Venture Capital Trusts (VCTs) are tax efficient, UK closed-ended collective investment schemes designed to provide capital for small expanding companies, and income in the form of dividend distributions and/or capital gains for investors.
They’ve been around since 1995, and today the VCT market is worth around GBP7bn and have become an increasingly popular way for investors to gain access to early-stage companies, particularly in the tech sector, which has been growing rapidly in recent years. Overall, VCTs can be a good investment idea for investors who are comfortable with the risks involved and who are looking for tax-efficient ways to invest in early-stage companies.
Nick Britton, head of intermediary communications for the Association of Investment Companies (AIC) explains why investing in VCTs is a option you should consider.
Venture capital trusts, or VCTs, offer attractive tax incentives for investing in small, usually unquoted UK companies. When I say “small”, I really mean it: these are companies that have no more than GBP15m of assets at the time of investment. Some are start-ups, some slightly more established but still what’s called ‘early-stage.’
The idea is that investors like you and me are never going to be able to invest in these companies on their own. And even with professional help, we might hesitate to take the risk.
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VCTs address both issues. They make it easy for investors to access a portfolio of early-stage UK companies via a listed fund structure that looks a lot like an investment trust. And the riskiness of these investments is mitigated by a generous set of tax breaks, including 30% upfront income tax relief.
Since the scheme was launched in 1995, it’s worked pretty well for investors, companies and the government, which recently reaffirmed its commitment to VCTs.
The average VCT has delivered a total return of 53% over the past five years, and 111% over the past ten years – excluding the 30% income tax relief.
In this article, I’ll look at all the tax reliefs available, how VCTs are different from mainstream investment trusts, why you might invest, the risks, and how VCTs might perform during tougher times.
Tax reliefs
Though there are many good reasons to think about investing in Venture Capital Trusts, the main draw for most people is the generous tax relief. The typical VCT investor will have maxed out their ISA and their pension allowances – much easier to do, for higher earners, since the annual allowance taper was introduced in the 2016/17 tax year.
VCTs offer 30% income tax relief upfront: so, if you invest GBP10,000, you get GBP3,000 off your income tax bill for that year. However, there are two important conditions: you must invest in new VCT shares (not buy existing ones through the stock market) and you must hold the VCT shares for five years. There’s also a GBP200,000 limit on how much you can invest in VCTs in a year and still receive tax relief.
In addition to the upfront tax relief, VCTs pay tax-free dividends. These can be quite chunky, with yields in the mid-single digits, because VCTs tend to pay out most of their capital profits as dividends. Any capital gains are tax-free too.
Venture Capital Trusts vs Investment Trusts
Apart from the tax relief, there are other important differences between VCTs and investment trusts. To begin with, VCTs need to follow a strict set of rules about what they can and can’t invest in. From HMRC’s perspective, these rules are designed to make sure that tax relief is going to worthy recipients: namely, UK companies that are too small and risky to get funding from other sources.
From the investor’s point of view, VCTs lock you in for at least five years if you want to keep the tax relief. In a way that’s academic, because if you don’t have at least five years to invest you probably shouldn’t be investing in early-stage companies anyway.
Probably more significant is the way you buy the shares and the way you sell.
As we’ve said before, you must buy new VCT shares to get all the tax reliefs. Most new Venture Capital Trust shares are ‘sold’ via financial advisers, but you can subscribe for them yourself via some investment platforms, through a service called WealthClub, and direct from some VCT managers. Pretty obviously, you can only subscribe for new shares in a VCT if that VCT has a share offer open. For the most sought-after VCTs, share offers fill very quickly, sometimes in days or even hours.
Limited liquidity
When it comes to selling the shares, liquidity is very limited. This is because you can’t receive the upfront tax relief when you buy VCT shares on the stock market – so few people are interested in doing so. To solve this problem, VCTs have buy-back schemes which allow investors to cash in shares at regular intervals, though this is usually at a discount and not guaranteed. You can, of course, continue to hold the shares forever and receive the tax-free dividends. VCT shares will, however, form part of your estate for inheritance tax purposes.
While VCTs are illiquid compared to investment trusts, the prevalence of buy-back schemes means that it is generally easier to exit your investment than it is when using the Enterprise Investment Scheme (EIS). With EIS, you are becoming a shareholder not in a fund-like vehicle, but in a specific early-stage company (or companies). Exiting the investment generally relies on those companies being sold, and the timing of that is uncertain to say the least.
The tax reliefs offered by EIS are similar, though not identical to those of VCTs. The main differences are that there are no tax-free dividends with EIS, but there are other reliefs, including loss relief, that you don’t get with VCTs.
Why invest?
As mentioned, the average VCT has produced decent returns over time, though some Venture Capital Trusts have done better than others. The AIC website allows you to research the past performance, yields and dividend histories of all VCTs, always remembering of course that this is no guarantee of future performance.
Financial advisers tend to use VCTs as a supplement to pensions, especially for those high-earning clients who have been hit by the annual allowance taper. A key attraction is the stream of tax-free dividends (again, not guaranteed). Some VCTs have dividend reinvestment schemes that allow you to reinvest these dividends while claiming fresh tax relief on the reinvested amount.
Beyond this, many VCT investors like to feel that they are helping businesses grow. These businesses create jobs, spur economic growth across the UK and help us compete internationally by exporting products and services. Because VCTs inject new money into businesses (rather than simply trading their shares, as most funds do) they actually make a difference. It doesn’t end with the money either – VCT managers roll up their sleeves and get much more involved with the nitty gritty of each business than an ordinary fund manager would.
That very active involvement means that VCTs have higher costs than conventional equity funds: annual management charges of around 2% are common, plus a performance fee if certain hurdles are exceeded. Again, you can find and compare these charges on the AIC website.
The risks for Venture Capital Trusts
Investing in early-stage companies is a risky business: many fail altogether, others deliver multiples of the original investment. The portfolio approach of Venture Capital Trusts dampens down these risks quite a lot: each VCT offers access to dozens of companies. But they don’t eliminate it completely.
For example, if a severe downturn hits the UK economy, it is likely that many of the underlying businesses in VCTs’ portfolios will be affected. The last time this happened was in the financial crisis. Generalist VCTs, which invest in a mix of usually unquoted companies, lost 19% on a total return basis in 2008. AIM VCTs, which as their name suggests invest in companies quoted on the Alternative Investment Market, lost 48%.
VCTs’ performance in the pandemic was robust, because their portfolios were tilted towards the kind of tech-enabled businesses that did so well in 2020 and 2021. However, 2022 broke a 13-year run of positive annual returns for VCTs. Generalist VCTs lost 4% on a total return basis and AIM VCTs (which respond much faster to changes in sentiment) lost 28%.
The outlook
On the face of it, the outlook for Venture Capital Trusts in 2023 might appear cloudy. The consensus is that the UK is heading into a recession. Received wisdom suggests that small, fledgling companies might find it harder to survive than larger, more established concerns.
However, this isn’t necessarily true. VCT managers point to the fact that many of their portfolio companies provide important services to other businesses which earn them recurring revenues. It’s fair to say they are less bullish about the prospects for more consumer-facing companies, but many VCTs steer clear of these anyway.
More important perhaps is to take the long view. Valuations of early-stage companies have just fallen and may continue to fall into 2023, driven ultimately by interest rate rises. That’s why we saw a negative return for VCTs last year. But this also means that new investments are available at more attractive valuations – laying the groundwork for good returns over the next five years.
The vast majority of VCT managers have been around the block a few times. They have seen the financial crisis, for example. They also have the benefit of VCTs’ permanent capital structure, which means there is no pressure to try and offload investments in bad times. While VCTs are certainly not immune to a UK economic downturn, they look well placed to weather it in reasonably good shape.
