How VCT investing has developed

As Annabel Brodie-Smith, communications director for the Association of Investment Companies, comments: "VCTs were a bold initiative to encourage the public to invest in small businesses with the capacity to transform the markets they operate in."

But with Isas not even a gleam in the future Labour Party's eye, the idea of a tax-incentivised, potentially higher-risk investment scheme seemed a little bit too esoteric, and VCTs were targeted mainly at the more sophisticated investors in UK society.

Now, however, investors with just a few thousand to spare can get into the venture capital trust market and benefit from generous tax allowances.

Initially, as Alex Davies, chief executive of Wealth Club, states, VCTs were a "bit of a rollercoaster" in terms of performance and management.

He explains: "While there were some great performers, which have continued to be so, such as Baronsmead, British Smaller Companies and Northern, performance from some others was truly terrible." 

But now, they are seen as well-managed, credible investment schemes. As the AIC points out, the industry has grown to £4.1bn in size.

Paul Latham, managing director of Octopus Investments, comments: "People are increasingly looking to VCTs to provide them with a credible way of investing in a tax-efficient manner."

So what are VCTs and how are they developing?

In a nutshell, according to the Association of Investment Companies (AIC), which covers VCTs, there are three main types of VCT, although the management styles of each can vary.

The three types are:

■ Generalist (which covers private equity including development capital).

■ Alternative Investment Market.

■ Specialist sectors, for example technology or healthcare.

Some VCTs had a fixed investment term for investors - before which they could not get their money out. These are called planned exit VCTs, compared with 'evergreen' VCTs which have no such maturity date - but which have in the past been seen as more expensive for investors to dive out of.

In terms of tax, investors in VCTs receive 30 per cent income tax relief when their money is put to work investing in underlying UK companies. Investors also benefit from not having to pay capital gains tax (CGT) on any investment returns.

Mr Latham says: "Recognising that investing in such companies involves taking more risk than investing in larger listed companies, and that VCT shares could fall or rise in value more than other shares listed on the main market of the London Stock Exchange, investors were offered tax reliefs in order to incentivise investment."

According to Mr Latham, VCTs have raised more than £7bn, helping to create jobs, reward innovation and bolster the UK economy. 

VCTs have always been able to invest in Alternative Investment Market (Aim) qualifying companies but the government agenda is to push VCT managers further down the capitalisation curve towards more early-stage companies than before.

The government's Patient Capital Review has recognised the value VCTs add to the economy through their support of ambitious smaller companies. Will Fraser-Allen

Yet according to Chris Hutchinson, manager of the Unicorn AIM VCT, the rules have become "considerably more complex and challenging over the past 20 years".

He explains: "There are now fewer types of VCT available and fewer specialist VCT managers around who are capable of delivering healthy returns to investors.

"The VCT sector was established by HM Treasury to allow small firms the opportunity to access the capital required to help fund their growth plans, and to help secure and accelerate employment growth.

"Several VCT strategies developed over the past 20 years, which in truth were not really designed to meet these two basic requirements.

"As a consequence, the rules have been refined and tightened a number of times in recent years to help ensure that capital raised by VCTs subsequently finds its way to businesses that genuinely require 'scale-up capital' to invest in product development, equipment and people." 

Evolution of VCTs

Explaining the changes is Jason Hollands, managing director of business development for Tilney.

He says: "The VCT industry has evolved over the past two decades, as the tax features have undergone changes and there have been quite regular adaptions and tweaks to the criteria of what constitutes an eligible qualifying investment."

For example, VCTs have often focused on areas where there appeared to be a government-led agenda. Before 2000, a lot of VCT money was invested in technology during the dotcom boom.

Stuart Veale, managing partner of Beringea, says the period of 40 per cent initial tax relief, and a three-year holding period (2004 to 2006), means people saw the limited life VCTs, which invested in low-risk, low return assets, tending to generate their returns through the tax relief.

He comments: "These came into their own following the global financial crisis - for a few years, they attracted a significant proportion of all funds raised." 

But this was not seen to be putting the investment money to where the government had intended - the growth and development of the investee companies themselves, rather than 'safer' seeming bets such as management buy-outs.

After all, if the Treasury is to provide a (now) 30 per cent income tax relief, it wants to make sure people are taking commensurate risk to bolster fledgling UK plc, not line their own pockets with a safe bet. For a quick glance at the tax changes, see the Info Box. 

Another once-popular area was solar panels and renewables.

However, this was banned from VCT and Enterprise Investment Scheme (EIS) investment in 2014 as the Treasury clamped down on investment vehicles which were benefiting from the subsidies and tax breaks on renewables.

Then, in 2015, there were other changes which Mr Hollands describes as "significant". These essentially "refocused the schemes on providing growth and development capital to younger businesses."

These measures, in essence, meant:

• All investments must support the growth and development of the investee company.
• There must be an age limit on investee companies, so they tend to be at an earlier stage than previously.

Mr Hollands continues: "The days of more conservative investment strategies such as management buy-outs and capital preservation-focused deals are now behind us. 

"VCTs are now firmly focused on the provision of growth capital, and sit at the high end of the growth spectrum."

Patient Capital Review

Recently, with the publication of the government's Patient Capital Review last year, coinciding with November 2017's Budget, which pledged more funding towards UK high-growth small businesses and enterprises, there has been an acknowledgement of the role that both EIS and VCTs can play in bolstering British business.

Among several recommendations made in the Patient Capital Review, published in October 2017, was a move to extend the investment limits for EIS and VCT schemes to allow managers to put more into start-ups.

It said: "[We recommend] extending the investment limits for existing EIS and VCT schemes: The popularity of these schemes has contributed significantly to the development of a vibrant UK start-up scene.

"However, the hard limits on investment size create inefficiencies as businesses transition away from tax incentivised investment, particularly due to the inability of Angels and VCTs to provide follow-on funding. To minimise this impact, the limits could be extended or removed, smoothing the transition from EIS/VCT funding to venture and raising up to an additional £1bn."

The review also suggested that any changes could focus on knowledge-intensive companies, to target the types of business that have the greatest need for patient capital.

The VCTs that remain are much larger, growing through both mergers and fundraising. This has resulted in greater diversification in VCTs' underlying investments. Stuart Veale

It also proposed: "To minimise the cost to government, a new Growth EIS or VCT, with a reduced level of tax saving could be created."

According to the review, this proposal targets the lack of capital availability, particularly at the boundary of the existing EIS and VCT threshold.

Currently, VCTs have three years to invest 70 per cent of the money raised into qualifying companies. But as a result of the review, with effect on or after 6 April 2019 the percentage of funds VCTs must hold in qualifying holdings will increase to 80 per cent from 70 per cent, while the period VCTs have to reinvest gains will double from six to 12 months.

Ms Brodie-Smith adds: "There's an additional stipulation from April 2018 that 30 per cent of the money raised must be invested in just 12 months.

"To sum up, HMRC wants VCTs to invest more of your clients' money, faster."

Moreover, from 6 April 2018, the amount of annual investment knowledge-intensive firms can receive through EIS and VCT schemes will also double from £5m to £10m.

However, to make sure VCTs are doing what they are intended to do, and not being used as a tax shelter, subsequent legislation has tightened up what VCTs can invest in.

In the Autumn Budget last year, chancellor Philip Hammond introduced a principles-based test for VCTs which, Mr Hammond said at the time, "will ensure the schemes are focused towards investment in companies seeking investment for their long-term growth and development". 

As Will Fraser-Allen, deputy managing partner at Albion Capital, says: "The government's Patient Capital Review has recognised the value VCTs add to the economy through their support of ambitious smaller companies, but will now herald some important changes.

"The Review will reshape the landscape for VCT investing and channel funding towards the most innovative growth companies."

From here on in, VCTs must demonstrate they are investing in UK companies that are pursuing long-term growth and 'knowledge-intensive businesses', so that the government can be certain that the tax incentives on VCT investment are being used to help promote British business.

Mr Hutchinson agrees: "From the government's point of view, this is clearly much more aligned with their aims for the VCT sector."

The road ahead

"The investment management industry has been tweaked a number of times over the past two decades in response to demand and opportunities for VCTs," says Mr Latham.

"It is now a mature market and there is significant choice for investors, with a range of VCTs in the market targeting different sectors."

Mr Hollands feels there have been other positive developments which stand VCTs in good stead for future investors, including the widespread adoption of discount control mechanisms.

He explains: "In the early years, VCTs traded at very significant discounts but boards have almost universally adopted buy-back policies.

"This is a factor which has lessened the demand for planned exit VCTs, as it is much easier now to exit evergreen VCTs at reasonable prices."

Given all the changes, Mr Davies believes: "Twenty years on, the VCT market has come of age. Governance standards have improved considerably and the poor VCTs have largely been weeded out."

This can be seen in the numbers of VCT funds under management - now, 10 managers account for approximately 75 per cent of all VCT funds under management, according to Stuart Veale, managing partner of Beringea.

He comments: "The VCTs that remain are much larger, growing through both mergers and fundraising. This has resulted in greater diversification in VCTs' underlying investments, tending to make VCT returns less volatile."

"The products themselves and the investment strategies have evolved considerably over time. Products have matured greatly since they first came to market, making them more appealing to investors," says Jack Rose, head of tax-efficient investment at LGBR Capital.

Mr Davies adds: "Today's crop of VCTs are well-managed, offering investors a decent mix of mature and younger businesses and consistent performance."

His point on performance is worth noting - although of course, past success is no guide to future returns.

According to the AIC, as at 30 September 2017, over the past 10 years, the average specialist VCT is up 86.3 per cent on a share price return basis. Overall, the average VCT is up: 

• 68 per cent over five years.
• 90 per cent over 10 years.
• 161 per cent over 15 years.

By way of comparison, the FTSE 100 is up 66 per cent.

He adds: "I think most people who have invested in VCTs over the past 10 years will be feeling pretty pleased with themselves."

simoney.kyriakou@ft.com