To VCT or not to VCT?

Venture capital trusts (VCTs) are on track for a record year of fundraising, thanks both to companies seeking capital as they emerge from the pandemic and investors looking for somewhere to put their money as tax allowances are frozen and dividend tax rates are about to increase.

VCTs are structured in a similar way to investment trusts. They are listed on the London Stock Exchange with a board of directors and produce annual accounts. However, they are rarely bought or sold on exchange for tax and liquidity reasons. Instead, they are open to new investment intermittently, normally leading up to the autumn budget and the end of the tax year. Some of the major VCTs have filled up already, such as the Mobeus funds which sold out in 24 hours. But there are many still raising funds and some about to open offers.

“This year, popular VCTs have filled quicker than ever,” says Alex Davies, founder of Wealth Club. “If you spot a VCT you like, act now, otherwise you face the very real possibility of missing out.”

How they work

VCTs are designed to encourage investment in small, young British companies. By their nature, they are risky investments and not suitable for everyone. HM Revenue and Customs (HMRC) has strict rules a company must meet to qualify at the point a VCT invests in them.

• It must carry out a ‘qualifying trade’. Most trades are included: the main exclusions are businesses HMRC doesn’t believe are in need of extra support, such as land, financial, property and energy companies. 
• The company must be be small - usually with gross assets of £15m or less and fewer than 250 full-time employees at the point of investment.
• The company must be be young - usually under seven years old (from the date of its first commercial sale) at the point of investment.
• Knowledge-intensive companies – typically tech and healthcare companies – that meet certain tests around research and development can be up to 12 years old and have up to 500 employees.

After a VCT raises money, at least 80 per cent must be invested in ‘qualifying investments’ that meet these criteria within three years. Legislation for VCTs has evolved over the years and since 2015 they have had to focus new investments specifically on early-stage growth companies, making them perhaps more risky than they once were. 

Tax privileges

UK residents aged 18 and over can invest up to £200,000 a year in new VCT share issues and receive 30 per cent relief on their income tax bill. Most people claim the tax relief when filing a self-assessment tax return, and you can only claim tax relief in the tax year you invest. To keep the relief, you must hold the VCT for at least five years. Any dividends or capital gains you receive from the VCT will also be tax-free.

Because VCTs have to pay out 85 per cent of income or reinvest proceeds within 12 months, “the rules set around them have turned them into distribution vehicles”, says David Hall, chair of the Venture Capital Trust Association. The average distribution yield across the generalist VCT sector is 3.9 per cent, according to Morningstar data, but the range is large.  

Because dividend payments are based on the sale of underlying holdings, they can be quite lumpy. Investors therefore often own a handful of VCTs to smooth out payments and spread risk. Jason Hollands, managing director of Bestinvest, says half a dozen VCTs is not uncommon for any one investor to have, and he knows of those with as many as 19.  

Many VCTs have automatic reinvestment schemes that allow you to use their dividends to buy more shares in them. If you go down this route, check that the shares are newly issued rather than bought in the market so that the amount reinvested qualifies for 30 per cent income tax relief as a fresh VCT subscription. If you buy VCT shares on exchange, you do not get the tax relief and there is very little liquidity. Similarly when you sell VCT shares, you normally get the best deal by selling them back to the manager via a buyback, not on exchange. 

If you have held a VCT for over five years, it could be worth selling it and reinvesting in another one to benefit from the 30 per cent relief again. Note you can’t invest back into the same VCT for at least six months if you wish to get the relief again.

Different types

There are three main subsectors of VCTs.

• Generalist VCTs invest in a wide range of small, usually unquoted companies in different sectors – from retail to healthcare and technology. This is the most common form of VCT.
• Aim VCTs invest in new shares issued by Aim-traded companies. These are not necessarily small or start-up companies, but they have to meet the VCT rules at the point of investment. Aim VCTs typically target tax-free growth as well as income.
• Specialist VCTs focus on one sector, such as media or healthcare. The lack of any sector diversification means they may be more risky than other VCTs.

Fees

VCTs are small portfolios but have resource-intensive investment processes, meaning that their fees are significantly higher than what you would reasonably expect to pay for an investment trust or open-ended fund. VCT initial charges can be as much as 5 per cent, although brokers such as Wealth Club and Bestinvest usually discount this. The annual management fee is usually around 2 to 3 per cent. 

“Look at the returns net of the fees,” says Hollands. “And do not forget the value of the tax relief.” If you receive 30 per cent income tax relief, for example, on a £10,000 investment and you break even on your investment after five years, that’s still the equivalent of a 43 per cent return, as you paid £7,000 initially, having received £3,000 back in tax relief. 

Open issues

Unfortunately, with VCTs you are at the mercy of what’s available, and while the fundraising season generally starts around September, not all trusts will be open at the same time. This year, there are plenty of offers, although some popular names were already sold out by late January. These include the British Smaller Companies VCTs, Octopus VCTs, Hargreave Hale AIM VCT (HHV) and Draper Espirit VCT (DEVC).

Picking a VCT

Because VCTs are high risk investments, it's important to back ones run by good managers. The older and more established VCTs tend to be more diversified and perhaps less risky if they still own holdings that were permissible under the old rules when VCTs could back management buyouts and acquisitions. 

Success also breeds success. A manager with a good reputation is likely to have access to the best companies, so it is worth looking closely at the manager's record.

But success also means popularity and some, like the Mobeus VCTs, sold out in 24 hours. Of those still open, Hollands highlights the ProVen VCTs, whose holdings include jewellery brand Monica Vinader, and are managed by Beringea, a transatlantic but predominantly US private equity and venture capital business. This could be particularly helpful for finding buyers when it comes to exits, he says.  

Davies’ three favourite managers that have offers open are the six Albion VCTs, Northern VCTs (two of which are open) and Pembroke VCT (PEMB). “Albion VCTs have made a real success of their transition towards growth capital investments,” he says. “Over the five years to September 2021, the six VCTs made NAV total returns of between 51.1 per cent and 73.8 per cent, assuming dividends are reinvested.” The VCTs are well-diversified with more than 70 investee companies, and Albion Capital is well-resourced with 27 members in its investment team.

The Northern VCTs' offer raised £9.3m on its first day. Like the Mobeus VCTs, they were historically management buyout investors, but recent performance has been driven by several new growth capital investments, such as Oddbox, the fruit and veg delivery business. The VCTs recently partially sold their stake in the business, generating a 10.9-fold return 18 months after their initial investment. The management of the Northern VCTs was recently acquired by Mercia Asset Management, which could help them access more attractive deals. 

Pembroke VCT invests in premium consumer brands. Its portfolio, which contains several wellness and ecommerce brands, has benefited from changing consumer habits following the outbreak of the pandemic and as a result has performed strongly through the pandemic. Profitable exits from brands such as Pasta Evangelists, a premium pasta delivery business, and Plenish, a premium oat milk brand, helped to fund generous dividend payments throughout 2021.

It is important to remember that VCTs are risky, illiquid investments that are not be suitable for everyone. Many have delivered lacklustre performance and it’s not a good idea to invest purely on the basis of the tax breaks available as these can change.