Venture capital funds prop up young companies as inflation bites

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Venture capital trusts deployed more capital last year despite raising less cash, as fund managers supported portfolio companies in their fight against inflation.

Some £664mn across 345 investments was deployed by UK-based VCTs in early-stage companies last year, according to the Venture Capital Trust Association, a trade body. The figure was up by 8 per cent year-on-year, but fell short of inflation around 8.8 per cent.

Fund managers said they were deploying capital to help some businesses in their portfolio navigate rising costs, particularly in labour intensive sectors such as software.

“All companies are facing the same pressures, the largest element a VCT is funding, is people,” said Will Fraser-Allen, chair of the Venture Capital Trust Association, a trade body. “Firms are experiencing inflationary effects and it costs more to get them to the same endpoint.”

Increased costs for firms mean it will become more expensive to expand business. Meanwhile, less capital will be available for new ventures that VCTs might want to back.

Fraser-Allen said a retreat from early-stage companies among institutional investors meant VCTs needed to commit for longer to ensure portfolio companies scaled up operations sufficiently to pursue later funding rounds in pursuit of a profitable exit via a public listing or acquisition.

While some early-stage companies have opted to reduce costs by cutting staff numbers or cutting office space to avoid taking on debt, others are issuing convertible notes to investors which can turn into equity at a later date.

The number of start-ups likely to grow and justify additional investment, known as the graduation rate, is expected to decline as many struggle with the current economic climate.

“Where the graduation rate is lower, there’s a decision to be made, should we invest further [in a company] or stop and invest elsewhere,” said Malcolm Ferguson, manager of Octopus Titan VCT. “If they’re hitting milestones, we will bridge.”

Orbex, the UK-based rocket company which received £10.2mn in investment from Octopus Investments in 2020 and £4.5mn in 2021, said it was considering a bridging round before pursuing a more substantial capital raise when market conditions improved.

“At the end of the day you’ve got to finish the design and make the launch vehicle, the longer you take, the more it’s going to cost,” said Martin Coates, interim chief executive of Orbex. “Getting that done as efficiently as possible is the least expensive route in the long haul.”

High inflation has yet to seriously squeeze VCT investors. The scheme has raised record sums in the past few years as individuals seek opportunities for tax relief. Last year VCTs raised more than £1bn, down slightly from a record £1.13bn in 2021-22, according to the Association of Investment Companies.

VCTs compensate for riskier investing in young companies by offering investors 30 per cent upfront income tax relief if they hold newly-issued shares for at least five years. Investments are also exempt from capital gains and dividend tax.

Tax relief has acted as a draw for retail investors at a time when capital gains and dividends allowances have been halved. Changes in the annual pension allowance, which increased from £40,000 to £60,000 are expected to hamper VCT fundraising this year.

Separately, fund managers are seeking details of what shape the scheme will operate under beyond a current sunset clause in 2025. The government has committed to extending the scheme but has yet to table any legislation.

Fraser-Allen said clarity was still needed, with uncertainty likely to affect how much cash could be raised and deployed to support companies.