Boss cites the example of Nu Nu Nursery group as evidence of this theory. Downing invested in the business at the top of the market before the 2007 recession. The group exited Nu Nu in 2008-09. Although they sold during the global financial crisis, Downing’s investors got all of their money back and kept the tax reliefs. 

Where a business is underperforming, Downing have a number of options. They can add to the management team, supply additional capital or force management to sell the asset the business owns, thereby realising the value of their investment.

Asset-backed investments are expected to make up 25% of the portfolio. The remainder of the portfolio will be made up of businesses at different stages of growth.

Downing categorise one of these stages simply as ‘profitable’. 10-40% of the portfolio will be allocated in this type of investment. As the name suggests, these are businesses generating profits. However, to fuel future expansion additional capital is needed.  A prime example of a Downing investee company at this stage is AVID Technology. The business is a leader in designing and manufacturing systems electrification and hybridisation of heavy duty vehicles. In plain English, vehicle manufactures use the technology AVID Technology creates to improve the efficiency of diesel engines products and vehicle powertrains. Moreover, the business has several patents pending.

The other stage, where around 30-60% of investor’s funds will be placed, is defined by Downing as “revenue generating pre-profit”. This type of growth capital investment is higher risk. That said, theses business will have customers, revenues, and proven demand. The idea is the working capital supplied by Downing will help the business move to profitability. A previous investment Downing made of this ilk was FirstCare, an absence management solutions company helping businesses track and reduce the number of absences amongst their employees. Since Downing invested, the business merged with its main competitor, became profitable and is now set to expand globally.  Please note the two examples given above were made by Downing in other funds and will not necessarily be held by this VCT.

Finally, investors can expect some exposure to the Downing UK Micro-Cap Growth fund. Up to 70% of the funds yet to be invested wil be invested with Downing’s public equity team. Judith MacKenzie – a Citywire-AA rated manager and twice Small Cap Fund Manager of the Year – runs this team.  

Exit strategy

In contrast to the existing share classes of Downing FOUR, this is an evergreen VCT offer. The focus is on providing longer term returns to shareholders and ongoing tax-free dividends from year four. Investors may benefit from special dividends if there are disposals within the portfolio.

There is an unusual buyback policy which investors may find appealing. The board of Downing FOUR VCT plc. intend to buy back shares in the company at a nil discount to NAV, subject to liquidity and regulations. This is refreshingly different from the rest of the market which typically offers to buy back shares at a discount of between 5-10%.

Risks

The usual risks with smaller companies exist with this VCT offer. For instance, VCT investments are illiquid and capital is at risk. Investors should only invest money they can afford to lose.  The value of tax relief will depend on the circumstances of the individual investor and tax rules could change in future.

Specifically, Downing FOUR VCT Generalist will take on development risk and, with only £20 million to deply (plus potential £10m over-allotment), the portfolio is likely to be fairly concentrated.

Fees

There is an initial charge of 4% before any Wealth Club saving. The annual management fee for this new share class will be 2.0% with the annual running costs capped at 3% of Net Asset Value. The performance fee is payable via a management share class and is first payable in 2021. The performance fee is 20% of dividends paid if the total return is at least £1 per share, which increases by 3 pence per share per year from 2021. If the performance fee takes the return below the hurdle then that portion isn’t payable. Arrangement and monitoring fees may also be levied. 

Deadlines

Deadline for shares allotted in 2016/17 tax year, unless fully subscribed earlier: 5 April 2017 (3:00 pm)

Summary

Downing are well versed in this type of investing. They are looking to back proven management teams, and many of the businesses will benefit from asset ownership. It’s a recipe which has worked for Downing historically and should make for a VCT with relatively low volatility and more predictable investments in the long run although of course there are no guarantees. For investors who don’t mind foregoing dividend income for the first few years, this may be an offer to consider. 

This review is not intended to be advice or a personal recommendation to buy the investment mentioned, nor is it a research recommendation. Wealth Club aims to highlight investments we believe have merit, but investors should form their own view on any proposed investment.

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