In this week’s blog, I look more closely at Venture Capital Trusts ‘VCTs’ – what are they, why might you consider investing in a VCT, who they’re suitable for and how you go about it.
But before delving any deeper, it’s important to note that ‘VCTs’ are high-risk products and not suitable for the majority of retail investors. They’re only appropriate for high net worth and/or sophisticated investors, and even then, only for a modest portion of investable assets (as a rule of thumb, I’d say no more than 20% of liquid assets).
What are they?
VCTs are similar to traditional investment trusts – listed companies, run by third-party fund managers, that invest in a range of underlying businesses.
The key difference is in the type of businesses they invest in – mostly small, unlisted, entrepreneurial companies, across a wide range of sectors.
VCT-qualifying companies
There are strict rules as to what a VCT can invest in. Within 3 years, the VCT must have 80% of its assets in companies that:
- Have a permanent establishment in the UK,
- Carry out a ‘qualifying trade’ (land dealing and financial activities are two notable exceptions),
- Have gross assets of £15m or less at the time of investment,
- Be less than 7 years old when they first receive VCT funding,
- Have fewer than 250 employees.
Note, the rules are more generous for so-called ‘knowledge-intensive’ companies (normally, those engaging in research and development) – they can have up to 500 employees; assets of up to £20m; and can receive VCT funding for up to 12 years.
In terms of portfolio size, most VCTs invest in around 30-40 underlying companies. However, the more established players (e.g. Albion, Octopus Titan, Baronsmead, Northern, etc.) hold significantly more, which provides additional diversification benefits.
And most VCTs will have a bias towards technology, often in ‘disruptive’ areas such as autonomous driving, AI, industrial automation, e-commerce, health tech, battery technology, etc.
Power investing on steroids
In a recent blog, I explored how the majority of stock market returns are driven by a surprisingly small number of underlying stocks. This is even more prevalent with VCT investment:
- Say you invest in a VCT that holds 50 underlying companies,
- Inevitably, a significant proportion of those companies, say 30-50%, will fail entirely, such is their nature (small, high growth, early stage),
- Some will do ‘ok’, perhaps returning 1.5-2.5x the initial investment,
- But the play is that a handful will do exceptionally well – ‘5 or even 10-baggers’. And these will drive the majority of overall VCT returns.
As an example, say you invest £50k in an evenly distributed portfolio of 50 companies (i.e. £1k in each). Over the subsequent five years, 25 of those companies fail, 20 return 2x (i.e. they double in value), 3 return 5x and 2 return 10x. By the end of the period, the portfolio would be worth £75,000, a 50% return or 8.4% annualised. That is despite half of the portfolio being worth nothing.
Please note, these figures are for illustrative purposes only and do not reflect actual investment returns, which can fluctuate and are not guaranteed.
Why invest?
To encourage investment in smaller companies, VCTs offer generous tax benefits:
- 30% tax relief on your initial investment, returned to you via rebate (upon submission of your tax return), assuming you have sufficient income tax liability to offset,
- Tax-free dividends (counterintuitively, the main source of VCT return on underlying company exits), and
- Tax-free capital gains, although in reality, most VCTs target a 5% pa dividend stream and a return of capital at the end.
Note here, tax relief is clawed back in the event of sale within 5 years – that is, except for some unforeseen liquidity event, any VCT investment should be kept for at least 5 years.
But it’s also important ‘not to let the tax tail wag the investment dog’. The investment case for VCTs is also a compelling one in my view, providing exposure to a diversified portfolio of mainly tech-focussed, small, high-growth, UK entrepreneurial businesses.
Who might consider VCT investment?
i. ‘Alternative retirement pot’ for high earners
The most common scenario is a very high earner, many years away from retirement.
I’d always prioritise pension and ISA contribution (potentially a modest GIA investment and/or debt repayment too), but for those with sufficient surplus cash remaining, I think there’s a good case for VCT investment.
This is particularly true for those who are restricted in pension contribution due to the tapered annual allowance – anyone earning above £360k for example is restricted to contributing ‘just’ £10k to their pension each year. Repeat VCT investment over several years can be used to build up an ‘alternative retirement pot’ and provide a source of tax-free dividend income to supplement spending needs in retirement.
ii. Tax-efficient cash extraction from limited companies
Another area is as a means of tax-efficient cash extraction from limited companies. The play here would be for the company director(s) to take substantial dividends out of the business, triggering a sizeable tax charge (33.75% higher rate or 39.35% additional). The proceeds would then be redirected into a new VCT investment and the resultant 30% tax relief would then offset most of the original liability on the dividends.
Five years later, the VCTs can be sold and the cash is ‘in your back pocket’, albeit with a fair amount of investment risk during the interim period.
iii. VCT recycling
The other key aspect of VCT investment is the ability to ‘recycle’ positions every 5 years to benefit from additional rounds of tax relief – this warrants a separate blog of its own.
How to invest?
Income tax relief is only available on new VCT shares purchased directly from the VCT manager, not purchases on the secondary market.
The process is relatively straightforward. Most VCT managers issue new shares once a year, normally between November and April. You buy shares directly from the VCT manager and will subsequently receive a share certificate (which you’ll need to keep safe as this will be required when selling the shares) and an income tax certificate (to claim your 30% tax relief).
Risks and disadvantages
As with any investment, you could lose money. However, the investment risks are much greater with VCTs than with other stock market investments because they invest in small companies, which are much more volatile than their larger counterparts.
For this reason, VCTs should be viewed as a long-term investment and are only suitable for experienced investors who have no need for immediate liquidity and can withstand a potential total loss.
Below is a summary of the main risks and disadvantages associated with VCT investment:
- Investing in early-stage companies is unpredictable and only suitable for investors who are comfortable with high risk.
- Investments could fall in value, potentially to zero, and investors may not get back what they invest.
- Tax relief isn’t guaranteed. Tax reliefs, tax rates, and tax allowances are based on current legislation. Tax rules could change in the future.
- Tax treatment depends on an investor’s circumstances. And tax reliefs depend on a VCT maintaining its qualifying status.
- VCTs are less liquid than stocks listed on the main market of the London Stock Exchange and can therefore be harder to sell.
- VCTs are long-term investments. Investors must hold VCT shares for at least five years to benefit from tax relief (if shares are sold before then, any upfront income tax relief that has been claimed must be repaid).
Conclusion
VCTs provide exposure to the ‘companies of tomorrow’, typically focussing in areas such as AI, autonomous driving, machine learning, DeepTech, HealthTech, etc. To encourage investment in such companies, they carry significant tax benefits, most notably, 30% upfront tax relief and tax-free dividends.
However, due to the nature of the underlying businesses (small and new), they also come with significant investment risks and are therefore only suitable for sophisticated or high-net-worth investors, and even then, only for a modest portion of liquid capital.
If you’d like to know more, please let me know.
When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance are a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
The Financial Conduct Authority does not regulate tax advice. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts and their value depends on the individual circumstances of each investor.
