VCTs are changing, but could still provide retirement income

Although these changes have come alongside substantial increases in the annual individual savings account (Isa) allowance, which from April rises again from £15,240 to £20,000, it still means higher earners might not be able to save more than £30,000 a year using a pension and Isa - less than was possible under the old pension rules.

So people may need to turn to tax-advantaged vehicles such as venture capital trusts (VCTs) and enterprise investment schemes (EISs) if they want to save more. These vehicles have been used for years to aid retirement saving and are becoming even more popular because of the increasing restrictions on pnesion saving.

VCTs offer an attractive range of tax breaks: if you hold a VCT new issue for five years you get 30 per cent tax relief to offset against your income tax bill. VCTs also don't incur capital gains tax when you sell their shares and pay tax-free dividends, which makes them attractive for those in retirement wanting to supplement their pension income. Plus, there's no lifetime limit, while the annual investment limit for VCTs is £200,000, rather than between £10,000 and £40,000 in a pension.

VCT tax reliefs

Source: Association of Investment Companies

However, just as VCTs become more necessary for some investors the industry has been shaken up by a number of rule changes. And these could affect VCTs' ability to pay an attractive level of tax-free dividends - one of the features that have made them a very attractive retirement income solution.

Since November 2015, VCTs can no longer invest any of their money in management buyouts (MBOs), which a number of generalist VCTs (funds that mainly invest in unquoted companies across a variety of sectors) favoured. These include the Maven, Mobeus, Northern, Baronsmead and British Smaller Companies funds. This kind of investment helped these funds pay steady, attractive and regular dividends.

"VCTs had a really consistent track record for around 10 years, but as more money is invested under the new rules their risk profile will increase, and dividends are likely to become more lumpy because you can't achieve the consistency that MBOs brought," explains Ben Yearsley, investment director at high-net-worth investment service WealthClub. "Although payouts may get larger with more special dividends as businesses are sold."

Another detrimental rule change that came into force in November 2015 was the prohibition on investing in companies seven years or older after their first commercial sale took place, or 10 years or older for what are deemed to be knowledge-intensive companies. This effectively pushes VCTs up the risk curve because they have to focus on earlier-stage and potentially riskier companies.

But despite the changes, advisers and analysts still believe VCTs have a role to play in providing retirement income, albeit with a few provisos.

"VCTs can be particularly attractive as part of a retirement income plan because yields are tax-free and they can distribute profits from successful exits of portfolio companies as special dividends," says Jason Hollands, managing director at Tilney Group. "A modest exposure to VCTs in the context of a well-diversified portfolio of more conventional investments can be a very useful source of tax-efficient income - as well as providing asset class diversification."

And as the new rules relate to transactions made since November 2015 most existing portfolio companies remain unaffected, so VCTs' portfolios should see a gradual evolution over time.

Michael Probin, investor relations director at Livingbridge, which manages the Baronsmead VCTs, says their portfolios are largely made up of investments made before November 2015. "We hold our investments, on average, for four to five years so in the medium term our dividends will be based on our existing portfolios," he explains. "Historically we have held about a year's worth of dividends, but in a few years this may increase to reduce the lumpiness of payouts. But this is quite a few years away and we are used to smoothing dividends."

VCTs can hold up to 30 per cent of their assets in liquid investments, and currently the Baronsmead funds have around 15 per cent in these.

Maven Capital Partners has segmented its business into funds that focus on growth - the area into which its VCTs fall - and raised alternative funds to invest in MBOs. "It is not quite business as usual, but the quality of transactions coming through is good," says Bill Nixon, managing partner at Maven. "It is true that the companies are generally younger with a higher risk profile than the typical MBO. But where you have a VCT with a hybrid portfolio - some buyouts and some high-growth assets - you have quite a good blend. However, the age rule is far too restrictive rigid."

That said, the Maven VCTs have completed six new transactions in the past year, worth £10.4m, and Mr Nixon says their rate of investment has picked up in the past six months.

The Mobeus VCTs have also completed six transactions over the past 12 months, worth about £17m - about the same number of deals as in 2015 - but with deal size in 2016 generally smaller than the year before. "We have been pleasantly surprised," says Mark Wignall, managing partner at Mobeus Equity Partners. "But we have a large team which is well connected, and we brought in a new partner to the growth team - Trevor Hope - which has benefited us by significantly expanding our contact base. And our particular strength in southern England is helping - London and southern England are a powerhouse for the types of deals [which qualify under the new rules]."

Mr Hope was chief investment officer at Beringea which runs the ProVen VCTs. He has invested growth capital into UK businesses across a wide range of sectors, including technology, media, leisure, business services, healthcare, telecoms and consumer services.

Mr Wignall says that the market for the types of deals that comply with the new rules is larger than he expected. But he adds that if VCTs are investing in younger and earlier-stage companies, steady dividends are less likely than with more mature investments. "So in the medium term we expect our dividend profile to be more volatile than it had been. With younger, earlier-stage companies the returns come more from capital gains from realisations than underlying companies paying dividends, as with the existing portfolios, and realisations are typically less frequent and predictable."

Although some generalist VCT managers have been adopting a new strategy, Philip Rhoden, director at discount broker Clubfinance, says: "Most of these managers have been raising VCTs for a long time and are experienced, although the recent rule changes mean some VCTs have changed their investment strategy a bit. Most of these are doing small top-ups, which reflects what they can deploy and how they can adapt their investment strategy to the new landscape."

And even though there is higher risk, investors still have some downside protection from the 30 per cent income tax relief these vehicles offer.

The rule on the age of the companies invested in, meanwhile, does not does not apply where the total investment represents more than 50 per cent of the company's turnover over the preceding five years.

And some VCTs didn't focus on MBO deals even before the rule changes and invested in more growth-orientated companies, examples being some of the ProVen VCTs and Octopus Titan (OTV2).

Capacity constraints

VCTs, in particular generalists, held off or only raised small amounts during the last tax year and in 2016/17 it is a similar picture, with some generalists doing small top-up offers and others, such as Mobeus and Baronsmead, not raising funds.

"Groups managing VCTs have been self-adjusting through a combination of hiring new team members with experience in the types of deals [that comply with the new rules] and reducing their near-term fundraising in recognition that there will be a smaller universe of new potential deals, and these might be for more modest amounts," says Mr Hollands.

Although the new legislation has been in force for a while, more details clarifying the rules are yet to be published - these are expected in the next few months.

Martin Churchill, editor of the Tax Efficient Review, points out that even if one investment fails to meet the new rules then the whole fund might lose its status as a VCT. In the past, that investment alone would fail to qualify, rather than the whole VCT.

Puma has postponed its 13th VCT issue because it is waiting to see what the exact terms of the investment rules are. David Kaye, chief executive officer at Puma, says they do not want to risk diluting the quality of the existing portfolios by raising a substantial amount before they know exactly how the rules are to be interpreted. A VCT offer had been announced because they had thought the rule detail would be published by January.

The Puma VCTs also have significant capital to deploy as they have undertaken large fundraisings for the past three years, including £30.6m by Puma VCT 12 in the 2015/16 tax year.

But Mr Kaye adds: "We have raised £220m across our 12 existing VCTs, and these types of funds will continue to be a major part of our business going forward. We are not pulling out of the market. The likelihood is that we will launch the Puma XIII issue this autumn by which time we should have seen the guidance notes. We don't expect significant changes."

HM Revenue & Customs (HMRC) has been taking longer with its advanced assurance process for approving VCT deals. However, managers report that times are improving and HMRC is conducting a consultation on advanced assurance that might come up with ways to increase the time that this takes.

VCTs have also been making some good exits from investments so are not short of cash.

Mr Probin says Baronsmead VCTs are not raising funds this tax year because their rate of investing has slowed but their realisations haven't, so they have sufficient cash.

VCTs must invest 70 per cent of new funds raised in VCT-qualifying companies within three years and maintain that position thereafter. The cash proceeds of realisations are excluded from this test for six months, after which a VCT could pay a dividend rather than having to make new investments, if necessary, to maintain that asset allocation.

"We would rather not be forced to make investments for the sake of it," says Mr Probin. "We would rather take the time to find good investments, so last year we paid out £55m in dividends across the VCTs."

Mr Probin says the Baronsmead VCTs will still target profitable companies, but in general they are less profitable than they used to be because they are younger. And while on average the Baronsmead VCTs used to invest around £4m-£5m per company, now it is more like £2.5m- £3m. In some cases they might deploy as little as £0.5m in a first round, and them more later on.

The Mobeus VCTs also have made some profitable realisations recently and have adequate liquidity. "If we raised more funds we would dilute shareholder returns," says Mr Wignall. "We hope to return in the next tax year, but that remains to be considered."

Maven Income and Growth VCT 6 (MIG6) did a small top-up offer of £8m which sold out in early February. "We have made a number of successful realisations recently and as a consequence we have a reasonably healthy cash position," says Mr Nixon. "It is a manager's responsibility to avoid cash drag."

But he says the VCTs may need to undertake a more substantial raising in the next tax year, depending on their investment activity, and that VCTs remain at the core of Maven's business.

This is at the same time as investors are rushing into these vehicles. The Association of Investment Companies (AIC) reports that fundraising in the 2016/17 tax year to 31 December 2016 totalled £169.5m, up 53 per cent on the £110.8m raised over that period in the 2015/16 tax year. This was helped by a number of VCT managers launching early in the 2016/17, but Ian Sayers, chief executive of the AIC, adds: "The pension rule changes and reduction in the lifetime allowance have clearly acted as a boost to investor interest along with its established track record both from a growth and income perspective."

Over the 2015/16 tax year VCTs raised £435m - the fifth highest volume since these funds were launched in 1995.

Advisers and analysts suggest that you don't wait till the end of the tax year to invest. "You need to invest faster than ever," says Mr Hollands. "If not you might miss out on the VCT you want."

Mr Yearsley adds: "This year could be the year when everything sells before 5 April. Offers from some of the best VCTs are simply flying off the shelves. The simple message is act quickly if you want to invest in a VCT as those who leave it late this year will be disappointed."

Choosing a VCT

The capacity squeeze means investors might find themselves contemplating VCTs they might not have considered in the past when there was a wider selection on offer. Although the VCT market overall is higher quality than, say, 10 years ago, due to the best funds surviving, many of the ones most highly regarded by analysts and popular with investors are not coming out or raising very little.

So it's important to do your homework before investing, and not pile into a VCT just because it is one of the few available.

When you are thinking of investing in a VCT, advisers suggest you look at its documents and satisfy yourself that its manager can find opportunities. You should also assess attributes including:

■ The VCT's dividend policy and the extent to which it has hit its targets.

■ Whether the VCT is losing capital - this should not be happening even if it's paying attractive dividends.

■ The VCT's internal rate of return - a useful measure for showing whether its assets have grown or declined.

■ How willing the VCT's manager is to do share buybacks to control a discount to net asset value; and

what its charges are.

Open offers

Among generalist VCTs, the highly regarded Northern VCTs have launched a small top-up issue of £12.9m for existing shareholders, and if they don't take it all up the offer will open to the general public on 20 February.

These VCTs have not raised money since 2013, when they raised £50m, so have had plenty of cash, and they favoured MBOs. But NVM Private Equity has been recruiting a new investment team specialising in early-stage investments, so its VCTs can invest in line with the new rules, although they will continue to have a generalist focus investing across various sectors.

In recent years Northern Venture Trust (NVT) has paid a base annual dividend of 6p, and Northern 2 VCT (NTV) and Northern 3 VCT (NTN) have each paid a base annual dividend of 5.5p. But Northern says the changes in VCT legislation mean that "future dividend payments may be subject to fluctuation. The dividends in respect of any financial year cannot be guaranteed and will be subject to the availability of distributable reserves, cash resources and applicable regulations. This is likely to lead to a lower annual income from investments made under the new rules, and hence to a reduction in the amounts of income available for distribution."

British Smaller Companies (BSV) is launching a small top-up issue on 10 February which will be only available to existing investors till 6 March. Its sister fund, British Smaller Companies VCT2 (BSC) did a £4.25m issue, which sold out in about a week, all of which was taken up by existing shareholders. These generalists invest in traditional industries across sectors including software, IT & telecommunications, business services, manufacturing & industrial services, retail & brands and healthcare.

The six Albion VCTs are seeking up to £34m and as of 6 February had raised £27.4m out of a potential total of £34m, with one of the funds, Albion Development VCT (AADV), fully subscribed. This offer gets broker Bestinvest's highest five-star rating. The combined portfolio contains around 65 businesses with an asset value of over £300m, of which 54 per cent is held in asset-backed investments, 32 per cent in earlier-stage growth companies, and 14 per cent in cash and equivalents.

Investors who split their allocation across the six Albion VCTs in this top-up offer wouldill receive a monthly dividend equivalent to about a 5.7 per cent annual yield. This is despite the VCTs rebasing their level of dividends last year to reflect the lower growth environment, with Albion Technology & General (AATG), Albion Development and Crown Place (CRWN) reducing their dividend targets. Albion says this is not because of the recent rule changes because it has always invested in growth-focused investments.

Octopus Titan is raising £120m having used its overallotment facility to increase its original offer of £70m. There have been concerns about managers raising more than they can invest, or being forced to invest in lower-quality investments to deploy what they raised. However, Matthew Woodbridge, director at Barclays Wealth & Investments, says: "We think Octopus Titan could be an opportunity to invest into a portfolio of early-stage companies. It has 50 companies in its portfolio, some of which need follow-on funding, and Octopus' ventures team is highly regarded. It doesn't have to adapt its investment strategy to fit in with the new rules like some of the others, and has a very broad portfolio. It offers the potential for rapid growth, but is higher-risk."

Mr Yearsley suggests Pembroke VCT (PEMV). "Despite being a relatively new entrant to the VCT market, this is well worth considering," he says. "The focus on early-stage growth investments is what VCTs were always intended for. Its manager Oakley might be relatively new to VCTs, but has been managing money since 2002 and its founder has been a serial entrepreneur since the 1980s. Oakley launched this VCT as the team had strong dealflow they couldn't use elsewhere. Unlike most VCTs, which focus on consistent dividends, this one is much more growth-orientated with a focus on upmarket consumer brands."

Aim and planned-exit VCTs

There is relatively good choice among Alternative Investment Market (AIM) VCTs, which mainly invest in shares quoted on this market rather than unlisted companies. Although the well-regarded Unicorn AIM VCT (UAV) has sold out, there is still capacity in the Hargreave Hale AIM VCTs which have raised around £9m out of a potential £20m.

"The Hargreave Hale team, led by Giles Hargreave, is one of the most experienced and capable smaller company fund management teams, with an excellent long-term record," says Mr Yearsley. "These VCTs are managed in a similar manner to their more mainstream quoted equity funds. These well-diversified VCTs are highly commended and over time their portfolios should become more aligned as new money is invested."

Hargreave Hale AIM VCT 1 (HHV) has about 67 Aim and eight unquoted qualifying investments and Hargreave Hale AIM VCT 2 (HHVT) has 62 Aim and six unquoted qualifying investments. Their managers prefer to allocate more to established and less volatile companies, while typically running a small group of holdings in earlier-stage, riskier businesses where the outcome is binary. Information technology, healthcare and consumer discretionary account for 37 per cent, 23 per cent and 22 per cent of assets, respectively.

Planned-exit VCTs aim to wind up as soon as possible after five years and protect rather than grow capital, although there is no guarantee how soon these will wind up, and it is unlikely to be the moment they hit their five-year anniversary. These are better for tax planning over a shorter period.

There is little planned-exit VCT capacity with the absence of Puma, but Triple Point Income is looking to raise £15m, and is five-star-rated by Bestinvest. Its managers will seek to return capital to investors after a 10- to 12-year holding period and are targeting an annual 5p dividend commencing in year three.

"The manager has built up a reputation for being able to return investor capital within a short period following the minimum holding time," say analysts at Bestinvest. "The long-term investment strategy is sector-agnostic, and may include a combination of food production companies; transmission network businesses; private hospitals and crematoria."

Triple Point Income will invest in small companies, usually newly established, with robust business models, strong asset bases and the capacity for consistent cash generation with a focus on the delivery of infrastructure and industrial support services.

Downing Four, meanwhile, is not strictly speaking a limited life VCT, but will look to buy back shares at a nil discount to its latest NAV, giving shareholders the opportunity to exit in one transaction with no exit penalties. Investors still need to hold it for five years to achieve 30 per cent income tax relief.

Downing Four will invest in post-revenue/pre-profit earlier-stage companies; later-stage profitable businesses and asset-backed trading companies across a range of sectors. The generalist shares will target a 4 per cent dividend in the financial year ending 31 March 2021 and onwards.

VCT offers

Source: Clubfinance and *Tax Efficient Review as at 7 February 2017

**Please note that many of these offers are likely to sell out before this date