Despite the economy stumbling towards recession, turmoil in markets and geopolitical instability, the last financial year saw a record £1.1 billion invested in Venture Capital Trusts (VCTs) – a tax efficient investment vehicle that operates like a venture capital fund but with a much more accessible minimum buy-in level.
Investing in still private start-ups and usually young growth companies, VCTs are considered a risky investment. Yet their popularity among British investors has soared over a year markets have generally taken flight from risk, wiping trillions from the market capitalisation of listed growth stocks.
Why would investors sell out of already publicly listed growth companies en masse but put more money than ever into even riskier smaller growth companies?
It’s a good question and one we’ll try to answer here while also explaining exactly what VCTs are, how they work, their potential benefits and risk profile and listing some of the main options available.
What are VCTs?
Simply put, Venture Capital Trusts are London Stock Exchange (LST)-listed companies that invest in smaller, still-private companies expected to achieve high growth over the coming years. Because the UK government wants to encourage investment in prospective start-ups and smaller growth companies, VCTs benefit from a special tax regime.
Up to a ceiling of £200,000 a year, investors in VCTs can set their investment off against their income tax bill, returns and dividends are protected from income or capital gains tax.
These tax breaks are designed to offset the inherently risky nature of investing in start-ups and still relatively small growth companies. That risk profile is also why VCTs are generally only recommended for consideration by high net worth and sophisticated investors, rather than the average retail investor.
Like traditional private venture capital funds, VCTs usually set a capital raise target and close to new investors once that target, usually between £20 million and £50 million with an overallotment facility in case of especially high investor demand. The minimum investment to buy into a new VCT raising capital is usually somewhere around £3000, compared to at least hundreds of thousands if not millions to invest in a standard venture capital fund.
Once a VCT is closed, it is still possible for investors to buy into it by acquiring available shares in the company vehicle listed on the LST. That also allows for a smaller stake in a VCT For example, shares in the Octopus Titan VCT currently trade at 87.5p.
VCTs have a manager who decides which private growth companies it will make investments in and the trust’s capital is usually split between around 50 to 80 companies, diversifying risk. The presumption is many of these investments won’t provide a return but enough will for the overall portfolio to realise attractive returns for investors.
Different VCTs invest in different kinds of companies. Some might focus exclusively on a particular profile of company like tech or biotech, while others will have less defined restrictions and invest in a wider variety of kinds of high growth companies that meet more general criteria.
A VCT can invest up to 15% of its money in a single company. Each company is allowed to receive up to £5 million of VCT or other tax-efficient funding over any given twelve months, and companies can receive up to £12 million over their lifetime.
VCTs are also only allowed to invest in companies that are less than seven years old from the date of their first commercial sale. However, there are exceptions for ‘follow-on’ investments and where an established company is looking to raise a significant amount of capital to enter a new product or geographic market which means the criteria is practically quite flexible and most high growth companies of modest size will probably qualify.
How to invest in a VCT? The season for new investment is open
There are three ways to invest in a VCT:
- A brand new VCT about to launch
- An already established VCT with at least a year of history launching its annual new capital raise
- Secondhand shares in a VCT listed on the LSE
Entirely new and established VCTs raising new capital, as many do annually, usually open for new investment for a period that falls somewhere between November and January. To buy into a VCT raising capital, you will have to go through a VCT broker which include several of the major retail investment platforms including AJ Bell, Interactive Investor and Best Invest.
VCT tax breaks
While it would be unwise to invest in a VCT purely to take advantage of the tax incentives, there is no disputing they are attractive.
The tax relief the VCT investment benefit from are:
- Upfront income tax relief of 30% on investments of up to £200,000 in new VCT shares
- Tax-free dividends
- Tax-free capital growth
You must, however, own a VCT investment for at least 5 years to benefit from these tax breaks. If you were to sell a VCT investment before 5 years had passed, you would be obliged to reimburse any income tax relief claimed against the original investment.
Income tax relief is capped at £60,000 and you can only claim relief against your income tax bill for the financial year you make the investment. If you have only paid £40,000 in income tax that is all you will be able to claim relief for, even if you invest the full £200,000 allowance.
It should also be noted investments in secondhand VCT share bought over the stock market do not offer the same upfront income tax relief that is available with newly issued VCT shares. But they do still count towards your £200,000 tax-free limit for VCT shares per tax year. However, you will still be able to take advantage of any tax-free income and growth.
How risky are VCT investments? Is now a good time to invest?
Because VCTs invest in smaller growth companies it might be presumed the returns are likely to come in the form of capital growth. However, while risky, capital growth can be good. According to the research company Association of Investment Companies, the top 20 VCTs had all at least doubled investors’ money on a net asset value return basis over the previous 10 years, as of early 2022.
However, it is often advised that investors should see capital gains as a bonus and expect the majority of returns to be paid as tax-free dividends over the lifetime of the VCT.
VCTs generally target dividend yields of 5% a year but Morningstar data indicates the average is actually 3.9% and the range is a wide one. Because a 5% yield is tax free it actually translates to a 7% yield for higher band income tax payers.
The tax relief is also a big incentive and it can make sense to sell VCT holdings after 5 years if they are in a healthy place to take advantage of the 30% income tax relief again.
One downside to VCTs is that they usually come with initial charges that range from between 2.5% and 5.5% and expensive annual management fees.
The VCTs available at any given time and which open for investment each year vary. You should be able to find a full list with any VCT broker. The table below shows those that raised funds during the last VCT open season between late 2021 and early 2022.
|Product||Target dividend||Initial charge|
|Albion VCTs||5% of NAV||2.50%|
|Amati AIM VCT||5-6% of NAV||3%|
|Baronsmead VCTs||7% of NAV||4.50%|
|Blackfinch Spring VCT||5% from 2024||5.50%|
|Calculus VCT||4.5% of NAV||5%|
|Downing Four VCT (AIM, Healthcare & Ventures)||4% of NAV||4.50%|
|Foresight Enterprise VCT||5%||5.50%|
|Foresight Williams Technology Shares||5% from 2024||5.50%|
|Maven Income and Growth VCTs||5% of NAV||2.50%|
|Northern VCTs||4.5-5% of NAV||4.50%|
|Pembroke VCT||3p per share||5.50%|
|ProVen VCTs||5% of NAV||5.50%|
|Puma Alpha VCT||5p from 2023||3%|
|Puma VCT 13||4p – 6p||3%|
|Seneca Growth Capital VCT||3p per share||5.50%|
|Triple Point VCT 2011||5p per share||5.50%|
|Unicorn AIM VCT||N/A||5.50%|
If now is a good time to invest in VCTs is a difficult question with the global economy floundering. However, a look back at the last major international shock to financial markets in 2008 may provide some insight into what might happen this time around. The FT Advisor notes:
“While the inherent risks of investing in VCTs must be acknowledged, their access to researched, managed, and diversified portfolios of early-stage companies make them an attractive option for many investors.”
“By investing in pioneering companies that are at the forefront of innovation, VCTs can deliver attractive returns that are uncorrelated to the performance of the wider economy.”
“Moreover, previous global economic crises provide indicators that VCTs can support future recovery.”
“VCT activity resurged remarkably quickly after the 2008 financial crisis, with a fall from £230m in 2007-08 to £150m in 2008-9, swiftly followed by a jump to £340m in the following financial year. Activity has since continued on a general upward trend to this day, and this impressive record of resilience bodes well for investors.”
A tough economy brings risks for young companies but major financial crises have also historically been followed by a new generation of successful high growth start-ups making their breakthrough into the big leagues. The kinds of companies VCTs invest in are theoretically the best placed to be among those that rise from the ashes of an economic slump.
And VCTs are also a long term investment of at least 5 years which should allow for plenty of time for the economy to move back into a positive cycle.
VCTs are not for every investor but for those who can afford to allocate some of their capital to higher risk assets in the pursuit of higher rewards, they are worth considering. Especially because of the tax advantages for higher earners. And right now might not be as bad a time to invest in Britain’s most prospective young companies as it may seem at first glance.