Patience is a virtue – government policy on growth finance

Legislative changes resulting from last year’s consultation on patient capital have now been enacted. Announced in the Autumn Budget and the government’s response to the consultation, the measures requiring legislation were effected when the Finance Act 2018 received Royal Assent on 15 March 2018. This article describes the various changes and explains their background.

Background – the government’s consultation

The patient capital review began in January 2017, and the Treasury opened the consultation, entitled Financing Growth in Innovative Firms, in August.

The review addressed the issue that, while the UK has a good record in innovation and creates world-leading start-ups, it does not perform so well in scaling up start-ups to larger businesses. If the UK is compared to the US, for example, the UK underperforms in the creation of start-ups that reach a $1 billion dollar valuation, there are fewer young listed companies, and a significantly lower proportion of research and development is performed by younger companies.

A principal reason for this is thought to be that UK businesses lack the long-term finance needed to scale up successfully. Such finance is referred to as patient capital, defined as ‘long-term investment in innovative firms led by ambitious entrepreneurs who want to build large-scale businesses’.

The consultation invited responses on a number of issues, including the strengths and weaknesses of patient capital in the UK, factors hindering the effective deployment of patient capital, barriers to investment in patient capital, current government interventions, possible ways of increasing the supply of patient capital, increasing effective retail investment in patient capital; and other measures to support investor capability.

The industry panel’s report

To support the patient capital review, the Prime Minister asked Sir Damon Buffini to lead an independent industry panel to assist in defining the themes for the consultation and to make recommendations. The industry panel’s response was published in November 2017.

The industry panel agreed with the premise of the review that lack of available patient capital is a major challenge for growing businesses aiming to reach scale, and made three recommendations to address this issue.

First, the panel recommended the creation of a patient capital investment vehicle, to invest in venture capital funds and other investors in high-growth businesses. Its second recommendation was to establish a UK patient capital investment company programme: PCICs would be private funds licensed by the British Business Bank to raise funds from commercial lenders through a BBB-guaranteed debenture. Thirdly, the panel suggested extending the investment limits for the tax-advantaged EIS and VCT schemes, with a particular focus on knowledge-intensive companies.

The government’s response

The government’s response to the consultation noted that respondents identified two particular areas of weakness within the patient capital market. The first is a gap in follow-on investment in companies that have already received initial investment, typically at Series B to Series D, or investments between £5 million and £50 million. The second weakness is that some companies still struggle to attract early-stage investment, especially businesses outside London and university spin-outs.

The government has brought forwards a package of policy measures to address these issues.

Tax changes to encourage patient capital

The following changes have been made to the enterprise investment scheme (EIS) and venture capital trusts (VCTs), with effect from 6 April 2018:

• The annual investment limit for EIS investors is increased from £1 million to £2 million, provided that any amount over £1 million is invested in knowledge-intensive companies.
• The annual EIS and VCT investment limit for knowledge-intensive companies is increased from £5 million to £10 million.
• Greater flexibility is provided for knowledge-intensive companies over how the age limit is applied when a company must receive its first investment under the scheme: as an alternative to the current date of its first commercial sale, a knowledge-intensive company may now choose to begin the ten-year initial investing period on the date on which its turnover first reached £200,000.
• The operating-costs conditions in the definition of a knowledge-intensive company are amended for companies that have existed for less than three years.
• The government has consulted on a new knowledge-intensive EIS-approved fund structure with further incentives to attract investment: on this, see our separate article on the consultations launched in the 2018 Spring Statement.

In order to ensure that the EIS, SEIS (seed enterprise investment scheme) and VCT schemes are focused on supporting investment in companies with high growth potential, a new risk-to-capital condition has been introduced:

• The risk-to-capital condition is met if, having regard to all the circumstances existing at the time of the issue of the shares, it would be reasonable to conclude that (a) the issuing company has objectives to grow and develop over the long term, and (b) there is a significant risk that there will be a loss of capital of an amount greater than the net investment return. If it is considered that an investment has been structured so as to provide a low-risk return for investors, then the investment will not qualify for relief. HMRC has published technical guidance on the new condition, including examples, and will not provide advance assurance for investments that do not appear to satisfy it.

The following change has also been made:

• The definition of ‘relevant investment’ is amended so that all investments, including risk-finance investments made before 2012, will count towards the lifetime funding limit for companies receiving investment under SEIS, EIS and VCT (£12 million, or £20 million for a knowledge-intensive company).

To encourage VCTs to focus more on higher risk areas of the market, while removing certain unnecessary conditions, the following changes are made:

• From 6 April 2018, certain historic rules providing more favourable treatment for some VCTs are removed.
• From 6 April 2018, VCTs are required to invest at least 30% of funds raised in qualifying holdings within twelve months of the end of the accounting period.
• A new anti-abuse rule has been introduced to prevent loans being used to preserve and return equity capital to investors: loans to investee companies must be unsecured and will be assessed on a principled basis, while safe-harbour rules provide certainty to VCTs using debt instruments returning no more than an average of 10% over a five-year period.
• From 6 April 2019, the percentage of funds VCTs must hold in qualifying holdings will increase from 70% to 80%.
• From 6 April 2019, the period in which VCTs have to reinvest gains will be doubled from six months to twelve months.

Finally, the following change will be made to the qualifying rules of entrepreneurs’ relief, now that the government has responded to a consultation on the technical detail launched in the 2018 Spring Statement:

• To ensure that entrepreneurs are not discouraged from seeking external investment through dilution of their shareholding, individuals will be allowed to elect to be treated as disposing of and reacquiring their shares at market value (without applying a minority discount) on the date in question.

Patient capital investment funds

The following measures have also been announced:

• The government has set up British Patient Capital, a new subsidiary of the British Business Bank, intended to become a leading investor in patient capital across the UK. The subsidiary is capitalised with £2.5 billion, unlocking a total of £7.5 billion (by co-investing alongside private investors), and it is intended that it will be floated or sold once it has established a track record.
• There will be investment in a series of private sector fund of funds, of which the first wave will be seeded by investment of up to £500 million by the British Business Bank. It is expected that there will be up to three such funds, with a ratio of public to private capital of around 1:2, unlocking total new investment of up to £4 billion.
• First-time and emerging venture capital fund managers will be backed through the established enterprise capital funds programme of the British Business Bank, unlocking new investment of £1.5 billion.

It is hoped that there will continue to be a mutually beneficial relationship with the European Investment Fund after Brexit.

The following measures will be taken to make it easier for companies in parts of the market to access earlier-stage capital:

• A new commercial investment programme will be developed through the British Business Bank to support clusters of business angels outside London.
• A National Security Strategic Investment Fund will be launched to support early-stage companies developing innovative technologies with the potential to contribute to national security.

Finally, and in response to the industry panel’s recommendation relating to patient capital investment companies:

• There will be a feasibility study to implement a ‘small business investment company’ in the UK through a new guarantee programme.

Removing barriers to investment

As initial actions to remove barriers to investment in patient capital, the following steps will be taken:

• The Pensions Regulator will clarify guidance on how pension fund trustees can invest in assets with long-term investment horizons, including venture capital funds, as part of a diverse portfolio.
• A working group of institutional investors and fund managers will work to tackle continuing barriers preventing defined-contribution pension schemes from investing in illiquid assets.
• The Prudential Regulation Authority will consider consulting on new guidance on the prudent person rule.
• The Department for International Trade will back overseas investment in UK venture capital in a measure expected to unlock £1 billion of investment over the next five years.

Other measures

The following further measures are to be taken:

• There will be a study to assess how best to support the next generation of high-potential fund managers to develop their knowledge and skills and raise their first or next fund.
• To increase diversity within the sector, venture capital and other financial services firms are urged to sign the Treasury’s Women in Finance Charter and commit to improving gender balance, and the British Business Bank is researching how barriers faced by businesses led by women in accessing venture capital can be overcome..

Other measures included in the Autumn Budget 2017 are as follows:

• The rate of R&D expenditure credit rose from 11% to 12% with effect from 1 January 2018.
• The government will work with stakeholders to overcome the barriers to obtaining growth funding faced by high-growth IP-rich firms such as those in the creative and digital sector.
• A new GovTech Fund supports innovators developing digital products to address public-sector challenges and a new GovTech Catalyst will give innovators a clear access point to government.
• Tech City UK has expanded its reach, becoming Tech Nation.
• The number of Exceptional Talent visas available annually for those in the digital technology, science, arts and creative sectors seeking to work in the UK is doubled to 2,000.

Next steps

The Treasury and British Business Bank will work with stakeholders on the delivery of these measures, and there will be a report for the 2018 Autumn Budget setting out how they are being implemented.

In the autumn of 2020, the government will evaluate the effect of the measures taken against the policy objectives of making progress towards unlocking capital of over £20 billion over ten years, deepening the pool of patient capital investors, reducing government investment by the end of the ten-year period, and targeting tax reliefs at growth companies. Resource allocation will be confirmed as a result of this evaluation; there may be a reconfiguring of resources if the UK does not maintain a mutually beneficial relationship with the European Investment Fund in the long term.

The government will hold a series of roundtables for stakeholders to discuss how best to create economic conditions which will enable high-growth companies to succeed.