Venture into exciting new areas in 2017 with VCTs

As governments cut back on tax breaks, investors are looking for new homes for their money. Venture capital trusts are an obvious option for the adventurous, says David Prosser.

Venture capital trusts (VCTs) are preparing for their day in the sun. With successive governments reining in the tax reliefs available to high earners on pension contributions and further reductions looking likely in the next tax year many wealthy savers are looking for alternative long-term, tax-efficient investment opportunities. VCTs, which offer a generous array of tax incentives to investors to put money into their portfolios of mostly unlisted companies, are an obvious port of call.

VCT tax reliefs can be highly attractive. If you buy new VCT shares during the 2016-17 tax year (rather than existing shares in VCTs traded on the secondary market), you'll be entitled to upfront income tax relief of 30% so a £10,000 investment costs only £7,000. This tax relief is yours to keep assuming you hold on to your shares for five years or more. In addition, any dividend payments the fund makes are tax-free, and profits when you sell are not subject to capital gains tax.

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These tax incentives reflect successive governments' desire to encourage investment in small, growing companies, which are inherently more risky than larger business. At least 70% of VCTs' assets must be invested in qualifying companies, with most funds backing unquoted businesses, though some also hold stocks listed on Aim, the London Stock Exchange's board for smaller companies.

However, there is a hitch. New rules introduced by the Treasury last year largely to comply with European Union regulation threaten to increase the risk profile of VCT investment over the medium to longer term. And in the short term, they may make it more difficult for VCT managers to offer new shares to investors.

That's because the definition of "qualifying" under new rules now presents something of a headache. Broadly speaking, VCTs are now required to invest in smaller and younger companies than in the past. To qualify as a potential VCT investment, a company must usually be no more than seven years old, have no more than 250 employees, and have assets of no more than £15m. The size and youth of these firms makes them riskier investments. There are slightly more relaxed rules for "knowledge-intensive" companies those that spend large sums on research and development but overall the risks attached to investing in a VCT portfolio are becoming more daunting than in the past.

Moreover, since VCT managers must invest 70% of money raised in qualifying companies within three years otherwise they endanger investors' tax breaks many are now scrambling to find opportunities to deploy the cash that has come in during recent issues. They've had to shift to looking at a slightly different group of potential investments and are likely to be taking more smaller stakes. The result is that for many VCT managers, raising new funds is less of a priority this tax year, because opportunities to invest are scarcer. The result may be a mismatch between how much investors want to put into VCT funds and how much capital the managers want to take. "While demand for VCT share issues will be buoyant this year given the pension tax relief changes, we anticipate there being less supply," says Jason Hollands, managing director of Tilney BestInvest, a wealth manager. "There have only been a handful of issues launched so far, though we're expecting a flurry in January."

The ten VCT issues that have been unveiled in 2016-17 are collectively seeking around £250m of investors' money (see table, below). By contrast, in last two tax years VCTs raised more than £400m of capital. Most of the fund-raisings announced so far this year are "C share" issues that is, existing VCTs looking for top-up investments, rather than brand new funds. They include Octopus Titan, which was one of the biggest VCT launches of 2015-16 and focuses on early-stage businesses that may take years to reach profitability, and Proven Growth & Income, another well-established fund, known for investing in retail and technology companies.

There are also two brand new funds, albeit from managers that run similar VCTs already. Triple Point Income VCT will focus on infrastructure-related businesses. Foresight Solar & Infrastructure has a similar tilt, but with a particular bias towards the solar energy sector.

This shortage of new VCT issues means that, while investors often leave VCT purchases until the end of the tax year, doing so could be a mistake, according to Ben Yearsley, managing director of Wealth Club, which specialises in advising investors on more risky products. "My advice is not to wait too long this time," he says. "With extra demand from pension investors and the effect of the recent rule changes, many of the big, well-known VCTs may only look to raise a small amount of new capital."

However, you shouldn't rush into VCTs simply to get a tax break. VCTs are substantially more risky than traditional pension investments, even if their diversification provides investors with some protection from the very high risk of individual VCT investments. What's more, if you need to access your money in the short to medium term, the lack of liquidity when selling VCT holdings on the secondary market could be a serious issue (demand is very limited since upfront tax relief is only available on new share purchases). Quoted market prices may bear little relation to what it is possible to sell VCT shares for, assuming that it is even possible to sell. And VCT charges are high, eating into returns (see below). All this means that VCTs are not suitable for many investors.

If you are planning to invest, keep in mind that the risks from C share issues will be lower than for new funds, at least for now. While money raised in both cases will have to be invested in assets that meet the new qualification rules, in a C share issue you're also getting exposure to an existing portfolio of holdings acquired under the previous rules.

Also think hard about the choice between generalist VCTs and limited-life vehicles. The latter aim to wind up as soon as possible after five years and the appeal of this is that they provide a clear exit route for investors. However, returns will still depend on the returns delivered by the underlying portfolio during that period. Similarly, a handful of VCTs invest in Aim shares, which may feel more comforting given the transparency of the value of listed securities. However, such businesses can be just as high-risk as unquoted companies.

Watch out for high charges

VCTs are expensive and high charges will reduce the returns investors earn. Octopus Titan VCT has initial and annual fees of 5.5% and 2% respectively and is by no means unusually costly charges of this magnitude are common in the sector. Buying through a broker should enable you to get a rebate of some or all of the upfront charge, but you'll still be subjected to those higher annual fees.VCT managers point out that investing in unquoted companies is a labour-intensive process, requiring extensive research, due diligence and ongoing engagement with the management of portfolio businesses.

There is some truth in that, but it's also the case that VCTs are one of the few areas of the financial services industry where the fund managers can still pay commissions to intermediaries in certain circumstances. What this means is that if you buy VCT shares on an execution-only basis through a broker or an online investment platform, you'll generally have to pay both upfront and ongoing commissions under a loophole in the regulation that outlaws such payments. VCT commissions are only banned if you buy through an adviser who gives you financial advice.

There's nothing to stop intermediaries handing back these commissions, but while most brokers refund the upfront fee, they still pocket the annual ongoing ("trail") payments. So check the details before you invest.