VCTs: Exploring unique investments while saving on your taxes

Once considered a niche investment option, Venture Capital Trusts (VCTs) have seen a boom in demand over recent years, raising a total of £619m during the 2019-20 tax year, the third highest amount since 2006. Investors are attracted to these vehicles by the lucrative tax breaks and the innovative areas they invest in, but they don’t come without caveats.

Tillit spoke to Ben Yearsley, co-founder of Fairview Investing, with decades of experience in the VCT market to gain an insight into what they are, the history and the pros and cons.

VCTs are a type of investment trust that invest in high-growth, early-stage companies. Because of the nature of the investments VCTs carry higher risk than other, more mainstream, investment trusts or open-ended funds. To compensate for this VCTs come with generous tax breaks for investors as a way to limit the downside risk. But have they worked?

A bit of history

Originally set up by the UK government in 1995, VCTs aimed to support early-stage businesses that were too small to get on the radar of institutional investors. The first VCT was the Murray VCT, followed shortly by Northern Venture Trust and Baronsmead VCT. By 1995/6 there were ten VCTs on the market and this number has now grown to over 70 today. Most of the first wave of VCTs have now been closed or restructured, but Northern Venture Trust is still going strong and has delivered a total return (after fees) of 146% over the last 10 years (to 12 February 2021), according to FE fundinfo.

Apart from supporting young businesses, VCTs were designed to give retail investors easy access to early-stage growth companies without having to invest directly in individual companies, as with traditional angel investing. However, in the course of the first decade of VCTs being in existence, there was a gradual move away from the original objectives. By 2004/5 many VCTs were in fact investing in lower risk areas such as real estate and a few years later, the introduction of feed-in tariffs for solar panels in 2010 pushed many VCTs to invest in solar energy. As such, these vehicles had gone from being used to support young, high-risk businesses compensated for by attractive tax rebates, to simply being lucrative tax-saving vehicles. Needless to say, this was not the purpose.

To combat this and to bring the VCTs back to their original purpose, in 2015 the government introduced a number of legislative changes. These included a ban on backing businesses that are more than seven years old (or ten years if they are “knowledge-intensive” companies) and preventing capital from being used for acquisition of existing businesses. These changes forced a lot of VCTs to change their strategy and resulted in the risk profile of VCTs rising again.

Something else that changed was the life span of these funds. Whilst most of the lower-risk VCTs were limited-life vehicles of six to seven years, VCTs today tend to be “evergreen”. Evergreen is a permanent capital structure without an end-date, meaning the VCT can keep raising new capital for the fund to invest. This is great news for investors as it offers them flexibility to invest or divest from the VCT whenever they want, which is not necessarily the case with a limited life vehicle.

Today’s market

The VCT market today counts 76 products with total assets of £5.1bn as of 31 December 2020, according to data from the AIC and Morningstar. The manager with the largest market share is Octopus Investments, which runs 27% (£1.4bn) of total VCT assets, according to AIC. This includes the largest VCT in the market, Octopus Titan, which invests in tech-enabled businesses with high growth potential.

Gresham House Asset Management and Albion Capital are the next largest players, but with significantly lower assets compared to Octopus. The best performing VCT over the last decade (up to 31 January 2021), with a total return of 350% over the period according to data from AIC, is Mobeus Income & Growth 2 VCT.

Key benefits

One of the big advantages of VCTs is that they tend to invest in unique assets, so they can be a useful tool to increase portfolio diversification. They also tend to naturally gravitate towards innovation sectors such as technology and biotech. In fact, recent research from the AIC shows that the majority (80%) of VCT managers are investing in areas that have been helping to fight the COVID-19 crisis and as a result VCT performance has been resilient throughout the pandemic. The average VCT delivered a positive total return of 4% in 2020, while the FTSE All-Share index suffered a 10% loss.

The second key benefit is the favourable tax break. Investors can claim back up to 30% of their VCT investment amount in a given tax year against their income tax, up to the total value of income tax payable. The maximum amount you can invest in VCTs in the 2020/21 tax year is £200,000, which means you could save as much as £60,000 on your income tax (depending on your personal tax circumstances).

To top it off, you don’t pay capital gains tax or tax on dividends, nor is there a need to declare VCT dividends on your tax return. So essentially, VCTs offer tax-free dividends and tax-free growth, though Yearsley points out that VCT share prices in general tend to be flat, so the dividends can be the real win. Of course, bear in mind that tax treatment depends on your individual circumstances and may be subject to change in the future.

Key risks

So, what’s the catch? Well, there is no reward without risk and the rule changes from five years ago mean the risk of investing in VCTs is now higher than before. In addition, many VCT portfolios are relatively concentrated (20-40 companies), which can create additional risk.

The stricter rules also mean it is now harder for VCTs to smooth out dividend payment. While in the past, a dividend of 8%-9% was not unusual, today VCTs target a dividend of 5% plus special dividends.

VCTs also carry much higher costs than other types of investment trusts, with 3-4% per annum not out of the ordinary, according to AIC data. This can be multiples higher than other investment trusts and is partly explained by labour intensity and performance fees. As a result, Yearsley notes that returns tend to be muted compared to what you might expect from early-stage businesses. According to Yearsley, investors might see annual returns in the region of high single digits, but combined with the dividends and tax breaks, this may well be worth it for some investors.

VCTs are not for everyone, and they should be considered in the broader context of your own personal tax situation, risk tolerance, and time horizon. But they could be an exciting investment option for investors looking to explore ways to invest in unlisted assets and long-term growth areas such as technology and healthcare. The fees are undeniably high compared to many other investment trusts, but the tax breaks on offer can soften the blow, or perhaps even make it worth your while.

Date of publication: 17th February 2021