Invest in VCTs: tax-free investments set to break records
Demand for venture capital trusts is on track to set a new record this year. David Prosser reports
Investing in long-term growth should not feel like trying to bag a ticket for an Adele concert. But when asset manager Gresham House opened its three latest Mobeus venture capital trusts (VCTs) to applications from investors last month, the phones did not stop ringing. The three funds hit their fundraising target of £35m within 22 hours and then closed their doors.
Not all VCTs launched in recent months have seen quite so much demand, but the sector is certainly running hot. By the end of January, investors had already committed £710m to new VCT launches, ahead of the £685m raised over the whole of the 2020-2021 tax year. “VCTs are on track to raise record sums,” reckons Alex Davies, chief executive of Wealth Club, an investment platform specialising in VCTs and similar investments. It looks increasingly likely that by 5 April, the last day of the current tax year, the sector will have surpassed the £779m raised in 2005-2006, the all-time record, achieved at a time when the funds offered more generous tax reliefs than they do today.
VCTs are collective investment funds that have a mandate to build portfolios of stakes in small, early-stage businesses. These are typically companies that have yet to float on the stockmarket, though some funds own companies that are listed on Aim.
The rules on qualifying VCT investments that the funds can make are extremely strict. Usually, VCTs may only invest in businesses worth less than £15m and with fewer than 250 staff. These businesses must be less than seven years old and certain sectors of the economy are off-limits, notably most financial services.
The fact that VCTs spread their money across a number of companies goes some way to mitigate the risks of investing in small, early-stage firms like these. However, investors should be under no illusions: these are immature and fragile businesses with plenty of potential for failure. This, of course, is why the Treasury offers investors a range of tax benefits for committing their money. These include up-front income tax relief of 30% – so investing £10,000 costs only £7,000 – as well as tax-free dividends and capital gains.
VCTs are listed on the London Stock Exchange, but income tax relief is only available on new VCT shares. This is what underpins the annual VCT season: each year, VCT managers launch new funds, or new share issues from their existing vehicles, to attract investors looking for that 30% benefit. Investors must then keep their VCT shares for at least five years, or repay the up-front tax relief.
Entering the mainstream
Even with these generous incentives, VCTs were for many years considered a niche investment best suited to high net-worth investors who already owned extensive portfolios of more conventional assets. More recently, however, the sector has moved into the mainstream.
The biggest factor driving this shift has been the steady erosion of the tax benefits available to more wealthy savers planning their retirement. The annual allowance governing how much savers may contribute to a tax-efficient personal pension is now £40,000 – and this allowance reduces if you earn more than £200,000 a year. In addition, the lifetime allowance caps the amount that investors can build up in private pension savings, including investment growth, at a little over £1m. Above this threshold, which is due to stay frozen until at least 2025, punitive tax charges are payable once you start cashing in your savings.
By contrast, VCTs come with a £200,000 annual cap on contributions, and no limits at all on how much you may build up in total. For growing numbers of wealthier savers worried about pension contribution limits, the funds are now seen as a useful long-term financial planning tool.
Tax allowances frozen
“With personal tax allowances and the pension tax allowance frozen until April 2026, plus dividend tax increases coming in the new tax year, it is reasonable to expect demand for VCTs to remain buoyant,” explains Jason Hollands, managing director of the investment platform Bestinvest. “They are one of the few ways – alongside contributing to a pension – that you can give yourself a juicy income-tax cut.”
A second driver of VCTs’ popularity is the income many funds offer. While early-stage firms don’t generate much in the way of dividends, VCT managers have become adept at structuring their portfolios’ investments and realisations to generate a steady stream of income for shareholders, all of which is tax-free. In an era of ultra-low interest rates – and disappointing yields on other assets – that looks very attractive.
Not that VCT managers want their funds to be seen purely through the narrow prism of tax relief or income. There’s probably “never been a better time to invest in VCTs”, argues Ewan MacKinnon, a partner at Maven Capital Partners. “History teaches us that firms born of crises such as Covid-19 and the 2008 financial crash can be among the best businesses to back. VCTs give investors the opportunity to invest in innovative, fast-growing UK” small and medium-sized enterprises.
Jack Rose, head of retail sales at Triple Point, points out that the VCT market is now more than 25 years old and has matured and developed considerably over that time. “You now have a core group of managers who have demonstrated strong and clear... records of delivering investors returns through multiple market cycles.”
However, financial advisers have some concerns about the explosion of interest in VCTs. “It would be a mistake to say VCTs are suitable for most investors – they most certainly are not,” argues Hollands. “The tax perks of VCTs are there for a reason: VCTs are high risk and therefore the government needs to give people an incentive to invest in them.”
Moreover, success brings its own problems, warns Ben Yearsley, investment director at Shore Financial Planning. “The thing that concerns me most is that this weight of money, coming on top of some very good years for fundraising, will undoubtedly mean VCTs are having to overpay for companies,” he says. “There is a finite pool of good-quality businesses to invest in – and overpaying now means lower returns in the future.”
Certainly, VCT managers are now casting the net wider than in the past, though they argue this is a reflection of the maturation of the sector. In the early years of the funds, most VCTs were generalist in nature, investing in qualifying companies across a broad range of sectors. Those funds are still plentiful, but there are also a growing number of specialist VCTs that concentrate on particular areas of the market. Downing, for example, operates a VCT focused on healthcare businesses. In addition, a number of VCTs invest purely in qualifying Aim companies.
One interesting new arrival on the VCT market this year is Octopus Future Generations VCT, the first fund with a mandate built on sustainability. This is in line with the growing demand for investments tilted towards environmental, social and governance (ESG) criteria – and may represents a new growth opportunity for the sector. “Early-stage companies that can provide innovative solutions to address these issues could have the potential for attractive returns,” points out Wealth Club’s Alex Davies.
If the combination of ESG issues and VCT funding turns out to be sound, some of the businesses that the Octopus fund backs may eventually join the ranks of well-known companies that have already graduated from previous VCT classes. Household-name businesses that have grown with the benefit of VCT funding include estate agent Zoopla, travel business Secret Escapes, meal-kit retailer Gousto and Depop, the secondhand clothing platform.
However, investors need to bear in mind that for every high-profile success story emerging from the VCT sector, there are also plenty of failures that you hear less about. Tax relief may soften the blow, but it doesn’t mitigate the risk of those disappointments entirely. With that in mind, VCTs certainly have their place, but there is every reason for investors to approach with caution.