Review - Octopus Apollo VCT
This is a top up to the longstanding Octopus Apollo VCT. It is seeking to raise £20 million, after successfully raising £40 million last year. The VCT portfolio already includes approximately 33 qualifying, cash generating companies from a mix of different sectors. Octopus Apollo VCT is currently in the process of merging with Octopus Eclipse VCT; once the merger has completed, this VCT will have approximately £130 million of assets and invest in around 50-60 companies.
- Large, well diversified VCT
- Regular income is key objective
- Largely defensive investment strategy
- Invests in typically cash flow positive businesses which have at least £1 million in annual profits
- A mixture of debt and equity: currently around 80% held in loans and 20% in equity
- After it has merged with Octopus Eclipse VCT, smaller, more growth orientated businesses will also feature
Octopus Apollo VCT is managed by the Intermediate Capital team at Octopus led by Grant Paul Florence. The eight members of the team have a wide variety of backgrounds including private equity and banking and are exclusively focused on this VCT. In total, Octopus manages over £600 million assets across a range of VCTs. After the merger with Octopus Eclipse there will be some smaller, more growth-orientated businesses in the portfolio; these investments will typically be managed by the Octopus Ventures team.
Target return and strategy
Maintaining the capital value (i.e. the current net asset value) and paying a regular dividend are the long-term priorities of the VCT. Dividends over the last two years have been over 5% of NAV (excluding the special dividend of December 2016) and the annual target is 5 pence per share. Please remember past performance is no guide to the future.
After the merger (and December’s special dividend), the net asset value per share will be approximately 64 pence. Maintaining the annual 5 pence per share dividend could well be much harder at this point, and it wouldn’t surprise me to see this cut to a more sustainable level, and possibly switched to a 5% dividend policy (roughly 3 pence per share based on current NAV). Dividends are variable and not guaranteed.
Whilst the previous strategy of this VCT was to take as little risk as possible and keep equity exposure to a minimum, after the merger the inclusion of some smaller, more growth-orientated businesses is likely to push up the risk profile.
Existing investments are typically split 80/20 between debt and equity. The debt might be a five-year loan of 80% with a charge or security over some assets, with the remainder invested into the equity of the business. After the merger the debt to equity ratio is likely to change, moving closer to a 50/50 split. Loans usually range from 5.5% to 10% over LIBOR, with the typical rate being 7%-8% over LIBOR.
These firms are not the early-stage businesses typically found in the Octopus Titan VCT. The Apollo managers look for businesses with annual profits of at least £1 million, recurring cash flow and defendable positions. They prefer non-cyclical businesses that can prosper regardless of the wide economic environment and which are not dependent on discretionary consumer spend. Business to business companies are a favourite. One example is Clifford Thames, which supplies the motor industry.
Revenue and profits are as important for younger businesses as they are for more established ones. A key question is why the company wants the capital as they can't use it to pay founders. The company might have need of liquidity, for new stock for example, or might want to enter new market such as the US. High margins are important too and loss making businesses aren’t considered appropriate.
The team is expected to keep applying the same strict criteria for loans it has used in the past: is the company able to generate cash, pay the interest and therefore repay the capital invested? Are there any bank loans that have precedence? If the deal goes wrong, can the whole investment be recovered from the debt and interest paid whilst writing off the equity position? With a larger percentage invested in equity this will be harder to achieve in future, although the team has considerable expertise in this area.
One deal completed recently was ISG, a company that designs and installs Wi-Fi targeting multi-site businesses. Many companies now find that offering free Wi-Fi is essential, and not just for just customers checking their emails. The company currently has an annual EBITDA of £2.5 million. Octopus has invested alongside Westbridge Capital. Westbridge has invested mainly in equity, Apollo mainly in debt with a £4 million loan paying LIBOR plus 12% and £1 million of equity for a stake of 9.8%. As is usual in Octopus deals, the management owns a reasonable slice of the equity. There is some more senior debt in the business, approximately £2 million, but the cash flow is good and the business mature and stable, according to Octopus.
In the past, a typical deal size for the Apollo VCT was £4 to £5 million. New rules have made it harder for VCT managers to find investments. The managers now believe deals of £2.5- £3 million will be more commonplace giving them capacity to invest between £10 million and £20 million each year.
The original objective which focused on capital preservation and income payments still holds true, focusing on payment of interest instalments and capital repayment of loans. If this happens the manager is happy to sit with the equity stake, which often pays a sizeable dividend after debt has been repaid. With the more growth-orientated investments, all options will be considered, with trade sale or floatation the obvious routes.
Both existing and new investors will have to become used to a slightly higher risk profile for VCTs as recent rule changes kick in. It will be important to ensure the interest payments are made and the loans are repaid . Limited equity upside means bad loans can have a detrimental effect on the portfolio value. After the merger and under the new rules, investors might have to get used to more volatility than in the past due to the greater exposure to more growth-orientated businesses.
Please remember capital is at risk. VCTs are high risk investments and are not suitable for everyone. Investors should not invest money they are not prepared to lose.
There is an initial charge of 5.5% (5% for existing investors) before any Wealth Club discount. The annual management fee is 2%. In addition Octopus is entitled to an administration fee of 0.3% p.a. and a company secretarial fee. Annual running costs are capped at 3.3%. Octopus also receives deal arrangement fees of 1.5%. A performance fee is also payable of 20% of gains above the Bank of England base rate.
Performance has been average over the last few years with the total return not being large enough to cover the annual dividend payment in three of the last five years. That is often the problem with “lower risk” VCTs as they are often having to run to stand still. The introduction of more growth-orientated deals after the planned merger with Octopus Eclipse should aid capital growth in future.
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 aim to highlight investments we believe have merit, but investors should form their own view on any proposed investment.