Are VCTs worth the risk for higher earners?

Once seen as a niche asset, venture capital trusts (VCTs) are experiencing a boom in demand as wealthy investors flock to the generous tax breaks they offer.

VCT investors can claim upfront income tax relief of 30 per cent for putting money into higher risk smaller companies, providing they hold the shares for at least five years. They also gain from tax-free capital growth and dividends, with no capital gains tax to pay if the shares are sold after five years.

Investors poured £731m into VCTs in 2018-19, the highest amount raised at the current level of upfront tax relief and the second best on record. Advisers report they are popular with high earners such as doctors, lawyers, finance professionals and entrepreneurs who have sold their companies.

The tax breaks on offer are undeniably attractive. And many funds have performed well in recent years. Figures from the Association of Investment Companies, an industry body, show the top 20 VCTs at least doubled investors’ money on a net asset value total return basis over the past 10 years.

Yet as investors eye new offerings in the autumn launch season for VCTs, they should beware of the potential risks as well as rewards. VCT performance can be volatile, with chunky fees, limited liquidity and the inherent instability of investing in small early-stage businesses among the factors that need to be considered.

“There is a real danger that some people are being attracted to VCTs based solely on the tax benefits and past performance,” warns Patrick Connolly, chartered financial planner at Chase de Vere.

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The investment case

VCTs have existed since 1995 but interest in them has soared recently. The 2018-19 figure for the amount of funds raised came on the back of a similarly strong year in 2017-18, when £728m of assets were gathered. The totals are not too far off the strongest VCT fundraising year ever recorded, which brought in £779m in 2005-6. However, this occurred when the upfront tax relief available was at a temporary rate of 40 per cent.

The recent increase in popularity can be linked to a number of factors — notably the reductions on tax relief available on other investments. Since 2016, for instance, higher earners have faced restrictions on how much money they can save into a pension and still receive tax relief. The so-called taper allowance affects those earning £110,000 a year or more and can gradually reduce a person’s annual allowance from the standard £40,000 to as low as £10,000. There is also a lifetime allowance on pensions contributions, which currently stands at £1,055,000.

“Ten years ago, [a higher earner] could put up to £235,000 a year into a pension and receive nearly £100,000 in tax relief. Today, that amount is limited to as little as £10,000 in a pension and just £4,500 in tax relief,” says Alex Davies, founder of specialist broker WealthClub. “[These] restrictions, along with the crackdown on buy-to-let and the ever-increasing dividend tax, make VCTs one of the last decent tax-efficient investments left for high net worth individuals.”

There is no lifetime limit on how much you can invest in VCTs. And investors can receive upfront tax relief on an investment of up to £200,000 each tax year. This amount can be spread across more than one VCT, to help with diversification.

Apart from the tax relief, investors also find VCTs attractive because they are a tax planning option encouraged by the state. Successive governments have continued to back VCTs because they consider the tax relief a useful way of channelling investment towards higher-risk small businesses that might not otherwise receive as much financial support. The AIC reports that by the end of 2016 VCT-backed companies had created 27,000 jobs.

Jason Hollands, managing director of Bestinvest, says: “Demand has been underpinned for tax schemes that have full statutory backing, given the crackdown on more aggressive forms of loophole-driven tax planning.”

The popularity of VCTs also reflects the fact that investors and advisers are growing more familiar with them and confident about investing in such funds, adds Annabel Brodie-Smith of the AIC.

“VCTs have a well-established record, having been around for 24 years. They have performed well with the average VCT returning 166 per cent over 10 years to the end of September,” she says.

Mr Davies adds: “Because of the generous tax relief you only need average performance to end up with a very respectable result.”

Another reason some financial advisers rate the funds is because the small, often unlisted, companies in which VCTs invest can offer both potentially high growth and diversification from other assets in a portfolio.

Are they right for you?

VCTs invest in smaller and younger companies, which are much more likely to go bust than more established ones. For this reason, financial advisers generally suggest VCTs are only suitable for experienced investors who already have a large portfolio of other assets and can invest for the long term. Investors should typically have used up their annual pension allowance and individual savings account (Isa) allowance before considering VCTs. Currently, individuals can save £20,000 a year tax free in Isas.

Simon Gibson, chief investment officer at wealth manager Mattioli Woods, says he assesses potential VCT clients on their ability to handle investment loss and lock their money away for the required five years.

“A VCT should rarely be somebody’s first port of call,” adds Mr Connolly. “There is little point being seduced by the tax benefits of a VCT if you’re then going to have sleepless nights worrying about the risks and the possibility of investment losses.”

As a result, and regardless of increasing interest, his firm does not invest in VCTs for the great majority of clients. “For most people the downside risks will outweigh the tax benefits,” he says.

However, the risks need to be put in the context of who is investing in VCTs according to Mr Davies. “VCTs are risky, but for the right type of person, arguably they are not that risky at all,” he counters.

VCTs offer potential income and capital growth benefits to wealthy investors, who have used up their tax-free allowances, and might otherwise be considering investing in property or investment accounts outside a tax wrapper.

“Neither property nor stocks and shares give investors any tax relief, so they are 30 per cent worse off right at the start,” Mr Davies says.

In addition, any returns would also be taxable, meaning your money has to work harder to get the same return as a VCT. To achieve the same 5 per cent income from a unit trust that a VCT would pay, an additional-rate taxpayer would have to receive a gross dividend of more than 8 per cent.

However, even if VCTs are suitable for your circumstances, you need to be comfortable with how much of your portfolio is held in these assets.

Advisers generally suggest VCTs should be a small part of an overall portfolio, but the exact proportion will depend on individual circumstances. This might include your investible assets, tax position and current income tax liabilities.

Mr Davies reports that WealthClub clients invest an average of £36,525 across a number of different VCTs each tax year. But Mr Gibson adds that some of his clients with multimillion pound portfolios have hundreds of thousands of pounds in VCTs.

Mr Hollands thinks a good rule of thumb is to have no more than 10 per cent of your portfolio in VCTs. Investors should speak to an adviser if unsure.

Hard falls

Despite the possibility of strong growth — and even with the support of VCT capital — many of the young companies that funds invest in are likely to struggle or fail. Investors may therefore get back less than they put in or even nothing at all. The economic uncertainty surrounding the UK may also weigh disproportionately on smaller, more domestically focused businesses. Meanwhile, the value of the companies favoured by VCTs can be uncertain, as they are often unlisted investments that do not have a readily available market price.

Selling VCT shares comes with difficulties. First, if you sell within five years of your initial investment you lose the income tax relief; hence planners say investors must be able to commit funds for the long term. Second, VCT shares are not heavily traded and are therefore relatively illiquid — although some providers offer buybacks.

Mr Connolly says: “The lack of liquidity of investing in very small companies explains why most VCTs stand at a discount to their net asset value. This discount acts as an exit penalty for investors, and even though some VCT providers offer to buy back their VCTs, investors can still usually expect to face a charge if they want to get out.”

VCTs are also much more expensive compared with other types of funds. This makes sense, to some degree, as investing in small, unlisted companies is complex and requires managers to be more hands-on than those investing in established, listed companies. However, the higher the fees, the more this eats into potential investment returns. VCTs typically levy annual management charges of between 2 and 3 per cent. And there are also initial charges and often ongoing administration, running costs and performance fees.

Some investment experts think VCTs could do more to reduce their fees. “They are stupidly expensive and that really frustrates me as they’ve been getting bigger and bigger, but we haven’t had the economies of scale passed through [to investors],” says Ben Yearsley, director at Shore Financial Planning.

Meanwhile, another key risk for investors is the potential for the government to change the rules. This has been brought into stark relief over the past five years when several changes were made with the aim of refocusing investment towards riskier businesses.

Changing landscape

In 2015, VCTs were banned from investing in renewable energy-producing companies and backing management buyouts or buy-ins. They also had to start investing in much younger companies — those that were under seven years old after their first commercial sale took place, or under 10 years old for so-called knowledge-intensive companies. The latter are defined as those with high research and development spending.

In 2017, the government tweaked the rules again, requiring VCTs only to fund companies that pose investors with a real risk to their capital. This has meant previously popular capital preservation strategies which relied on asset backing are hard to do. They are no longer a feature of the market.

Many older VCT providers still hold companies acquired before the new rules were introduced. But, over time as these companies are sold and new ones bought, it is likely that VCT portfolios — and by extension dividends — will become more volatile.

“Mature VCTs have an advantage in that their legacy portfolios of businesses backed before the rule changes, including asset backed deals or MBOs [management buyouts], these provide some ballast while the portfolio evolves over time,” Mr Hollands says. “This is clearly advantageous from a risk perspective (and the ability to generate dividends), to newer VCTs with greener portfolios where it will take time for business exits to come through.”

Other changes force VCTs to invest the money they raise more quickly than in the past and the percentage of qualifying investments they must now hold in funds has risen to 80 per cent, up from 70 per cent.

Some investment experts worry that a change in government could mean further turmoil for VCT investors.

“If Jeremy Corbyn gets in, everything is up for grabs,” says Mr Yearsley.

Meanwhile, the shifting rules have prompted many VCTs to change their investment strategy and teams in the past few years. This means the strong past performance delivered by VCTs cannot be relied upon in future.

“In the past, dividends of between of 8 per cent or 9 per cent were not uncommon. Today most VCTs are targeting a 5 per cent yield plus special dividends on exit,” adds Mr Davies.

Ones to consider

Of the VCTs open to investment at time of writing, Mr Davies, Mr Hollands and Mr Yearsley all think highly of Pembroke VCT.

The fund has been running since 2012 and focuses on investing in companies capable of significant organic growth and sustainable cash generation. Its focus on hospitality and consumer-facing business make Pembroke stand out from other VCTs who tend to neglect these sectors. Since launch it has raised more than £75m and invested £55m in 40 companies.

The portfolio includes Five Guys, the upmarket burger chain, Plenish, the cold-pressed juice and nut milk business and Alexa Chung’s fashion label.

“There are a few companies that may well be ripe for a decent exit in the near future,” says Mr Davies. “[Manager] Andrew Wolfson has an entrepreneurial background, so he knows first-hand what it takes to start and grow a business.”

However, at the moment Pembroke has yet to have any successful exits, he adds. Economic uncertainty and a messy Brexit may hit the areas in which the fund invests harder than other VCTs, but Pembroke’s managers say many of its businesses export internationally and therefore benefit from a depreciation in sterling.

The VCT is seeking to raise £20m and has the potential to raise a further £20m through its “overallotment facility”. It is targeting an annual dividend of 3p and may also pay special dividends when significant realisations are made. It has an initial fee of 3.5 per cent, falling to 2.25 per cent if investment is made by December 15.

Mr Davies and Mr Hollands are also fans of Octopus Titan VCT. It is one of the few VCTs that has not had to change its strategy due to the rule changes because since launching in 2007 it has always invested in young, high-growth businesses.

The largest VCT in the UK, last year it raised a record £227m — about one-third of the market, according to WealthClub. This was more than three and half times larger than the next biggest-selling VCT.

Mr Hollands approves of Octopus Titan’s “well diversified portfolio” which consists of around 75 companies, including travel club Secret Escapes and ecommerce site Depop. One of its past successful exits was Zoopla, the first £1bn VCT-backed company.

“It has a great record of spotting and nurturing rising stars and achieving high-profile exits,” Mr Davies says. “In terms of risks, the VCT is now very big — £825m and continues to raise a lot of money. This means that to receive outsized returns, the exits need to be big. In addition, when you raise lots of money you need to ensure that the quality of investments remains high.”

This year Octopus Titan is seeking to raise £120m, with the potential to raise a further £50m if oversubscribed. It is targeting an annual dividend of 5p and may also pay special dividends when significant realisations are made. It has an initial fee of 5.5 per cent.

Mr Connolly says the only VCT he would use for clients, from those currently available, is Downing Four VCT — also on Mr Gibson’s favourites list.

A generalist VCT investing in a portfolio of growth investments at different stages in their business life cycle, its largest sector weightings are technology, healthcare, education, pubs and manufacturing. Mr Connolly says: “We prefer to invest in established VCT products from experienced and proven fund managers.”

Downing Four VCT aims to a produce dividend income of 4 per cent a year from 2020. It carries an initial charge of 5 per cent and is looking to raise up to £20.3m (with an overallotment facility of a further £20.3m). So far, it has raised £11.4m and it is closing its offer on October 31.

Several VCT managers have yet to launch their offers but will do so in the coming weeks, such as Amati Aim VCT and Maven Income & Growth VCTs.

As the tightening tax climate constrains the options available to investors, their appetite for VCTs is unlikely to abate.

What are VCTs?

A venture capital trust is an investment company listed on the London Stock Exchange. VCTs aim to make money by investing in very small companies which meet certain criteria and need investment to fuel their growth plans.

Due to the role these businesses play in supporting the economy, the government offers investors generous tax benefits for investing in these high-risk companies. (See table)

There are different types of VCT.

Generalist VCTs: These are the most common. They invest in a broad range of companies in different sectors.

Aim VCTs: As the name suggests, these VCTs invest mostly in companies listed on Alternative Investment Market, or those about to list on Aim.

Specialist VCTs: These VCTs are becoming much rarer. They tend to invest in just one sector, such as health or technology.

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