Use investment funds to find fast-growing private firms

Only a decade ago investing in fast-growing private, non-listed companies was largely the preserve of institutional investors willing to put millions of pounds to work over long timescales. But today the funds targeting private companies are proliferating so fast that one could forgive investors for being slightly confused. Here is an overview of the various structures and strategies.

Tax-efficient VCTs

Arguably the most accessible structure, and certainly the most tax-efficient, is the venture-capital trust concept we discussed a fortnight ago. These trusts have been redesigned in recent years to focus more on genuinely risky, fast-growing companies – hence the generous tax incentives, which include upfront 30% tax relief. But VCTs also have their downsides.

Performance has been extremely varied, and many funds continue to trade at sizeable discounts to net asset value (NAV). Investors also only retain the tax privileges if they hold the shares for the full five years. And although there are some first-rate fund managers in this sector, not all of them are in the top tier of private-equity or venture-capital managers.

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Perhaps the hottest niche outside of VCTs, and certainly the fastest-growing in terms of funds managed, is what one might call the pre-IPO (initial public offerings) model. The Chrysalis fund pioneered this approach, but Baillie Gifford’s Schiehallion fund – relatively inaccessible to most private investors on internet platforms – is now giving it a run for its money, with 12-month price returns of 39%. The idea here is to invest in the later stages of development of young businesses (once they have found their feet), mostly backed by well-established venture-capital funds.

Many of the businesses such as Starling Bank – a big part of the Chrysalis portfolio – are still relatively young and only just nudging into profit, but valuations can be extremely high. Baillie Gifford has an excellent pipeline of global deals, jam-packed full of tomorrow’s potential unicorns. The downside of both funds is that they are primarily aimed at institutional investors and Schiehallion continues to trade on the specialist-fund segment of the main market. One other risk to be aware of is that both funds depend heavily on the IPO pipeline remaining open, which could be problematic if investors turn bearish and new listings struggle. Both of these pre-IPO growth capital funds are run by mainstream fund managers, not specialist private-equity or venture-capital firms.

Venture into venture capital

Growth capital for youngish firms can also come through traditional venture-capital (VC) groups such as Draper Esprit, whose shares are quoted on the London market. It is now worth over £1bn. Draper Esprit is much closer to the business model of the archetypal Silicon Valley tech buccaneers, and has delivered solid, 45% returns for investors over the last year. But be aware that VC investing is always highly risky and in a market sell-off this asset class tends to underperform. Sticking with that “traditional” VC model, it’s also worth looking at Augmentum Fintech, which is London listed and is focused solely on venture investing in the fast-growing fintech sector.

There is also a small subgroup of explicitly tech-focused VC funds. They usually concentrate on one core sector, such as life sciences. In this category you will find a growing number of biotech VC funds, notably Syncona, RTW Ventures, PureTech Health and Arix Biosciences. These all run diversified portfolios of very early stage and later-stage businesses as well as a smattering of listed biotech firms. The business model here can seem very different from the conventional VC model. Specialist teams of scientists employed by a fund manager scour the university and research sector looking for teams to build new products.

PureTech is up by 112% over three years, while Syncona has gained 123% in five years. This brings us to the university spin-out expert, the IP Group. It commercialises intellectual property from the university sector. Over the last year its shares have risen by 60%.

Finding profitable businesses

All these funds tend to back earlier-stage businesses, not more mature but still high-growth businesses already making solid profits. That is a category that private-equity (PE)firms tend to focus on, but their approach is radically different.

In this part of the PE/VC spectrum, there is more emphasis on using financial engineering to maximise returns, and there is also a big focus on buyouts and rolling up a number of businesses into a new, arguably more efficient entity. But that does not mean that PE funds ignore fast-growth private businesses.

Hg Capital in particular and increasingly Oakley Capital are very much focused on private-growth businesses in European tech. Hg has provided a share-price return of 28% over the last 12 months. Dig around inside the portfolio of both managers and you will find all manner of tech-enabled businesses providing everything from business services to educational services and even Rightmove rivals in southern Europe.

Investing in fast-growth, private businesses is not for the faint of heart. Valuations for the underlying portfolio businesses can often be astronomic and realisation records are key: you need the managers to show that they have made investors money on numerous exits. And remember that the promise of any future realisations is mightily dependent – though not exclusively so – on stockmarkets remaining bullish and the IPO pipeline staying open.