Consolidation of Investment funds expected to rise
It is likely that there will be a continuing move towards investment funds consolidation over the next few years, particularly venture capital trusts (VCTs) and conventional investment trusts.
In the case of VCTs, this is likely to result, in part, from proposed changes to the VCT rules which were set out in the draft 2012 Finance Bill published in December 2011. Among other changes to the rules, which are intended to ensure that VCTs are focused on higher risk investments, these revisions increase the amount which a VCT may invest in any one single company. Up until now, VCTs have been unable to invest more than £1,000,000 in any one company during any one year and, as a result, VCT fund managers have been keen to establish sister VCTs which can invest alongside each other in order to increase the amount that can be invested.
This means that VCTs, as well as investment trusts generally, incur additional legal, financial and listing costs. Such funds may also suffer from the increased administration fees associated with having more than one board of directors to manage the VCTs. With the changes to the VCT rules and, as funds mature, it often makes sense for funds to be merged together to create one larger VCT with lower running costs to benefit from economies of scale. This particularly makes sense for smaller VCTs especially those under £10m or those with over-lapping portfolios. A combined, larger vehicle should have fewer costs which can be spread over a greater asset base. This means that it can utilise its funds more efficiently by investing a greater proportion of the assets and sustaining a higher level of dividends and other returns.
SGH Martineau acts for a large number of investment funds and VCT clients and we are already seeing an increase in the number of funds being consolidated. There are two tried and tested procedures for merging funds: (i) a scheme of reconstruction under Section 110 of the Insolvency Act 1986 and (ii) a scheme of arrangement under Section 895 of the Companies Act 1986.
A Section 110 scheme means one of more of the funds being placed into solvent member’s voluntary liquidation and the assets/investments transferred to the acquiring VCT, in return for shares in the acquiring company. A Section 895 scheme is a court procedure which enables the holdings in one or more of the target funds to be transferred to the acquiring company. Although a Section 110 scheme includes the ability for dissenting shareholders to be bought out by the liquidator as part of the process, this risk has been felt to be acceptable. This is due to the purchase price being that which would be received on a break-up value and tax reliefs potentially being reclaimed by HMRC, compared to using a Section 895 scheme which can be less time and cost efficient. Mergers can also be completed using a more routine offer by one company for the shares of the other, though in practice it is difficult to effect due to the number of shareholders who must agree to the offer (i.e. a greater need for positive action).
There are a number of challenges involved which investors should be aware of, including assessment of the purchase price. Each VCT needs to be carefully valued so as not to prejudice one set of shareholders. Most mergers are completed on a relative net assets basis, though more costs may be allocated to one fund in comparison to the other due to its greater need to consolidate. If valuation is an issue, it is possible to merge the funds into segregated share classes and then merged following a period of time. This can allow time for the portfolios to mature and valuations to be assessed whilst reaping the benefits of being in a merged firm immediately.
There are also other circumstances where fund consolidation is the next logical step. Sometimes a fund may be unhappy with the performance of its fund manager and so could choose to transfer that fund’s assets to a more successful one. Or it could be that the focus of the investment is changing, which we are seeing more and more with VCTs in particular in light of changing rules. Fund consolidation is not just a popular move with investors – fund managers are also attracted as fees are based on the amount of funds under one roof.
For anyone considering funds consolidation, you need to ask whether the fund in question is really viable in its own right, or are the associated costs too high? The VCT market has generally felt that a two year recovery of the merger costs from the annual savings post merger is an acceptable level to put proposals to shareholders.
Consideration will also need to be given as to which fund should be the surviving company and which merger route to use.Each fund should complete due diligence on the other – and clarify if any regulations apply, to ensure this is built into the process. If a Section 110 scheme is favoured, investments also need to be checked for transfer issues and solutions worked into the process. Investments may comprise loan securities, as well as shares, which may have additional documentation and benefit of which also need to be transferred.
Care needs to be taken to ensure that the due diligence process does not infringe any confidentiality undertakings or other restrictions on disclosure of information relating to the investee company which were accepted when the original investment was made.
Where the merger results in a change of manager, it is likely that relationships with the investee companies will need to be managed very careful, as the boards of those companies may be unhappy to discover that they are dealing with somebody completely new.
Discussions will also need to be had with the funds various advisers so as to terminate their arrangements in the target funds. Where the advisers are the same for both funds, this can be achieved relatively easily without any compensation payments as such advisers see the benefit of remaining appointed to the larger vehicle. Where the advisers are different, there may be additional payments which need to be factored in when looking at the efficiency a merger would bring.
In summary, a larger investment vehicle may be significantly better placed to absorb the inevitably high running costs associated with investment funds, in particular listed companies. An enlarged vehicle should be more able to reduce costs and, as a result, maximise investment opportunities and, more importantly, shareholders returns.
Kavita is partner and head of corporate finance at top 70 UK law firm, SGH Martineau. She specialises in private equity and corporate finance transactions including the establishment of investment funds, public and private fund raising, venture capital and private equity investments, takeover, mergers and reconstructions.
Kavita has secured an impressive portfolio of work from London for the firm. Her recent work includes venture capital investments in the environmental infrastructure sector including renewables and solar energy.
Kavita sits on both the VCT Forum and VCT Technical Committee of the AIC and is a member of the EIS Association. Kavita can be contacted on 0800 763 1645 or by email at firstname.lastname@example.org
Andrew has been a partner and member of the corporate finance team at SGH Martineau since 1985. He specialises in private equity, mergers and acquisitions and corporate finance transactions including the establishment of investment funds, public and private fund raising, venture capital and private equity investments.Andrew is a member of the Law Society’s Standing Committee on Company Law and was actively involved in the consultation process that culminated in the enactment of the Companies Act 2006. He can be contacted on T: 0800 763 1556 or by email at Andrew.email@example.com