Venture Capital Trusts (VCTs) are 20 years old. Since their launch, the internet has gone from blinking infant to dominant adult. Over the same period, VCTs have gone from 12 funds and £160m in 1995/96, to 94 funds with a record £435m in 2014/15.
New fundraising has been rising steadily from £267m in 2012 to £450m in 2016. In part, this is down to long-term performance. For a number of years, the best VCTs have delivered tax-free yields of 6 per cent to 8 per cent, while maintaining capital value; comparing favourably to headline interest rates on long-term savings and a more volatile stock market performance. More recently, the changes to pension rules, caps applied to contributions and latterly the freedom to access your pension fund have seen an increased search for alternative investments.
With all these changes to the economic backdrop, it is not surprising that the rules surrounding VCT investments have also undergone a number of adjustments. Having been announced in July 2015, the latest set came into force last November. Based on these, is there anything in the latest tranche of rule changes that investors should note?
The revised rules are designed to only allow investment in younger companies seeking funds to grow instead of those more developed companies whose growth is blocked or constrained by its existing shareholders. The biggest change is the age restriction. Now, companies, or their trade, have to be less than seven years old (with some exceptions, still to be clarified as these are part of the draft guidance). Additionally, VCTs are no longer allowed to hold non-qualifying investments, other than for liquidity purposes prior to them being made in qualifying investments.
Following the July 2015 Budget, there was some uncertainty as to when the rules would apply – guidance to the VCTs was a little unclear, but suggested that any investments would have to comply with the new rules – which had not yet been written. Not unsurprisingly, this meant that investment rates last year were lower than had been expected – as it turned out, investment was about 30 per cent lower than the previous year, despite funds raised being broadly constant at £420m to £430m.
The other difference from previous changes was their retrospective nature. The new rules apply to money that had previously been raised but not yet invested and they also apply to all existing portfolio businesses as if they had been made under the new rules.
In this latter case this means that there is a risk some businesses that require further funding from the VCTs will not be able to access it. The impact for investors of lower investment rates in 2015 was principally that the mix of VCT choice in the 2015/16 tax year was a little different. However, this did not dampen demand; in fact, the main impact was less diversification available, with one-third of funds raised going to one manager.
In the short term, there has been more of a struggle to implement the new rules. Guidance on how to operate within them did not appear until early May and then only in draft form, six months after the introduction of the Finance Bill, and there has been a noticeable slowing of advanced assurance. As a result, the lower investment rates experienced in 2015 have been further suppressed. The first quarter of 2016 was particularly affected, with rates 85 per cent down on the previous year. It is to be hoped, that as with any transitional arrangement, this will eventually work its way through the system, but there has to be some risk that this puts unnecessary pressure on VCTs nearing the end of their three year investment periods. There is also a likelihood that this could impact the number and range of VCTs seeking to raise funds in the current tax year.
Rules
The impact on VCTs has been getting clearer as the rules have been released. However, it has not been easy for investors to follow without a forensic analysis of results announcements. A very small number of trusts have said when raising further monies there is not likely to be any change. Comments from those who in recent years have raised the most money range from: “a new strategy to be put to shareholders for their approval” to “returns may be lower/more volatile in the future”. This is arguably not to be unexpected. Funding the international expansion of an existing profitable business is likely to deliver profits/income in the early years of an investment – at least in terms of yield to the investor. Whereas investing in supporting growth in a young company often involves investing in people and marketing support which will push the business into losses for a period. This in turn will push returns further into the future with the nature of the return more likely to be capital rather than a mixture of capital and income.
There seems little doubt that there is a bigger adjustment being made than has been the case in recent years. The focus on younger businesses means that return profiles are likely to be different than those seen in the past. While the kernels of what makes a good investment in an unquoted business remain the same, the challenge for the managers is to adapt to a more restrictive set of rules, reducing the population of potential investments while at the same time both communicating clearly with investors and continuing to deliver returns.
VCTs have evolved to be an increasingly important part of portfolios and the recent changes to pensions have reinforced that position. Managers and trusts have long records in coping with rule changes, and while past performance can never be a guide to the future, I am confident that VCTs will withstand the latest rule changes and continue to play a key role in the market.
David Hall is managing director of YFM Equity Partners
| Key Points |
Venture Capital Trusts have been with us for 20 years. Revised rules are designed to only allow investment in younger companies seeking funds to grow. The focus on younger businesses means that return profiles are likely to be different than those seen in the past. |
