Join the flood of money heading in to Britain’s smaller companies

Regular readers will know that I am extremely irritated by some of the recent changes to the UK’s pension system.

The lifetime allowance, which means you pay extra tax on any part of your pension fund that grows beyond £1m, is stupid, and the taper on annual contributions is exactly the kind of thing that gives taxation policy a bad name (being complicated, badly thought though and therefore weirdly punitive).

But, as is the case with almost everything, these lousy policies have a silver lining.

Once they have £1m-odd socked away in a nice safe pension, the well-off now look for somewhere else to put their money. They can afford to take some risk, they fancy some tax relief and they are in it for the long term.

They are joined in their quest by one-time buy-to-let investors facing yield-crippling changes to their tax-relief regime. As it has gradually dawned on them that their best days are long behind them, they too are looking around for something outside a pension wrapper that suits their criteria (long term, tax efficient, income producing).

The result is a flood of money heading for the magnificently generous tax regime for investors in smaller companies in the UK. A pension offers you income-tax relief on pensions, relief on all returns inside the wrapper and inheritance-tax relief to your heirs on your death. That’s wonderful, but it isn’t as unique as it sounds: you can get remarkably similar benefits from sticking your cash into a venture capital trust (VCT).

These are investment companies that hold small, mostly unlisted, companies (with a value of under £15m). Buy in at launch and hold for at least five years and you will get 30% income-tax relief up front and your dividends and capital growth tax-free. You’re effectively getting a UK smaller-company growth fund with some substantial benefits on the side. That’s why, according to investor service Wealth Club, VCTs saw their strongest demand in a decade in the tax year to April, raising £542m.

This isn’t the only way our tax system now funnels the cash of the well-off into the smaller company sector. Our inheritance tax hysteria has helped here too. The UK’s Alternative Investment Market (Aim, where all our very small companies are listed) has worked well, even as similar smaller company exchanges in Europe have bombed.

The reason for this is all about tax, says Simon Rogerson of Octopus Investments (what isn’t?). A large number of Aim stocks are eligible for business property relief: hold them for two years and you get to pass them on to your children inheritance-tax free.

Imagine the planning possibilities in that. You are well off. You are happy to take largeish investment risks in exchange for tax breaks. You are soon to have an inheritance tax allowance of £1m. You have £1m in your pension. You leave it intact to pass on to your heirs – effectively as a modern version of the family trust –inheritance-tax free. Then, if you can find a good VCT manager you trust, you can put another pile of money into smaller companies (up to £200,000 a year) and live on the tax-free yield from those until you start to feel a little doddery. Then you can shift it into Aim stocks – hopefully two years before doddery turns to dead. Job done. And people wonder why IHT is so often referred to in the UK as voluntary.

I don’t approve of all of this. But I do approve of its side effect: a pretty hefty amount of capital knocking around looking for investment opportunities in smaller companies. Still, capital is useless if there is nowhere for it to go. This is where some good news comes in. Over the past decade the UK has finally got to grips with figuring out how to turn its amazing intellectual property (we are an ideas machine) into money.

The government has encouraged universities to think more commercially and spin out companies more effectively. They’ve also created a supportive atmosphere: the Financial Conduct Authority runs a “regulatory sandbox” system for financial disrupters, for example. Students have changed: they don’t want to be just academics or investment bankers any more. They want to be the magic mixture of both that makes an entrepreneur. All this is good for all of us.

There is always more to be done. It would be nice if our pension funds thought more in terms of long-term growth and less in terms of liability matching – that is, if they held less in the bond market and put more capital to work to help newish companies get real scale.

It would be good to see a few new companies headed for the FTSE 100. And as Mike Lynch, founder of Invoke Capital, told an audience at the Prosperity UK conference this week, the government might want to think of ways to cut down visa friction for very highly skilled immigrants to the UK: if there is any group we want to know that they are still 100% welcome here it is those that bring creative talent to our start-up sector.

These quibbles aside, the key points for investors are first that the UK is now good rather than bad at taking its ideas — its IP — and making money out of them. Second, it is getting easier for us investors to be part of that shift.

VCTs are a start. I’ve been very critical of them in the past. Returns are very, very far from guaranteed (that’s why you get the tax kicker) and too many managers reckon that you’re saving so much on the tax side you won’t notice their take verging on the outrageous. Fees have long been too high.

Still, we mustn’t tar everyone with the same brush, and Wealth Club is currently suggesting you look at the Pembroke VCT which is “one of the lowest cost”. Outside that, there are Enterprise Investment Scheme (EIS) investments (which I will look at another time – they come with even higher risk) and some really good investment trusts to look at.

Just coming to market is the Downing Strategic Micro Cap Investment Trust. It is planning to take what it calls an “influential strategic” stake in between 12 and 18 companies valued at under £150m private-equity style (this simply means they’ll be regularly bothering management with their ideas on strategy and so on).

The target return is 15% a year, which isn’t unreasonable over the long term, given that the Numis Micro Cap index has returned an average of 16% a year if you go back to 1955.

Another listed trust is the River & Mercantile UK Micro Cap fund. This one targets Aim-listed companies with a market cap of £100m or under. Neither of these are inheritance-tax avoidance vehicles and it’s worth noting that their shares will be illiquid. Buy them for the long term.

Otherwise, if you want exposure to the occasional unlisted firm but would like to think you could hold them beyond the micro-cap stage, there are Baillie Gifford’s Edinburgh Worldwide Investment Trust (disclosure: held by members of my family) and Scottish Mortgage Investment Trust (which I hold). Both can hold unlisted investments but have no limits on how big they can grow.

This article was first published in the Financial Times.