Despite ajn tough economic outlook, appetite for venture capital trusts continues to grow.
Investors have flocked to their generous tax breaks and the chance to back high-growth startups.
Venture capital trusts raise money from investors to invest in early-stage, usually privately owned, companies, or those listed on the junior Aim market.
In return for taking on this higher level of risk, they offer a tasty 30 per cent income tax break and tax-free dividends, along with an annual investment limit of £200,000.
But advisers say you must never invest solely for a tax break and there are some concerns about the effect all the money having flooded into VCTs in recent years has had on valuations. We explain what you need to know.
What are VCTs?
VCTs are a special form of investment trust, listed on the stock market, which allow investors to buy shares in their portfolio of companies.
Run by specialist fund managers, VCT deliver most of their returns through dividends rather than capital gains, and come with tax breaks to encourage people to provide much-needed funding to back young companies.
Over the last few years, there have been a number of successful exits for UK VCTs that have paid out handsomely to various trusts, notably Cazoo, which listed in New York in 2021, and Depop, which sold to Etsy for $1.6billion.
Other well-known companies that have used the schemes to grow include flower delivery firm Bloom & Wild, meal delivery kit Gousto and burger restaurant Five Guys.
But there have also been many companies invested in by VCTs that have fallen by the wayside or not seen such success, which is why investors must be very careful what they back.
The Government launched the VCT scheme in 1995 to encourage investment into businesses in need of next stage funding. With this came tax breaks for investors willing to take the higher risks and accept the potential losses and volatility that comes with investing in early stage companies.
VCTs are investment companies listed on the London Stock Exchange which raise money from investors in young start-ups that are either listed on the Aim market or not listed at all.
As an investment company, when someone invests in a VCT they became a shareholder of the trust itself. This means investors get exposure to any investments the trust makes after their initial investment, as well as the existing portfolio.
VCTs raise funds periodically by issuing new shares through an offer for subscription. Investors can buy shares in the new offers through a specialist broker like Wealth Club, or invest directly through an online broker or financial adviser.
Pembroke VCT’s Simon Porter told This Is Money the vast majority of the investors in Pembroke have been advised in some form by an IFA or invested through a platform.
Crucially you must buy new VCT shares to get the income tax break. Investors can also buy shares second hand on the open market, but these don’t offer the same upfront income tax relief that is available with new shares. Investors can still take advantage of any tax-free income and growth though.
The maximum amount investors can invest in VCTs is £200,000 per tax year and the minimum depends on the trust itself, but it’s usually around £3,000-£5,000.
VCTs come with much higher charges than standard funds or investment trusts and can carry initial charges for investing, which some brokers will cut. Pay attention to this if you invest.
Why invest in VCTs?
A big attraction of VCTs has long been the generous tax breaks they offer. Investors can claim up to 30 per cent income tax relief on the amount they have invested in a VCT, provided they hold the investment for at least five years.
So, if someone invests £10,000, they could get £3,000 off their tax bill that year.
The amount of income tax investors claim cannot exceed their amount of income tax due. With an annual investment limit of £200,000, the maximum amount of relief is £60,000.
VCTs also offer tax-free capital gains and tax-free dividends.
Increased investor appetite has undoubtedly been underpinned by the growing tax burden as a result of frozen tax thresholds, the tapered annual pension allowance and the Lifetime Allowance.
With a reduction in the threshold for paying the 45 per cent additional income tax rate coming in April, as well as cuts to the £12,300 capital gains tax-free annual allowance (down to £6,000) and to the £2,000 tax-free dividend allowance (down to £1,000), more investors might be looking to VCTs.
What’s the investment attraction of VCTs?
Aside from the tax benefits, VCTs also offer investors exposure to the UK’s growing number of high-growth technology companies.
The UK is a leader in Europe for creating innovative start-ups and scale-ups but they are underrepresented in the main FTSE stock market indices.
Research by Wealth Club, a platform that offers investors the chance to invest in VCTs, shows that almost half of VCT investments are in businesses that have grown revenues by more than 25 per cent year on year.
Because of niche strategies, VCT performance varies wildly across the sector. Some large VCTs have seen their share prices jump between 20 and 30 per cent over five years, while others have plunged over 30 per cent.
But investors should look at what a VCT’s total return is, rather than solely the share. Sentiment can change, causing the share price to rise or fall, meaning VCTs can slump to a discount.
The upside is that, by pooling investments with those of others, VCTs allow investors to spread their risk over a number of small companies. But VCTs are still a niche and highly risky investment because the companies they invest in are at an early-stage and the vast majority will fail.
In terms of returns, dividends have stayed resilient in the face of a number of successful exits. A higher proportion of VCTs held or raised their dividends in 2022 than in the previous three years.
But performance is choppy: after 13 consecutive years of positive returns, the average VCT delivered a total return loss of 8.5 per cent last year, according to the Association of Investment Companies.
Over the longer term, the 10 biggest generalist VCTs have delivered an average NAV total return of 97.7 per cent, according to broker Wealth Club, outperforming the main market over 10 years. AIM VCTs have on average performed 3.1 times better than the AIM market.
One thing to consider if you’re looking to invest in a VCT is that they are pricier than your average fund. Initial charges can be as much as 5 per cent, partly because they require more management than more mainstream investments.
> Pembroke’s Simon Porter on whether more cash into VCTs can dilute portfolios
How to pick the right VCT for you
Broadly there are different types of VCT: generalist, Aim and specialist.
The most common is generalist VCTs, which invest in a wide range of small, usually private companies in a range of sectors. They focus on diversification across many early stage companies, which they will often then try to actively work with to help them grow and succeed.
Many early stage companies will fail, so a diversified portfolio approach is considered essential. Often some VCTs will look to back proven entrepreneurs or business people they have worked with successfully before – and some trusts will target particular types of company or sectors.
Pembroke’s Simon Porter says he tends to see times where an investor has said they’ll put £10,000 across three VCTs to diversify their portfolio.
Often VCTs will look to back established entrepreneurs and some target particular types of company or sectors.
Aim VCTs invest in new shares issued by Aim-listed companies and target tax-free growth as well as income. Because they are investing in listed firms, the price of these trusts can be more volatile, because the companies are constantly being valued by the stock market rather than assessed periodically, as with unlisted businesses.
However, there is more flexibility for them to enter or exit investments, because ordinary shares are more easily sold on the market.
There are also specialist VCTs, which focus on just one sector, and the more rare hybrid trust like Baronsmead VCT which invests in both generalist and Aim companies.
What companies qualify for a VCT?
HMRC has set criteria a company must meet to qualify for VCT funding.
It must carry out a ‘qualifying trade’, which excludes businesses HMRC doesn’t believe need extra support like land dealing, financial activities, forestry, farming, running hotels and energy generation.
The company must be relatively young – usually less than seven years old – and small, with fewer than 250 full-time employees and usually gross assets of less than £15million.
The VCT has to invest at least 80 per cent of the money raised into companies that meet this criteria.
Who should invest in VCTs?
VCTs were once favoured as a tax-planning investment for older, wealthier investors – and a sizeable chunk targeted stable, dividend-paying assets rather than exciting young companies.
The rules changed to shift investment more towards early stage companies some years ago and this made VCTs riskier.
Because VCTs are higher risk, they tend to be considered only by wealthy, experienced investors, who have used up all of their other allowances for Isas and pensions.
But with the high profile success of disruptive early stage companies over recent years, a younger cohort of investors is getting interested in VCTs. They must remember the importance of diversification and that this high risk element should only be a small part of their overall investments, however.
VCTs invest in small companies which are more volatile than their bigger peers and so they should be considered a long-term investment and aren’t for everyone.
‘VCTs are for experienced investors who have no need for immediate liquidity and can withstand a potential total loss,’ say Wealth Club.
The number of VCT investors claiming income tax relief increased by 9 per cent to 19,475 in the 2020/2021 tax year, according to the latest figures. The numbers are still, clearly, small but for those who have hit their pension lifetime allowance.
But investors should be aware that while they might offer generous tax breaks and an opportunity to invest in innovative new companies, they are highly risky and a high proportion of a fund’s portfolio will fail.
How to get profits from a VCT?
One thing investors may notice is that unlike traditional growth-focussed investment trusts or funds, VCTs share prices do not make big share price gains.
This is because profits usually come from dividends paid out, rather than a rise in the trust itself’s share price value.
This means performance is measured by total return, but even that can be lumpy.
Wealth Club explains: ‘Although most VCTs are growth investments, and any growth is tax free, the majority of returns (if any) are normally paid through tax-free dividends.
‘A diverse, well established VCT portfolio can therefore produce a satisfying stream of dividends throughout the year.
‘After the sale of a successful company within the portfolio, the profit can be distributed to investors as a larger or special dividend, and the remaining capital reinvested in new opportunities.’
What VCTs are on offer?
There are currently seven open offers for VCTs, which include Octopus Titan VCT, the fund behind Depop and Cazoo among others.
We spoke to Octopus Titan VCT’s Malcolm Ferguson on how it invests and how VCTs are navigating the current climate.
While some of the deadlines are not until later in the year, they are proving popular among investors meaning they might fill the allotted beforehand.
|VCT||Type||Target dividend||Initial charge||Net initial charge||Funds raised/sought||Deadline|
|Albion VCT||Generalist||5% of NAV||2.5%||2.5%||£58.5m / £80m||24 Feb 2023 for next allotment|
|Baronsmead VCT||Generalist||7% of NAV||4.5%||3%||£24.9m / £40m||24 March 2023|
|British Smaller Companies VCT||Generalist||–||5%||3%||£41.6m / £50m||31 March 2023|
|Northern VCT||Generalist||4.5% to 5% of NAV||4.5%||2.25% (1.75% existing investors)||£11.7m / £18m||Limited capacity|
|Octopus Titan VCT||Generalist||5p per share||5.5%||3% (2% existing investors)||£142m / £175m||31 March 2023|
|Pembroke VCT||Generalist||5p per share||5%||3%||£16m / £40m||5 April 2023|
|ProVen VCT||Generalist||5% of NAV||5.5%||2.5%||£9.7m / £40m||4 April 2023|
|Source: Wealth Club|