Octopus Live Online follow up Q&A

Jessica Franks, Head of Tax

We recently ran two episodes of Octopus Live Online: The Estate Planning Show, the second of which took a closer look at the Octopus Inheritance Tax Service. More than 3,000 advisers registered for the two-part series and we received over 500 questions during the two shows. Obviously, it was impossible to answer so many questions during the shows and I hope that your local Octopus inheritance tax expert has been in touch by now to personally answer your question. 

Quite a few similar themes came up and I’ve grouped the questions and answered them below. 

Both episodes are available to watch again online or share with any colleagues who missed the shows but might enjoy them. The recordings, along with other snippets of content are available here.

Please remember, the Octopus Inheritance Tax Service puts investor capital at risk. Before we start, I’d like to recap some key risks to keep in mind.

  • The value of an investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they invest.
  • Tax treatment depends on individual circumstances and could change in the future.
  • Tax relief depends on portfolio companies maintaining their qualifying status.
  • The shares of unquoted companies could fall or rise in value more than shares listed on the main market of the London Stock Exchange. They may also be harder to sell.

Product performance

How interlinked are the stock market and this product’s performance?

The Octopus Inheritance Tax Service was designed (twelve years ago) in response to advisers and investors seeking an investment that targeted predictable growth over the long term, and that was capable of doing so even in times of market volatility. As it invests into the shares of unlisted companies, the value of investors’ portfolios does not move around in line with short-term market sentiment. For example, share prices falling simply because investors are nervous about what might happen and so withdraw their money, irrespective of the current performance of and outlook for the company they hold shares in. The value of these companies is derived from the performance of and outlook for the underlying assets and businesses that they own. As such they are not directly correlated to stock market performance.  

As investments need to be made into trading companies in order to qualify for Business Property Relief (BPR), investors should expect the value of the shares they own to move around based on the performance of that company. The value of the assets the company owns may also be influenced by wider market sentiment in the sectors they operate in which is why we have two primary strategies in place to reduce the impact of this on investors over the long term:

  1. First up is the scale of the portfolio company – Fern Trading Limited – that we have carefully grown over the last ten years to a £2 billion group. This enables it to deploy sector diversification as well as owning hundreds of separate assets, which intentionally reduces risk for investors, both due to the performance of each individual asset being less determinative of performance of the group, and because we have selected sectors that should complement each other to mitigate downside risk. There is no focus on adopting a strategy that would be expected to deliver growth ahead of target and this product is not suitable for investors who want to target extra growth, although returns are not capped.
  1. Our “Growth Shield”. We charge 1% (plus VAT) annual management charge (AMC) on this product, but it is simply accrued on a client’s portfolio and is not collected until an investor asks to sell some or all of their shares, and then only if 3% growth has been met on average across their full investment period. In this way, despite the fact that Fern’s share price has moved around a little within the target range, all investors who have sold down their investment after two years or more have received at least 3% growth on average. If the share price hasn’t grown by 4% or more in that period, we therefore have given up some or all of our AMC – exactly what this product was designed to do.

What impact will COVID-19 have, if any, on the growth outlook for the target yield?

Fern Trading Limited (the underlying company into which new client money is invested) is the parent company of a group of c.200 subsidiaries and undertakes a range of trading activities which include asset-backed lending through our in-house property, healthcare and renewable energy teams. It also owns and operates energy sites that generate income every year, both from selling energy and from long-term government incentives.

Its strategy is designed to be one that can deliver long term predictable growth for shareholders despite market uncertainty. Indeed, in the ten years since Fern started trading, we have experienced some varied market conditions, but it has always targeted the same net annual performance for investors over the long term. Of course, short term performance has moved around within a relatively small band. Indeed, while we don’t know the final terms of Brexit, we do know that during the last few years of uncertainty, the Octopus Inheritance Tax Service has continued to deliver in line with target performance. It also did the same further back, in 2008/09 during the financial crisis.

While we don’t know what the full shape of the Government interventions for COVID-19 will look like, the opportunities that are available for Fern to pursue have not changed or diminished, and the outlook for its existing assets and businesses has been analysed in detail and remains strong. This is due to the nature of the assets targeted and the focus on capital preservation in downside situations at the expense of pursuing strategies that have more potential for upside. We think Fern’s balanced business strategy helps to put it in a strong position in order to continue to target predictable growth for investors despite uncertainty, as does the experience of our large specialist inhouse teams, many of whom were responsible for managing lending businesses during 2008-09. 

Fern’s share price has barely moved given the current economic situation. Can you please discuss why this is so stable?

Fern operates a diversified business strategy, with just over half of its business comprised of owning and operating renewable energy sites. The other half comprises a large scale secured lending business, fibre broadband businesses and operational healthcare infrastructure businesses. Fern’s strategy is designed defensively, to perform solidly across all trading environments rather than to outperform when times are good. That’s what it has been targeting and delivering for the last decade.

There have been some changes to the share price of Fern recently. At the end of March we were provided with the latest long-term energy price forecasts by two independent experts, whose views are followed by the renewable energy industry more broadly. Combined, their long-term view of these energy prices is now lower than it was last quarter. 

As a result, we slightly reduced the valuations of Fern’s renewable energy assets. The impact of this was a 4.0 pence reduction in Fern’s share price, or 2.5%. The impact of this small share price reduction for most investors in Fern who have been invested for more than 12 months will be limited to a reduction in the amount of Octopus AMC accrued on their portfolio. As a result, the value of most investors’ portfolios post charges may not be reduced at all, despite the reduction in share price.

This is due to the way our AMC is calculated and collected. It accrues during the entire period an investor owns their portfolio, and is only collected when an investor sells shares, and then only once the investor has realised 3% growth per year on average after this fee is taken into account. It is designed to smooth out short-term volatility such as this and align Octopus with our customers. So investors are unlikely to have seen the impact of this small drop in value, which is exactly what the product is designed to deliver for them.

About 25-30% of Fern’s business comprises short term lending in the property sector. The loans Fern makes include residential loans (buy-to-let, bridging), commercial loans and development loans, with an average loan size of around £500,000 for residential, and £2-3 million for commercial and development loans. Typically, Fern lends to professional borrowers, with a 6-18 month maturity. There are typically more than 200 loans in this part of Fern’s business at any one time, spread right across the UK, and the average loan to value (LTV) is below 65% which provides a meaningful level of protection for Fern’s capital should loan interest and capital need to be repaid over a longer period.

We always monitor this part of Fern’s business very closely and review any non-performing loans in great detail to assess timing and amounts of any recovery processes. At the moment there is nothing that would require a material reduction in the value of Fern’s lending business or individual loans, but we’re stress-testing all the loans and paying attention to how the property sector as a whole changes over the coming weeks and months.

We are expecting demand for new loans to be lower than normal in the current climate.  We also always adopt a risk adjusted approach to lending and have adjusted our criteria to a more cautious set of conditions than in a more positive market. One of the reasons we operate one large diversified company is so that we can deploy more capital into sectors that look most attractive at any time.

Can you explain the growth shield mechanism and how charges are accrued rather than taken each year within the portfolio?

The Octopus Inheritance Tax Service targets 3% growth per annum on average for investors over their holding period after our annual management charge of 1% (plus VAT). Therefore, Fern targets annual growth of 4.2%. Our AMC is deferred and contingent, it accrues on an investor’s portfolio, but we are not entitled to collect it until the shares are sold. And only to the extent that Fern’s performance over the investor’s holding period has been sufficient for us to do so. 

In this way the value of our accrued AMC (or “growth shield”) is expected to grow over time and acts as a first loss buffer against a downwards movement in Fern’s share price. It’s pretty unique in this respect – the potential protection for the investor is significantly different to the position if we simply assessed annual performance and took our AMC annually when we could.  It cannot protect against losses completely, but it does ensure that we lose out first and has been instrumental over the past decade in ensuring that investors receive the 3% average annualised growth that they expect from this investment.

Has the 3% target growth always been achieved?

The Octopus Inheritance Tax Service targets 3% growth per annum on average for investors over their holding period after our annual management charge of 1% (plus VAT). Therefore, Fern targets annual growth of 4.2%.

To date, the vast majority of investors who held their investment for at least two years before selling have achieved at least 3% average annualised growth after our AMC. Returns are not capped, so some investors will have achieved more than 3%. However, since the target of the investment is to seek sectors and opportunities which are capable of providing predictable growth for shareholders, this is unusual. Since inception, Fern’s share price has not grown by the overall target of 4.2% on average. So on average, we have not been entitled to collect our accrued AMC in full when investors have sold their shares – this is exactly what the service is designed to do and has ensured that we miss out before investors do.

Fern’s share price performance since inception is shown below. Due to how our AMC accrues and is collected, it is the average annualised performance of Fern’s share price that is most relevant to investors.

Annual growth in Fern’s share price (discrete):

Fern’s ten-year performance to May 2020:

Annual growth in Fern’s share price (discrete)

May-19May-200.00%
May-18May-196.97%
May-17May-180.70%
May-16May-175.56%
May-15May-163.44%
May-14May-154.40%
May-13May-143.56%
May-12May-134.06%
May-11May-124.11%
May-10May-114.21%

Fern’s average annual performance

Number of years held10.00%
23.42%
32.51%
43.26%
53.30%
63.48%
73.49%
83.56%
93.62%
103.68%

You can keep up to date with Fern’s share price at www.Ferntrading.com, and see performance since inception in our “Underlying Investments” document that is available to both advisers and investors.

Please remember: Fern’s past performance is not a reliable indicator of future results.

How do you target 3% growth for shareholders on the unlisted companies – do they pay dividends?

The portfolio companies like Fern do not pay dividends. This is because for most investors, dividends would be less tax efficient than capital growth. For those investors who want to receive a cashflow from their investment, we can arrange regular withdrawals which pay out to investors, funded through share sales. We can also facilitate ad hoc withdrawals.

Investment strategy

Do you feel it’s a disadvantage to have all clients in the IHT Service investing into one shared company – other providers split each client into their own company with an individual tax return

No quite the opposite – we consider it to be a huge advantage.  

  1. Diversification across sectors

It ensures that each investor always has an equal pro-rata exposure to every part of Fern’s business (people who invested five years ago are not stuck with only those parts of the business that we had five years ago). 

  1. Reduced concentration risk

As part of its business activities, Fern holds more than 500 underlying assets. 

  1. Liquidity 

Investors are buying and selling shares in the same one company, which enables us to buy and sell shares in that company on behalf of clients every week. If we had to sell shares in different companies according to exit requirements in that particular company, or undertake share buybacks from a small company that we were no longer trying to grow, we would not be able to offer investors such a seamless investment and withdrawal process.

  1. Ability to accommodate large single investors

By being over £2bn in size, Fern can accommodate large individual shareholders without presenting it with either a deployment risk (as you can’t have excess cash laying around doing nothing for BPR purposes), or a liquidity risk.  Indeed, Fern has over 10,000 individual shareholders, and we’re able to manage Fern with the interests of each shareholder, from the largest to the smallest, treated equally and fairly.

  1. BPR qualification 

By running one large company, we are able to ensure that it carries out a trading business on a large scale, employing hundreds of staff and undertaking activities in each sector in a meaningful way. Rather than having lots of companies doing a few things on a small scale that would have more hallmarks of an investment business, and therefore not be expected to qualify for BPR. 

  1. Tested by HMRC over ten years

Thousands of Fern shareholders around the country have passed away over the last ten years. That means HMRC has considered thousands of claims for BPR in respect of the shares in Fern. If we added in new companies with no trading track record, it would take a long time for them to replicate this level of comfort.  We haven’t heard of a single example of a claim being rejected.

Is Fern too big? Can it grow too large so that it no longer is a BPR qualifying company?

There are no limits as to how large a company can be from a BPR qualification perspective.  

We have carefully grown Fern over the last ten years to be a trading business in excess of £2 billion market value. From an investment management perspective this is a significant strength. In addition to the benefits to investors that are listed in Q7 directly above, incremental investment management benefits include:

  1. Scale improves the set of opportunities Fern can explore. We are able to deploy meaningful amounts of capital to test a new sector, while still keeping that activity small relative to the overall size of Fern’s business. It gives us access to opportunities we simply wouldn’t be able to complete for with a smaller balance sheet and enables us to consider and prove very small diversification opportunities without them comprising a significant part of Fern’s business. 
  1. Our size is a key reason we’re able to employ high-quality, experienced managers. It’s also why we’re approached to consider acquiring commercial grade assets in the sectors where we specialise.
  1. There are ten separate parts of Fern’s business, with returns driven by very different factors. The scale we have reached has enabled us to build this sector without compromising the quality of the assets we acquire by being forced to by smaller projects that tend to have less predictable growth expectations and be less in demand (relevant to liquidity and long term value) as a result. Scale has also enabled Fern to spread its business across more than 500 assets, significantly reducing concentration risk but without having to acquire lots of small assets that would be expected to be of lower quality, harder to manage or more difficult to value. Again, this is only possible due to the slow build to significant scale that we have achieved.   

What measures do Octopus have in place to ensure that the quality of Fern’s business does not diminish on the basis that inflows continue to increase?

We have been growing Fern Trading Limited in a measured way for the last ten years. Further measured growth is something that we plan for, as you might expect any solid trading business to do.

  1. We have a dedicated portfolio management team of eight investment professionals who are responsible for overseeing the investment management of this product on a day-to-day basis. They are responsible for assessing all opportunities that are originated by the sector specific investment teams across Octopus. They are also responsible for managing Fern centrally on an ongoing business management basis, with resource dedicated to such specialisms as cash flow management, valuations, investment committee, new sector research and banking relationships. Part of their role is planning for growth, including pipeline management, strategy and investment committee membership.
  2. We run all of our investment management in-house and have grown this essential and valuable resource at the same pace as our funds under management, with investment professionals now totalling more than 150 people across the Renewables, Property, Healthcare and Fibre sectors.
  3. Scale is a benefit for us in terms of investment management: it is much more straightforward to find quality opportunities when you are able to spend more than £20 million, than needing to deploy smaller amounts. So, scale has the opposite effect to pushing us towards weaker opportunities – it opens up many more quality opportunities.
  4. It also enables us to diversify Fern’s business continually without compromising on quality. We are able to make small steps into new sectors with without them comprising material part of Fern’s business until they are proven.

What are the proportions of total amounts deployed in secured lending compared to renewables? Do you provide a more detailed breakdown?

Yes we do. Please click here – we keep this up to date every six months.

From what I can see, the level of gearing in Fern is higher than other BPR providers. Has this led to the more volatile return profiles in the last few years? If so, if your offer was very similar to a competitors, why would we use Octopus if the return profile is low and a bit volatile?

All investment management decisions require risk and reward trade-offs. 

Our strategy is to acquire commercial grade and in-demand assets and businesses for Fern, such as large renewable energy sites. The wider market expects owners of these assets to be able to take advantage of attractive lending rates from major banks. Fern takes a sensible amount of this available debt, which results in the returns to Fern as the equity owner being at the necessary level for Fern’s shareholders.

Due to its size and track record in the sectors it operates in, we can borrow from mainstream banks on very competitive terms and have a lot of experience of doing so. We consider this leverage risk to be one we are more comfortable with for this mandate than the alternative risk that would come from buying assets that the market has priced as inherently more risky on their own. Other managers may take a different approach and instead choose to acquire assets that are “higher risk” on a standalone basis.

We set our strategy for Fern by taking into account the three core parts of our mandate under the Octopus Inheritance Tax Service. We focus on how much of Fern’s capital could be at risk, how saleable its assets are expected to be and whether BPR qualification is expected to continue in downside situations, and develop strategies designed to mitigate all three of these risks.  

As such, we chose to have a strategy in place for Fern that enables it to:

  • Own very high-quality assets that are sought after in the market because we (like others) expect these to be most likely to perform in line with expectations, and be easiest to sell if needed. As a result, the price per megawatt of energy expected to be generated is high, and yields are low as a result.
  • Be very well diversified across as many assets as possible – borrowing at sensible levels enables us to reduce concentration and sector risk across Fern even further.
  • Only deploy capital in sectors that we consider to be robust from a BPR perspective, both now and in the future.
  • Only trade in sectors that are core to people’s needs, such that even in an economic downturn, Fern’s businesses and assets should remain in demand.

The way that we collect our AMC provides a potentially valuable buffer for investors against some short-term volatility, and you can see from the performance track record that it has done what it was designed to do and ensured that investors receive 3% growth on average over their investment. 

We expect every manager to have a mandate that they are working towards and a strategy in place to deliver that for investors. Each will be taking different risks and rewards depending on what their product is designed to deliver.

Can Fern Trading hold cash as a liquidity measure and, if so, what is your usual weighting?

As the Octopus Inheritance Tax Service is an investment into the shares of unlisted companies such as Fern, it is naturally illiquid as there is no external market for shares to be purchased or sold. Octopus creates a market on a best efforts basis for Fern shares every week between people wanting to buy and sell shares and this has delivered more than £700 million of liquidity for investors over the last 12 years.

In the event that more investors want to sell their shares than buy shares, Octopus could ask Fern to offer its shareholders liquidity by purchasing back shares from them like any company could. For Fern to do so, it would need cash. It is not our strategy for Fern to hold cash in case it is asked to provide its shareholders with the opportunity to sell their shares back in the future for two key reasons:

  1. Cash drag is expensive and would require Fern to take more risk with the cash that it has deployed in its business in order to make up for this drag on returns.
  2. Companies that hold significant amounts of cash for long periods of time can risk their BPR-qualifying status.

The most likely situations in which Fern would need to consider repurchasing its shares would sensibly be expected if a very significant proportion of Fern’s investors requesting to sell shares. Fern would not hold this amount of its business in cash.

Instead, Fern’s business strategy is designed with the potential future liquidity requirements in mind. It has a carefully balanced business model split between operating a secured lending business and owning and operating businesses:

  • The Fern Group has a £160 million revolving credit facility available from a syndicate of mainstream banks. This is in place to make sure it can pursue the best opportunities when they arise without holding cash back to do so. It can also be used to repurchase shares if required. For context this would be enough to meet the needs of every withdrawal investor in a typical year even if there are no inflows into the product.
  • Second, the lending part of Fern’s business comprises more than 200 separate loans, with an average term of between 12-18 months. This means that around £40 million of loans mature every month, providing natural and regular liquidity – a cash flow that could be paid out to investors rather than redeployed in the trading business if needed.
  • Lastly, Fern owns and operates commercial scale renewable energy sites. It intentionally acquires sites that are institutional grade – if it needed to sell them it would expect to be able to do so within 6 – 12 months. These also generate significant amount of cash from the revenues they generate each year, that are typically put back to work in the business but don’t have to be.

By owning assets don’t you reduce liquidity?

Fern’s lending business has proven to be naturally very liquid over the last ten years, however just focusing only on liquidity would not help Fern to achieve its target of long-term predictable growth for investors. A business model focused on one sector would also leave Fern very exposed to changes in that sector, for example, to the quality of available opportunities and market rates each time a new loan is written. It also carries redeployment risk – each time a loan is repaid the funds have to be reused in Fern’s business and we would have limited visibility over what the potential returns for the new use could be ahead of time.

For these reasons, five years ago we diversified Fern’s business by starting to operate in other sectors in addition to continuing to run its lending business. Owning and operating renewable energy sites complements a short-term lending business because once a site is purchased, we have better visibility over the revenues that it could produce for the next 20 or so years.

While the lending business is naturally liquid – loans are made and repaid every day with around £40 million of repayment received every month – and an average loan term of around 18 months, Fern intentionally purchases renewable energy assets that are institutional grade and therefore sought after by other institutional investors. We would expect Fern to be able to sell most of these assets within 6- 12 months should it need to – faster than the loans that it makes would naturally mature.

Fern has access to cashflow from other sources that it would expect to utilise ahead of selling any assets, primarily a £160 million revolving capital facility that is it entitled to use to facilitate share buybacks from investors should it want to.  For context, this is sufficient to facilitate 100% of withdrawal requests in a typical year even if no inflows were received into the product.

Renewable energy, healthcare facilities – this sounds like “ethical” investing. Could we put it to clients in this manner from an ESG investing point of view?

Ethical investing is not part of the mandate of this product, but Octopus does have a focus on investing in sectors that support key areas of the economy – renewable energy, healthcare and supporting the provision of housing stock. 

We have large in-house sector specific specialist investment teams spread across these sectors, meaning that these are the sectors we will continue to focus on supporting, as well as continuing to diversify Fern’s business as it grows into adjacent sectors, such as electric vehicles and fibre optic infrastructure.

For clients who are keen to ensure that they invest into sectors that are benefiting the UK, the Octopus Inheritance Tax Service should appeal.

Given the potential long-term nature of an investment in the Octopus Inheritance Tax Service, what safeguards are in place for the stewardship of the future investment approach which prevails now with successive directors, CEOs etc?

The investment of clients’ money is governed by the product mandate of the Octopus Inheritance Tax Service, which is set out in the product brochure. This includes the requirement that client funds are invested into one or more unlisted companies that have been set up and are run by Octopus, and that have been identified as being capable of targeting the following for investors:

  • Qualification for BPR.
  • 3% growth on average each year over the period they have held their investment, after annual management charges.
  • Liquidity – bearing in mind this is an investment into the shares of unlisted companies which are themselves naturally less liquid than the shares of listed companies.

Octopus as an FCA authorised manager has to make sure that all investments made by the Service are capable of meeting this mandate, and that those previously made continue to do so.

In addition to Octopus’ responsibilities, the boards of directors on each of the portfolio companies, Bracken Trading PLC and Fern Trading Limited, comprise majority independent directors, selected for their experience. Directors do sometimes change, but we would look to replace any board members with another suitably qualified independent director who would bring a valuable external viewpoint to the quarterly board meetings and more frequent board calls.

What sectors have you had to leave?

To date we haven’t had to leave any sectors, but there have been some that we have chosen not to enter and also that we have chosen not to grow.

For example, Fern initially entered the solar market by lending to companies that were undertaking the construction of new solar energy sites in the UK. Fern lent part of the costs of constructing the site, and therefore the shareholders’ equity was in first-risk position, protecting Fern’s debt to some degree in the event the site was not valued in line with initial expectations once completed. We considered this to be an appropriate strategy for Fern in line with the mandate for the Octopus Inheritance Tax Service – it was a way for Fern to diversify its business into a new sector, while reducing the amount of risk (and potential for incremental upside that belongs to shareholders) it took while the sector – solar – was fairly embryonic in the UK.

Over time, solar energy became a much more established sector in the UK with the market for solar sites becoming developed, and therefore their value has become easier to assess and predict. As a result, owning and operating solar energy sites became suitable for the Octopus Inheritance Tax Service mandate as part of Fern’s wider business strategy.

In contrast, Fern also provided loans to fund part of the cost of constructing anaerobic digestion sites. This was a very small part of Fern’s business (c.1%) as we looked to see whether the market would develop. For anaerobic digestion this did not happen, and we didn’t consider the sector to ever have become appropriate for our mandate for the Octopus Inheritance Tax Service. Therefore, we decided that Fern should not make any further loans in the sector or to develop, own or operate anaerobic digestion sites. These loans have now been repaid to Fern, with c.£1 million remaining outstanding.

Another example would be the healthcare infrastructure sector, a sector where we undertook a good deal of due diligence before starting to lend to fund some of the cost of infrastructure projects and for which the outlook seemed to be a good fit for our mandate. However, the sector has not yet developed in the UK in line with our expectations (and those of the commercial due diligence we undertook). Therefore while Fern still has a strong presence, we have decided not to grow this sector further at the present time.

This is typical of how we operate for this mandate, testing the water in new sectors where we have appropriate investment expertise in a small way or in a lower risk position, hoping to broaden the position if our initial test proves positive or the sector becomes more established.

Sector specific questions

What impact is COVID-19 having on your property lending business?

About 25-30% of Fern’s business comprises short term lending in the property sector. The loans Fern makes include residential loans (buy-to-let, bridging), commercial loans and development loans, with an average loan size of around £500,000 for residential, and £2-3 million for commercial and development loans. Typically, Fern lends to professional borrowers, with a 6-18 month maturity. There are typically more than 200 loans in this part of Fern’s business at any one time, spread right across the UK, and the average loan to value (LTV) is below 65% which provides a meaningful level of protection for Fern’s capital should loan interest and capital need to be repaid over a longer period.

We always monitor this part of Fern’s business very closely and review any non-performing loans in great detail to assess timing and amounts of any recovery processes. At the moment there is nothing that would require a material reduction in value of Fern’s lending business or individual loans, but we’re stress-testing all the loans and paying attention to how the property sector as a whole changes over the coming weeks and months.

However, we have seen a small increase in payment holiday requests from borrowers, which we consider on a case by case basis. These aren’t waivers; just short deferrals during which Fern’s interest rates continue to accrue. Offering these occasionally to borrowers we know and trust is a reasonable step to help the wider economy in what are trying times.

We are expecting demand for new loans to be lower than normal in the current climate. We also always adopt a risk adjusted approach to lending and have adjusted our criteria to a more cautious set of conditions than in a more positive market. One of the reasons we operate one large diversified company is so that we can deploy more capital into sectors that look most attractive at any time.

Has there ever been a default on the secure lending, where you have been forced to sell a property? If so, what impact did this have on the value of Fern?

Within Fern’s property lending business, we have lent well in excess of £1 billion across thousands of loans for more than ten years. We intentionally adopt a strategy of making hundreds of smaller shorter term loans rather than having only a few loans, each of which would be a significant part of Fern’s business. As a result, at any one time we typically have around 250 loans in place, providing Fern with a significant mitigation to concentration risk. 

Over the last decade that Fern has been making property loans, on several occasions borrowers have defaulted and Fern has had to step in to enforce its security. That’s the nature of a lending business; whilst the vast majority of loans perform as expected with minimal extra effort required from the lender, a small proportion do require special measures to recover capital and interest. The key to managing through these situations is to have relatively low loan-to-value ratios (Fern averages below 65%, and rarely lends above 70%), which provides an equity buffer such that the borrower feels the pain first before Fern’s capital or returns are at risk.

Given Fern has a large and diversified loan book of over £500 million in size and across more than 200 borrowers, individual defaults or any small losses have had no discernible impact on the value of Fern. 

We have a specialist team of around 70 property specialists managing this part of Fern’s business and they monitor Fern’s loans on a regular basis. They are comfortable in taking all actions appropriate for a lender in order to ensure the security of this part of Fern’s business.

How big is your exposure to Bridging Finance on London residential properties?

Based on Fern’s current lending business, Fern has £40 million of loans classes as “residential bridging loans”, around 9% of Fern’s overall property lending business. Of this, £35 million is secured against property in Greater London – 7% of Fern’s property lending business and less than 2% of Fern’s overall business.

What is the value in solar sites once tariffs end/come close to ending? Income yield reduces thus surely the capital value will also fall. Is the land owned by Fern or just the infrastructure?

The market value of renewable energy sites such as solar sites is typically based on a discounted cash flow model. This takes account of all of the revenues that the site is expected to generate over its useful life, and all of the costs in producing them. These are then discounted back using the current market discount rate appropriate to that site. This valuation takes into account considerations such as: how certain are those inflows and costs, what inflation will be, is there a repair contract with a reliable manufacturer in place, among others.

Long-term government incentives are one of the revenues streams that get factored into the model. They are only included as a revenue line for as long as they have been agreed to be paid. So, if a site has 20 years of tariff agreed when it is purchased, the current value of 20 years of tariff will have been factored into the value of the site when it is purchased. Therefore, the valuation assumes no further value from the tariff once it comes to an end.

Fern does not own the land on which its renewable energy sites are built. It has a long lease, typically from a farmer, that is equal or longer in length to the tariff period. When sites are purchased, they are assumed to have no value at the end of the lease period. This is how all energy sites are valued, not just those owned by Fern.

Likewise, when a site is purchased, the expectation (built into the valuation) is that the value of the site will reduce down to nil at the end of the ownership period – that is fine and completely normal – as the profits that the site makes every year effectively pay down part of the capital cost of the site, and partly produce profits that Fern will deploy into other trading opportunities – creating capital value elsewhere in its business. In that regard, it is not dissimilar to a loan that repays capital and interest with each repayment – Fern will deploy the income (both repayment of capital and interest received each month/year) in other opportunities, so increasing capital values and profitability elsewhere in its business. 

Has the government removed the Feed in Tariff generating element payment for new sites? If so will this make solar less attractive for new investment and will it mean that solar becomes a smaller part of the overall portfolio?

Long-term government incentives for generating renewable energy were put in place in the early 2010s to help build the renewables market in the UK. These took the form of Feed-in Tariffs (FITs) and Renewable Obligation Certificates (ROCs). Almost all of the solar sites that Fern owns and operates qualify for ROCs. ROCs (or other government incentives) are no longer available for new sites coming online, but the sites Fern owns were built when ROCs were available and will continue to benefit from them over the ROC period for several years to come. Sites that qualified for FITs at the time of construction can also continue to benefit from them but new sites cannot.

Fern has acquired energy sites since the incentives have been removed but has used a different strategy. It has acquired some solar sites at the stage when planning permission has been granted and is now developing these sites to operation, at which point it intends to sell them. It has already sold a few sites and is building several more. These sites do not qualify for ROCs (because ROCs are no longer available for new solar or onshore wind sites being built today) but it is a different strategy for Fern, adding diversification and using Octopus’s expertise and experience to generate returns for shareholders on a shorter term basis from developing and selling the sites. It has also looked to add more diversification by buying sites outside of the UK, in jurisdictions where renewable energy opportunities are currently more attractive.

Tax

Can a client switch from another BPR qualifying investment, such as your AIM IHT Service to the Octopus Inheritance Tax Service and retain their BPR, or is the 2 year clock re-set?

If an investor wants to sell shares in any company that qualifies for BPR (maybe their own business, or a different company they have invested in such as an AIM-listed company or portfolio) and reinvest some or all of the proceeds into another qualifying company, they can benefit from replacement relief. This means that if they die holding those new shares within two years of purchasing them, their estate should still be able to claim BPR as long as they have held BPR-qualifying shares for a total of two years out of the last five years preceding their death. And the shares held at death replaced other qualifying assets or shares.

Given how much money is being spent by the Government, they will need to start reigning in more money from tax as soon as they can. How concerned are you that they might reduce the tax breaks available through BPR?

We haven’t seen any negative comments from Government about BPR-qualifying investments. Encouraging private investors who can afford to take more risk with some of the wealth to invest into trading businesses which support the UK economy is something the Government has been keen to do for many years. It does it through a variety of interventions such as EIS and VCT as well as BPR. Each have their own tax and investment risks and rewards. 

The money that we invest from BPR-qualifying investors is a valuable source of capital for both unlisted and AIM-listed companies held within investors’ portfolios. We have been able to support some of the companies for a long time, seeing them grow and expand their business operations, employ more staff and generate larger revenues. Fern employs over 300 people and was named as one of the London Stock Exchange’s 1,000 Companies to Inspire Britain last year.

We invest into sectors that the Government has been keen to support and maintain an open dialogue with the Treasury and other relevant stakeholders.

We can only look to past statements to form a view of Government thinking and potential direction of travel: 

  1. The Government asked a panel of industry experts to look at the role that tax reliefs and government funding could play in UK investment and entrepreneurship in 2017’s Patient Capital Review. This was published alongside the Budget in that year and said “Finally, the consultation asked about Business Property Relief (BPR). BPR plays a valuable role in preventing the breakup of otherwise viable businesses purely in order to meet IHT liabilities. BPR was also extended in the 1990s to all levels of shareholdings and shares quoted on growth markets. These extensions have supported investment in growth markets such as the Alternative Investment Market. A number of respondents suggested that some of the investment supported by BPR is in low-risk companies and that it could play a greater role in supporting investment into innovative firms. The Government will keep BPR under review, and is committed to protecting the important role that this tax relief plays in supporting family-owned businesses, and growth investment in the Alternative Investment Market and other growth markets.” This is the most recent commentary from the Government about its views on BPR.
  1. The Office of Tax Simplification started to look at inheritance tax around two years ago. It received feedback from more than 3,000 people, both members of the public and professional advisers, as a result of which it issued two reports. The first at the end of last year focused on suggested administrative simplifications and improvements, such as to the IHT forms and requirements to complete them, and to the amount of information that is provided to the public from which they could work out whether IHT should be relevant to their estate or not. The second was issued in July this year and made eleven recommendations as to how IHT could be simplified. The report focused on three areas: lifetime gifts, interaction of IHT with capital gains tax (CGT), and businesses/farms. Three quite technical potential changes to BPR-qualifying companies were suggested, two of which would increase the types of business that might expect to qualify for relief, and one that would prevent businesses with significant amounts of non-qualifying activities from qualifying (as they do today). None of these suggested changes would impact the unlisted or AIM-listed companies that we invest in to. A separate potential change to CGT was also suggested, which could result in BPR and APR-qualifying assets not benefitting from CGT uplift to probate value on the death of the original owner. However, this would not impact the availability of BPR on those assets.

Unlike some other forms of estate planning, BPR-qualifying investments do leave the investor with shares in a trading company whose business will continue.

Other

BPR is considered high risk, given the relatively stable share price of the ITS, what do you see as the main investment risks? if this is purely related to the fact investment is into a single company share, does the regulator recognise the diversified nature of the investment proposition?

The headline risks that require this to be treated as a high-risk investment are the same whether you invest into one unlisted company or a portfolio of 25 AIM-listed companies:

  • Investment into the shares of companies not listed on a main stock exchange are considered to have the potential to be more volatile and less liquid than those of listed companies.
  • Tax rules can change in the future and investments cannot be guaranteed to qualify.
  • Like any investment, capital is at risk and an investor might get back less than they invest.

From an individual client suitability perspective, a product designed to target one outcome over another might be more suitable, but a high-risk investment will need to be considered suitable for that part of a client’s wealth.

What percentage of your clients access their investment before death?

Around 20%.

Do you have any data on how many estates leave the investments with Octopus once an investor has died?

More than 25%. Often inherited by the surviving spouse or older children who benefit from an immediate inheritance tax advantage if they continue to hold the investment themselves.