Review - Downing TWO VCT

Archived article

Archived article: please remember tax and investment rules and circumstances can change over time. This article reflects our views at the time of publication.

This offer seeks to raise £15 million in a new share class (K) of the existing Downing Two VCT. Capital preservation is seen as important by the manager, so the majority of an investor’s profit should come from the initial tax break. Asset-backed companies will feature heavily in the portfolio.

Highlights

  • Hybrid portfolio of asset backed companies and those with predictable revenue streams
  • Backs proven management teams
  • Well-resourced investment team of 25 specialists
  • Freehold properties a strong feature

The manager

Downing LLP is a well-established manager of venture capital and EIS funds. There are three strands to its business: quoted equity and unquoted – with the latter split between asset backed and renewables.  Its investment team comprises of 25 people, managing over £230m in VCTs and has been managing limited life VCTs since 2004. 

The Downing Two VCT (K share) will not feature quoted equities and is unlikely to feature any renewables. Therefore, the asset-backed team, led by Jonathan Boss, is key to this VCT. Downing currently manages £243 million in asset-backed investments, of which £110 million is in VCTs.

Target return and strategy

This VCT targets a return of £1.10 per £1 invested and aims to return all the proceeds within six years.  The qualifying investment pot will be a mix of asset-backed investments and those with predictable revenue streams. In addition, in the non-qualifying section, secured loans and other fixed income investments will also feature. Dividends are not a priority in the early years.

Downing has had to change its investment strategy because of new rules.

In the past, Downing bought up under-performing public houses, for example, and put an excellent management team in place.  This is no longer allowed, as new rules prevent investment in existing trades or business.

What is still possible is backing quality, proven management teams and converting buildings (and hence still have freehold property) previously used in another trade into a pub, bar, children’s nursery or wedding venue. So the rules are now more complicated, but not insurmountable when trying to build an asset-backed portfolio.

Another area of focus is data centres. Once built, these provide consistent, reliable income streams, often with large blue-chip clients on long-term contracts. This has the double benefit of asset backing, i.e. the centre itself, and consistent income.

Half of Downing’s asset-backed deals over the last six years would have qualified for investment under the new, tighter rules. Hence deal flow shouldn’t be an issue.

Exit strategy

Exits have been quite fruitful over the last two years, largely down to a better banking environment according to Downing. A mix of trade buyers and management teams refinancing to purchase businesses will be the primary routes to exit.

Risks

The key risk with this product is what happens if one or two investments don’t work out. With low returns from each one anticipated, if they run into financial difficulty it will be hard for the remaining companies in the portfolio to make up the shortfall.  Another risk is the exposure to commercial property and the interest rate cycle. Don’t forget the freehold property is there to help provide downside protection.

Fees

The initial charge is 4% (before the Wealth Club saving). The annual management fee is 1.8% per annum, with a cap on the total running costs of 2.75% each year. Downing can also receive deal arrangement fees of up to 2% and monitoring fees too. If investors receive at least £1 per share in dividends, Downing is entitled to receive 20% of the excess above this, capped at a maximum of 6p, as a performance fee. For example, if the total return due to investors before the performance fee was £1.10, investors will actually receive £1.08 and Downing gets 2p. There is a 6% compound hurdle rate to hit in order for the performance fee to become applicable, however this is based on 70p net cost and merely gets you to £1 after six years. It does, however, incentivise the managers to exit in a timely fashion.

Summary

Downing has created a niche for themselves in the asset backed market and whilst their other VCT offer this year seeks to achieve a much higher level of growth than this offer, it is the same team with the same expertise managing both. In my opinion, this is not an exciting VCT.  A targeted £1.10 return after six years is hardly going to set the world on fire, however if that can be delivered with much lower volatility and more predictability, there could be a place for it. If you take into account the net cost of 70p, assuming full the initial tax break, it does stack up. This is managed by a quality team.