Venture capital trusts have enjoyed a boom in demand as investors flock to their generous tax breaks – and ability to back up-and-coming, exciting businesses that have become hot property in recent years.
The total invested in VCTs has risen from around £350million annually a decade ago to £685million a year, data from the Association of Investment Companies data shows.
While a main driver has been changes to pension rules, managers have reported VCT investors are getting younger – with many attracted both to the tax relief on offer and trusts’ backing of unlisted early-stage companies
Recent high profile successes for venture capital include online used car seller Cazoo, fashion marketplace Depop and recipe box seller Gousto.
British online used car seller Cazoo had raced to a $8billion or £5.8billion valuation by the time it listed on the US stock exchange via a Spac this summer. It was backed by an Octopus VCT
The tax breaks are on offer as VCTs are meant to invest in fledgling growth companies and businesses scaling up, and investors should expect some to succeed but others to fall by the wayside.
In return for this higher risk investing in the companies seen as the future drivers of economic growth, investors get up to 30 per cent income tax relief and tax-free dividends.
‘I’d say there are more younger investors now than there were 10 years ago. It’s becoming more of a mainstream tax planning product,’ said Ken Wotton, manager of Baronsmead VCTs.
While the tax breaks may be appealing, VCTs are not for everyone. We look at what they invest in, who should invest in them and whether they’re the right addition to your portfolio.
What are VCTs?
VCTs are investment companies listed on the London Stock Exchange which raise money from investors to invest in young, usually privately-owned companies that are not listed on the stock market, or those listed on the junior market Aim.
As an investment trust, when someone invests in a VCT they become a shareholder of the trust itself.
It means investors can get exposure to any investments the VCT makes after the investment as well as the existing portfolio.
They were introduced in 1995 to offer investors generous tax relief and have since become a well-established alternative for experienced investors.
VCTs are enjoying a boom in demand but they remain a high risk investment and performance varies widely
What do VCTs invest in?
Broadly there are two different types of VCT: generalist and Aim.
The most common form is generalist VCTs which invest in a wide range of small, usually private companies (those not listed on the stock market) 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.
Ken Wotton, manager of Baronsmead VCTs
Aim VCTs invest in new shares issued by Aim-listed companies, and target tax-free growth as well as income. While they are investing in stock market listed forms, the price of these trusts can be more volatile because the companies are valued daily rather than periodically as with unlisted firms.
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 more rarely a hybrid trust like Baronsmead VCT which invests in both generalist and Aim companies.
‘We look for high quality businesses with good potential. Even though they’re small, they’re super high risk,’ Baronsmead manager Ken Wotton said.
‘We’re not backing total start-ups and we’re not backing binary outcome concept opportunities where the market opportunity is still to be proven.
‘This means we won’t invest in things like early stage drug development or biotech businesses waiting on FDA approval.’
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.
Why invest in VCTs?
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.
The amount of income tax investors claim cannot exceed the amount of income tax due.
Additionally, VCTs offer tax-free capital gains and tax-free dividends, if the VCT pays out dividends.
Aside from the tax benefits, VCTs offer exposure to early stage startups – Cazoo and Depop were funded by Octopus Titan VCT – as well as help diversify a portfolio.
Jess Franks, head of retail investment products at Octopus Investments, said: ‘As a result of the investments they make, VCTs are high risk, which you need to be comfortable with, but they also offer the potential to generate a tax free income stream and growth if the portfolio companies they invest into perform well.
‘Few investors will have much allocation to this asset class.
‘Unquoted companies are also less likely to be affected by market sentiment, as their shares aren’t traded on a main stock exchange. Instead, their share prices are calculated periodically, based on the underlying performance of the business.’
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.
Investors should make sure that they are aware of the high risks and only assign a small part of their overall portfolio to VCTs.
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.
Rule chnages mean that is no longer the case and VCTs should back growth companies. They are becoming more mainstream – aided by the reining in of pension tax relief for high earners – and managers are starting to see a pool of younger investors come through.
However, specialist broker Wealth Club clarifies that VCT investments are long-term and ‘not for everyone’. Any investor needs to be aware that they must think long-term, could wait years for successful investments to pay off and could lose all their money on those that fail.
It adds: ‘They are for experienced investors who have no need for immediate liquidity and can withstand a potential total loss.’
Demand has largely been driven by the changes to pension rules, which have placed further restrictions on the amount you can invest into a personal pension, both annually and over your lifetime.
A number of advisers are using the VCTs to complement retirement planning where clients may be at risk of breaching their lifetime allowance.
Alex Davies, founder of specialist VCT broker the Wealth Club
‘Even for someone in their mid-40s whose current pension pot is significantly below the lifetime maximum, when you consider the impact of another 20 years of growth and contributions, the lifetime limit can feel relevant,’ Octopus’s Franks said.
‘VCTs can be a good complement to pensions, because they target a tax-free income stream while also benefiting from generous up front tax relief in recognition of the risks that investing in early stage companies can bring.
‘For example, some VCTs will target a 5 per cent dividend and investors might choose to build up large holdings over time with the aim of generating a steady tax-free income in retirement, although this is clearly not guaranteed.’
Alex Davies, founder of Wealth Club, predicts even more investors will flock to VCTs off the back of the dividend tax rise announced earlier this month.
‘The fact VCT dividends are tax-free is hugely valuable, and will be even more so once the new rate of dividend tax comes in next April.
If a VCT pays a 5 per cent dividend, you get 5p in your hand for every £1 invested. To match that outside of a tax wrapper, you should get a dividend of 7.55 per cent if you are a higher-rate taxpayer or 8.24 per cent if you are a top-rate taxpayer,’ he said.
Franks also suggests business owners, who are now facing higher income tax bills than in previous years, could use VCTs as a way to offset the costs.
‘In a similar manner, buy-to-let landlords have experienced reductions in tax relief in recent years.
‘High rate taxpayers who own rental properties can no longer fully deduct their mortgage interest from their rental income and pay tax on the net income. For landlords who want to invest for the future, VCTs offer a way to extract and invest rental income tax-efficiently.’
How can I invest in VCTs?
VCTs raise funds periodically by issuing new shares through an offer for subscription. Investors can buy shares in new offers through a specialist broker like Wealth Club, or invest directly through an online discount broker or financial adviser.
As VCTs are listed companies, investors can also buy shares on the open market through a broker. But it is vital to realise that second-hand VCT shares do not 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.
The maximum amount investors can invest in VCTs is £200,000 per tax year and the minimum depends on the VCT, but is usually around the £5,000 mark.
VCT initial charges can be as much as 5 per cent, partly because they require more management than more mainstream investments.
How do you 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 gains. This is because profits usually come from dividends paid out, rather than a rise in the trust itself’s share price value.
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.’
|VCT||Type of VCT||Minimum subscription||Initial charge before discount||Discount||Closing date 2021/2022 tax year|
|Downing FOUR VCT – AIM Shares||AIM||£5,000||4.5%||3.75% existing shareholders
3.25% new shareholders
|29 Oct 2021 for early bird saving|
|Downing FOUR VCT – Healthcare Shares||Healthcare||£5,000||4.5%||3.75% existing shareholders
3.25% new shareholders
|29 Oct 2021 for early bird saving|
|Downing FOUR VCT – Ventures Shares||Generalist||£5,000||4.5%||3.75% existing shareholders
3.25% new shareholders
|29 Oct 2021 for early bird saving|
|Foresight Williams Technology Shares||Technology||£3,000||5.5%||3% for new investors 3.5% for existing share holders||29 Dec 2021 for 2021/22 allotment|
|Hargreave Hale AIM VCT||AIM||£5,000||3.5%||2%||11 Oct 2021 for first allotment|
|Octopus AIM VCT||AIM||£5,000||5.5%||5.5% existing clients (until 14/12/2020) 4.5 new clients (until 14/12/2020)||1 Oct 2021|
|Octopus Apollo VCT||Generalist||£5,000||5.5%||5.5% existing clients (until 14/12/2020) 4.5 new clients (until 14/12/2020)||Limited capacity|
|Pembroke VCT||Generalist||£5,000||5.5%||3.5% for existing shareholders
3% existing shareholders
|15 October 2021 3pm for first allotment|
|Puma Alpha VCT||Generalist||£5,000||3%||1%||Very limited capacity (allotment in 2021/22)|
|Seneca Growth Capital VCT||Generalist||£3,000||5.5%||4.5%||24 Sept 2021 (noon) for 2021/22 allotment|
|Source: Chelsea Financial Services|