In Focus: TaxApr 12 2021

Q&A: How VCTs attracted the income-seeking investor

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Q&A: How VCTs attracted the income-seeking investor

Over the past decade, venture capital trust investing has grown in popularity. 

This is partly to do with continued tweaking of tax rules around pensions and property investment – traditionally the mainstay of people's retirement plans – and the search for a tax-efficient vehicle to save within.

But as David Hall, chair of the Venture Capital Trust Association, says, there is more to a VCT than simply its tax-efficient nature. 

He tells FTAdviser In Focus of the rising attraction of VCTs for income-seeking investors wanting to put their money into some of Britain's strongest performing small businesses.

FTAdviser: Why are VCTs becoming such an important part of pensions planning?

David Hall: There are a few cases where VCTs are attractive as part of long-term financial planning. Similarly to pensions, VCTs have a tax efficiency to them, in terms of both upfront relief and the tax-free income returns that follow.

Secondly, VCTs are income distribution vehicles. The conditions set for compliance with the ongoing VCT rules mean that trusts are forced to distribute at least 85 per cent of its net income as dividends.

VCTs provide an opportunity to invest in some of the most exciting, high-growth companies in the UK

While the dividend patterns across VCTs vary, it does mean that when considered over five to 10-year periods, investors often get a level of dividend income each year.

Finally, the investment is the property of the investors, so unlike buying an annuity, any capital value belongs to an investor’s estate.

FTA: Should clients invest in a VCT for the investment story or the tax benefit?

DH: VCTs provide an opportunity to invest in some of the most exciting, high-growth companies in the UK. Tax benefits are a reward for what are deemed more ‘risky’ investments.

However, VCT managers seek to focus on industries and companies that are likely to see growth in the medium to long term and build a diversified portfolio that goes some way to mitigating the risk.

From the government’s perspective, the tax relief provides a further mitigation of that risk.

As well as this, in the current climate, VCT investors will also be supporting the small businesses whose growth will underpin the country’s economic recovery.

This means people investing in VCTs are helping the UK build back and alleviate the economic scars the pandemic created.

We are hoping the government will recognise this and expand the limits of schemes such as VCT and EIS/SEIS funds, and increase tax breaks to make such investments more attractive.

FTA: Government policy so far has been to support VCT investing – will this continue?

DH: We hope so and the recent Kalifa report described VCTs as an integral part of the venture capital ecosystem and something that should be built upon.

For VCTs to optimise their economic impact for the UK, some alteration of our investment regulation created by the state aid rules would really help.

Before January 1, VCTs had to comply with EU legislation instead. This meant the government was not allowed to provide financial support beyond certain limits, with income tax relief regarded as state aid.

A significant majority of VCT investors hold a diversified portfolio of investments.

Now we have left the EU, we hope the government will continue to support VCT investing by allowing VCTs to provide more support to the emerging small businesses, especially in the context of the Covid-19 pandemic.

Coming out from under some of the state aid restrictions, such as increasing the amount that can be invested, would be a good first step.

FTA: What sort of developments might we see in the VCT space? 

DH: Developments take place in sectors where the pace of change is growing. At the moment, this includes areas such as cybersecurity, edtech and fintech, as they are all industries providing solutions to the problems the pandemic has created.

However, VCT managers are interested in all sectors where there is future growth through increasing market and customer adoption.

This undoubtedly incorporates clean energy, as well as businesses that are making a positive impact either on their community, the environment and wider society.

FTA: When should people be thinking about investing in VCTs – at the start of the tax year or towards the end of it, when other forms of tax-efficient investing may have been exhausted?

DH: Increasingly, VCTs tend to issue offers nearly all year round. The inflows to VCTs are much more consistent across the year, with summer perhaps the lowest point and there is still some bias towards the first quarter of a calendar year. 

However, this year many investors recognised that there was the widest choice of VCTs from September onwards and as the tax year end approached there was less and less choice. This trend started a few years ago and seems to be here to stay.

FTA: What makes VCTs appeal to income seekers?

DH: VCTs are appealing to income seekers because investments tend to have an up-front tax efficiency – especially for individuals who want to invest funds from September onwards.

As well as this, the tax-free dividends are very attractive to those wanting to make big returns on long-term investments.

Strong returns are also helped because VCTs typically invest in fast growth businesses within innovative sectors. For example, the 30 most valuable companies to graduate from VCTs created a combined value in excess of £12bn.

FTA: How does one balance the higher volatility, and often quite chunky fees, with the investment strategy of a VCT?

DH: Our investor surveys over the past few years suggest that a significant majority of VCT investors hold a diversified portfolio of investments.

With each VCT itself generally having 30-50 investments, there is a diversification that mitigates the risk.

Despite the returns for individual VCTs having a higher degree of volatility, holding multiple investments in multiple VCT funds can help to mitigate this risk through diversification.

Looking across the sector recently, Octopus, Mobeus and Mercia have had strong returns from individual investments including Cazoo, Parsley Box, Virgin Wines and Agilitas.

Last year saw Gresham, YFM and Maven also see strong returns with the sales of Glide, Eikon and Global Risk Partners, and a strong performance from the Aim market.

At the time of the first investment by a VCT, a business is usually around 4-6 years old, employs between 30-40 people and has sales of £2-3m receiving around £2.25m on average. 

Investing in unquoted businesses requires more than just one company and the path to this creation is highly labour intensive, with often two or three fund managers working with a single investment.

In exchange for the tax relief, the government requires investment to be where there is a market failure.

This means VCTs typically invest in fragile, small businesses that not only require capital but also potentially a lot of advice and support, in exchange for which they grant the tax relief.

However, the returns we seek to quote are net investment returns after all costs.

Simoney Kyriakou is senior editor at FTAdviser