VCTs to become higher risk but reliefs remain attractive

Open VCT offers

Sources: Bestinvest, Tax Efficient Review and Wealth Club as at 12/02/18

“VCTs are attracting investment quickly and at record levels,” says Alex Davies, chief executive officer and founder of Wealth Club. “The message is clear: if you want to invest in a VCT and spot one you like, you should do so now, rather than leaving it until the end of the tax year when it may not be available.”

VCTs are tax-advantaged schemes that aim to encourage investment in small, unquoted companies, or those listed on the Alternative Investment Market (Aim). They offer a number of tax benefits that are particularly useful for investors who have exhausted their annual pensions and individual savings account (Isa) allowances, or pensions lifetime allowance, currently £1m. If you hold a VCT new issue for five years you get 30 per cent tax relief to offset against your income tax bill, and they pay tax-free dividends. You also do not incur capital gains tax (CGT) when you sell VCT shares.

Demand for VCTs has risen for reasons including the introduction of the tapered annual pension allowance in 2016, which restricts tax relief on pensions for those earning more than £150,000. The annual investment limit on VCTs is £200,000, rather than between £10,000 and £40,000. And there is no lifetime limit on how much you can invest in VCTs. The reduction in tax relief available to buy-to-let landlords has also increased interest in VCTs.

Changing investment landscape

However, a number of rule changes mean that VCTs can’t target the type of investments they used to. For example, since 2015 VCTs have no longer been able to invest in management buyouts (MBOs), and can now only invest in companies under seven years old after their first commercial sale took place, or under 10 years old if they are knowledge-intensive companies (see box above).

The 2017 Budget, meanwhile, introduced a risk-to-capital condition, which all investments held by VCTs, Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) must meet from 6 April 2018. This principles-based test is designed to reduce the scope for capital-preservation strategies.

“There’s been a subset of VCTs that have focused on capital conservation to minimise their risk, for example by using asset backing,” explains Jason Hollands, managing director at Tilney Group. “While asset backing is still allowed, HM Revenue & Customs (HMRC) has essentially added a test which allows them to review each company and veto it [if it is not risky enough]. The risk must be real.”

Another change that will come into force from 6 April is that VCTs must invest at least 30 per cent of funds raised in qualifying investments within 12 months of the end of the accounting period in which they were raised.

And from 6 April 2019, the percentage of qualifying investments a VCT must hold will increase from 70 per cent to 80 per cent.

However, the amount knowledge-intensive companies can receive via EIS and VCT schemes annually will double from £5m to £10m in April.

Knowledge intensive companies

To qualify as knowledge-intensive companies must:

• have fewer than 500 full-time equivalent employees at the time the shares are issued
• have spent an amount of their overall operating costs on research and development or innovation that is at least either:
  • 10 per cent in each of the three years before the investment
  • 15 per cent  in any one of the three years before the investment
• either:
  • be carrying out work to create intellectual property and expect the majority of their business will come from this within 10 years
  • have 20 per cent of their employees carrying out research and development when they receive investment and for three years after. These employees must have a relevant Master's or higher degree

Source: HM Revenue & Customs

In aggregate, the various changes since 2015 are likely to have an impact on many VCTs’ future returns. “VCTs are now investing in young, fast-growing businesses, which makes them slightly more risky than if you had invested in them five or 10 years ago, when they had investments with lots of asset backing and MBOs,” says Mr Davies. “So VCTs have gone up the risk scale.”

But in the short term, VCTs’ risk profile will not change massively because they still hold less risky companies acquired before 2015 alongside younger, fast-growing companies. And Mr Davies argues that even in a few years’ time, when the newer companies outweigh the companies invested in before 2015, investors should not feel the increase in risk that much.

“Hopefully by that point, the companies VCTs are investing in now will be more mature,” he explains. “And so they will be able [to balance out] newer, younger businesses in the portfolio.”

But dividends are likely to be much more volatile than they have been over the past decade. “You won’t get VCTs paying out5 per cent year after year regardless,”argues Ben Yearsley, director at Shore Financial Planning. “You might get years when a VCT is paying a dividend of 2 per cent and sometimes a dividend of 10 per cent. But returns might be slightly higher, because the rule changes are forcing VCTs to invest in higher-risk, potentially higher reward companies.”

However, Bill Nixon, principal manager for the six Maven VCTs – generalist funds that have changed their investment approach since the 2015 rule changes – sounds a note of caution.

“You hope a higher risk equates to higher return, but only time will tell,” he says. “If we’re investing in younger businesses, we require an equity stake commensurate with a higher risk, so that if it works we are able to make five to 10 times our money. With the older type of businesses, we would have looked to make around two times our money. So, there’s definitely a higher risk and the prospect of higher returns, but ultimately that depends on the success or failure of the underlying businesses. There’s also the prospect of higher losses – it cuts both ways.”

Although VCT returns may become higher-risk, possibly with greater returns, their generous tax reliefs remain. So they could still be attractive for individuals who have used up their pension and Isa allowances, and would benefit from the income tax relief.

“Investors need to look at VCTs more as an investment product with a tax kicker, rather than what they’ve been seen as for the past 10 years, which was a tax product with an investment return,” says Mr Yearsley. “It was only for that 10-year period that VCTs were like that. When they were first launched in the 1990s they were an investment product with a nice tax kicker to compensate you for the risk [of investing in smaller companies].”

VCT managers will also face pressure to invest the money they raise faster, and hold a larger proportion of assets in qualifying investments. This could affect how they raise funds.

“The message we’re getting from managers is that investing in early-stage businesses often means that [they will] invest in a broader spread of deals, knowing that some will potentially disappoint,” explains Mr Hollands. “This could lead to a larger number of smaller fundraisings.”

And because VCTs have raised a lot of money this tax year they might not come back to market in such a big way next year. VCT managers now need to keep a close eye on their investment deal pipeline and make sure they do not raise more money than they can deploy. Managers are also constrained because they need HMRC to confirm whether each investment they want to put money into is eligible. VCT managers report that receiving HMRC approval can take up to 18 weeks, although the government plans to speed up this process to around 15 days.

High-risk investments

Although VCTs offer attractive tax benefits, their high risks mean that you should only invest in them if you have a high risk appetite and long-term investment horizon.

VCTs typically invest in early-stage unquoted smaller companies that need a financial injection to grow further. While these can make strong returns you can also incur large losses on them, and they are volatile. These types of company are much more risky than the large, established companies other funds tend to invest in, and some will struggle even with the support of VCT investment, and may fail altogether.

VCTs also charge higher fees relative to other funds. This is partly because they invest directly in early-stage unlisted companies, which is much more labour intensive than buying shares listed in an index.

And as has been demonstrated over the past few years, the rules on VCTs can change, which could affect the returns you get from them.

VCT shares are also not heavily traded, making them quite illiquid. In any case, you should not sell your shares within five years of your initial investment or you will not receive income tax relief. Mr Yearsley suggests that whereas before the rule changes investors could hold VCTs for the minimum five years, the increased risks mean you should now hold them for at least seven to 10 years. Or you could hold them indefinitely.

Types of VCT

Generalists mainly invest in unquoted companies across a variety of sectors, so are arguably lower risk than specialist VCTs focused on one area.

• 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 as to 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.

• Aim VCTs mostly invest in Aim shares but cannot invest across the whole of this market because of the restrictions VCTs face on company size and industries. They also have to put their qualifying money (70 per cent of what they raise) into initial public offerings (IPOs).

Fund recommendations

Of the generalist VCTs still open at time of writing, Mr Davies suggests Maven Income & Growth VCT 3 (MIG3) and Maven Income & Growth VCT 4 (MAV4). These are seeking to raise £30m with an over-allotment facility of £10m, split equally between the two VCTs. These VCTs have historically invested in established, cash-generative and profitable companies, which still represent around 88 per cent of their portfolios.

“The Maven VCTs give investors access to a decent portfolio of existing investments, plus newer ones in younger and more dynamic companies,” says Mr Davies. “Since the rules became more restrictive in 2015, Maven has been one of the most active managers. Recent investments include online doctors The GP Service, Rockar, an innovative car dealership and Chic Lifestyle, a cloud-based inventory management platform for boutique hotels. With 10 regional offices, Maven has access to deals many of the more London-centric VCTs might miss.”

The Maven VCTs do not have a specific dividend target, but rather a stated objective of generating maintainable levels of income for shareholders. Broker Bestinvest says Maven Income and Growth VCT 3 and Maven Income and Growth VCT 4 have paid average annual dividends of more than 6p and 5.4p per share, respectively, over the past five years.

Investors can apply for one or both VCTs and the minimum investment is £5,000, with a minimum of £1,000 per VCT. Initial costs are capped at 5 per cent. These two Maven VCTs had raised 79 per cent of their targeted offer at time of writing.

After not fundraising for two tax years, Mobeus has been seeking up to £80m with Mobeus Income & Growth (MIX), Mobeus Income & Growth 2 (MIG), Mobeus Income & Growth 4 (MIG4) and The Income & Growth (IGV) VCTs. However, only Mobeus Income & Growth VCT and The Income and Growth VCT remain open, as this family of VCTs has raised 94 per cent of what it is seeking. The Mobeus VCTs are targeting a dividend of between 4p and 6p a year and have a maximum initial fee of 3.25 per cent.

“The offer provides access to a mature legacy portfolio of MBO deals in companies that are profitable, as well as a growing exposure to new growth company investments which are being led by a beefed-up team experienced in earlier-phase investing,” says Mr Hollands. 

Around 80 per cent of the Mobeus VCTs’ portfolios are invested in older, lower-risk businesses which were backed as MBO deals, with the remainder in new riskier investments offering the potential for high growth.

A VCT that has not had to adapt its strategy to conform to the investment rule changes is Octopus Titan (OTV2). This VCT focuses on early-stage companies, which it often invests in before they have reached profitability, but where the product concept is proven or there is revenue growth.

Octopus Titan is the largest VCT and this tax year it has already broken the record for a VCT fundraising round. The VCT met its initial target of £120m in January and is now drawing on its over-allotment facility, meaning it could raise £200m in total.

Octopus Titan is targeting an annual regular dividend of 5p a share, and will aim to pay dividends when there are significant gains from the realisation of portfolio holdings. The VCT has an initial fee of5.5 per cent.

"Octopus Titan was an early investor in Zoopla (ZPG), the first VCT-backed company valued at more than £1bn," says Mr Davies. "Other investments include Graze.com, Secret Escapes and Eve Sleep (EVE). It has also had successful sales to the likes of Google [known as Alphabet (US:GOOGL)], Amazon (US:AMZN), Twitter (US:TWTR) and Microsoft (US:MSFT). For example, last year it sold [artificial intelligence start-up] Magic Pony to Twitter for a reported $150m (£108.09m), and SwiftKey, [which makes keyboard apps for Android and iOS devices, to Microsoft for a reported $250m."

Choosing a VCT

The capacity squeeze means investors might find themselves contemplating VCTs they might not have considered 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 already closed.

So it’s important to do your homework before investing, and not pile into a VCT just because it is still open.

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:

■ 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.