Venture capital trusts: overpriced or time to buy?
Jonathan Price, a lecturer in business law, has invested in venture capital trusts every year for the past 20 years and is deciding which to top up next.
“VCTs have been brilliant investments for me,” he says, explaining that he and his wife, who live in Herne Hill, south London, put in around £10,000 to their portfolio of VCTs during the annual funding season, which usually runs from the autumn to the end of the tax year. They now have investments with all the main VCT managers.
“I generally put in the minimum amount each time, investing in three a year, so I’ve built up quite a portfolio of regular income,” he says, adding that it gives him “the warm glow that comes from knowing I have helped UK plc by investing in early-stage companies”.
He’s not alone. Despite Britain’s dismal economic outlook, more than £440mn has been raised by venture capital trusts since the start of the tax year, putting them on track for one of the best years of funding on record.
Enthusiasm for VCTs is largely thanks to the tax perks. While the amount that can be invested into a pension with tax relief has collapsed in recent decades, VCT investors can claim income tax relief of 30 per cent up front to back young companies, providing they hold the shares for at least five years.
Most VCTs target dividend payments of around 5 per cent and these are shielded from dividend tax too, a design becoming all the more attractive as the tax-free dividend allowance will be slashed to £1,000 in 2023 and £500 from April 2024.
“For wealthier investors, VCTs are one of the last sensible tax efficient investments left” says Alex Davies, founder of specialist broker Wealth Club, adding that he would “certainly” be maximising his own VCT allowance this year.
While the tax perks are attractive and the returns on some have been strong, investors need to tread carefully, if at all. There are many factors that could trip returns — from overvalued holdings to limited liquidity to chunky fees and the difficulty small companies may face getting through the recession.
What’s the investment case?
VCTs have become a key source of funding for UK start-ups, currently managing £6.1bn through around 80 funds owning over 1,100 companies, according to Will Fraser-Allen, chair of the Venture Capital Trust Association. Popular brands owned by VCTs include vegetable delivery company Oddbox, jewellery brand Monica Vinader and luxury travel company Secret Escapes.
“Some elements of the press think [VCTs are a] tax break for the rich, but they are actually making money available for companies that wouldn’t exist otherwise,” says Philip Hare, a tax specialist at Philip Hare & Associates, which advises VCTs and other tax efficient vehicles for investors in start ups.
Of the offers that are currently open, Alex Davies, founder of broker WealthClub, points to the six Albion VCTs as an “all-weather portfolio”. The portfolio invests in around 70 companies across a broad spread of sectors.
He also describes the Pembroke VCT as one that is “coming of age” and has recently achieved some successful exits: fresh pasta delivery service Pasta Evangelists, then organic plant-powered drinks brand Plenish and most recently women’s fashion retailer ME+EM.
At £1.2bn of assets, Octopus Titan VCT is the largest and in Davies’s view “one of the most exciting” having made successful investments in online estate agency Zoopla, Depop, the vintage fashion brand, and pet insurer Many Pets.
Jason Hollands at broker Bestinvest suggests a further two: British Smaller Companies VCT, a relatively concentrated portfolio with “a strong tech bias”. And the Baronsmead VCTs, which were recently taken over by Gresham House and contain some managed buyout companies which have “exit potential”.
Despite a funding drought across swaths of private markets that has widened rapidly this year, managers of VCTs argue now is a good time to invest.
“The first two years of a recessionary cycle are often some of the best to invest in a business,” says Malcolm Ferguson, manager of Octopus Titan VCT.
He gives three reasons for this: companies have access to better talent as larger firms lay off staff, funding scarcity reduces the likelihood of a rival popping up giving companies more breathing space and incumbent companies are less likely to develop a competing product.
Over the past 10 years, the weighted average net asset value total return is 101 per cent for both Aim VCTs and generalist VCTs, according to data from the Association of Investment Companies.
But there is a long tail of poor performers. Of the 50 or so VCTs with a five-year record, nearly two-thirds have failed to deliver a net asset value total return of more than 30 per cent.
What’s the catch?
Recent falls in valuations of VCTs could present a buying opportunity. But some investors think there are further falls to come. One FT Money reader has been investing in VCTs every year for nine years, but decided not to this year because he doesn’t think valuations yet reflect what’s going on in the wider economy. “Better to wait until next year’s fundraising by which time the [value of the assets in the trust] should’ve adjusted and you won’t overpay,” says the reader.
According to data from the Association of Investment Companies, over 12 months to November 28 2022, the average net asset value total return was -29 per cent for Aim VCTs, which have the majority of their holdings in companies quoted on the Alternative Investment Market. The comparable figure for generalist VCTs was -4 per cent. While the pricing of quoted companies tends to be more volatile and swings with market sentiment, the discrepancy has prompted speculation that private companies have further writedowns to come.
Jason Hollands, managing director at broker Bestinvest, is cautious about the outlook for investing in young growth companies in the current recessionary environment as they “can have a voracious need for additional funding as they grow” and “investors cash will be used to feed hungry mouths in existing portfolios, not just deployed into new deals”.
But Oliver Bedford, manager of Hargreave Hale Aim VCT, adds that while it’s “clearly a difficult market”, recessions “tend to spawn innovation” creating opportunity for long-term investors.
The amount of money raised by VCTs may also be a bad omen for future returns. Ben Yearsley, investment director at Shore Financial Planning, is more cautious this year than in the past. He thinks VCT managers have “all been a bit greedy” and raised too much money in recent funding rounds, enabling entrepreneurs to “name their price” as venture capital trust managers compete under pressure to invest.
Others are put off by the fees. While some have lowered their annual management charge, they usually range from 2 per cent to 3.5 per cent, with transaction charges, performance fees and entry fees, which are often discounted by brokers, all paid on top. Roughly speaking, around two-thirds of the 30 per cent of tax relief could be eaten up by fees over five years, according to an FT-reading finance professional.
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Running a venture fund is more resource intensive than a fund of mainstream public equities, and investors should check a trust’s annual report for a breakdown of the fees and directors’ pay. While Yearsley says the fees are “what annoy me the most” about VCTs, Price says he doesn’t mind paying, as the managers earn their whack.
While VCTs are funds listed on the stock market, they are very thinly traded, so access to your money can be difficult if you want to make a redemption. VCTs will normally buy the shares back from you rather than you having to sell them on the exchange but at a discount to the net asset value.
According to HM Revenue & Customs’ statistics, 17,700 investors claimed income tax relief on VCTs in 2020, the latest year for which data is available. Dr Simon Hayley, senior lecturer in finance at Bayes Business School in London, observed: “These very large tax breaks still attract rather modest numbers of investors”.
How do VCTs work?
Venture capital trusts are companies listed on the London Stock Exchange which make money by investing in small UK companies. HM Revenue & Customs has strict criteria for VCT investments.
There are three types of VCT: generalist VCTs, which invest across a range of private companies, Aim VCTs, which mostly own companies listed on the Alternative Investment Market and specialist VCTs focusing on a sector, which are pretty rare.
At the point of investment, all companies within a VCT must:
Be small — usually with gross assets of £15mn or less and fewer than 250 full-time employees, rising to 500 for “knowledge intensive” companies such as technology and healthcare
Be young — usually under seven years old, rising to 12 for knowledge intensive companies
After a VCT raises money, at least 80 per cent must be invested within three years in “qualifying investments” meeting these criteria. Legislation has evolved over the years and since 2015 VCTs have had to focus new investments specifically on early-stage companies, increasing the risks involved.
VCTs are not the only tax efficient way to invest in start-ups. Enterprise Investment Schemes have even more generous tax breaks — including:
The ability to defer any taxable gains from the sale of other assets where the proceeds are used to invest in an EIS
Carry forward any losses, less the income tax relief received, against your income tax bill
Inheritance tax exemption if held for more than two years
But these involve individuals investing directly into companies, so past performance is hard to measure; they are deemed even higher risk than VCTs.
Who are VCTs suitable for?
Anyone over 18 and resident in the UK for tax purposes can invest in a VCT and claim tax relief. But experts recommend they are considered only by high earners who want to lower their income tax liability and already make use of mainstream individual savings account and pension allowances. Investors must be comfortable with the high risks involved, and willing to invest for at least five years.
While VCTs invest in growth companies, the tax and investment rules have turned them into distribution vehicles. This means tax-free dividends are the main form of investors’ returns, with managers paying out the proceeds of sales to shareholders as dividends and raising funds via new share issuances.
“VCTs can be a useful component of a tax-efficient income portfolio, but if you don’t need the cash, many VCTs provide dividend reinvestment plans where new shares are created each time, meaning you can claim additional 30 per cent income tax credits on these,” says Hollands.
But he stresses that VCTs are “not going to be suitable for most investors”, given their risk. Davies says when Wealth Club survey investors who buy VCTs through its platform, generally they will have at least £1mn of investable assets and invest around £35,000 a year into VCTs usually spread across three different funds.
Those hoping for a stable dividend income should note that payouts can be lumpy, and if managers struggle to sell holdings in difficult economic conditions then they will pay out less to shareholders. Data from Wealth Club showed that the average dividend yield was 7 per cent across VCTs in the year to the end of September, with a range of 0 to 17 per cent.
How should I pick one?
A retired investment banker from London who has been investing in VCTs for the past decade, says that a mistake he made when he started was to invest in new funds with exciting narratives.
Now he suggests: “only invest in VCTs with a proven track record”. He recommends investors track the management team carefully as there have been a number of takeovers among VCT managers. He has also found that top-up offers have tended to perform better than big fundraisings because “the big ones have to invest new money and it’s a risk”.
Unlike VCT investor Jonathan Price, he says he tends to invest in the same VCTs every year: Amati Aim, Albion Enterprise VCT and British Smaller Companies VCT.
While VCTs are listed on the stock market, in order to qualify for income tax relief you must invest in new fundraising offers. This puts investors at the mercy of what is available and popular funds can fill up quickly.
So far this year four VCTs have already filled up, with Octopus Aim VCTs closing their offer within 20 days. There are about 30 VCTs open to new funding, with seven due to open in the coming months.
While still niche, VCTs have become increasingly popular investment vehicles over the past 25 years even though the tax regime has tightened, pushing trusts into less predictable investments. As an FT Money reader says: “While attractive on a prima facie basis, I think VCTs are quite risky and expensive”.
The tax advantages were due to expire in 2025 through a 10-year “sunset clause” was introduced in 2015 after VCTs and EIS fell foul of EU state aid rules. But following Brexit, the UK government launched an inquiry into the venture capital market in April and said in September it intended to extend the schemes beyond 2025, with more detail to come.
Still, nobody should be tempted by tax perks alone. Even more than in past years, say wealth managers, savers should not invest more in VCTs than they can afford to lose.