Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Find out about the funds which benefit from a 30% tax break
Experienced investors may be aware of an investment which benefits from a 30% boost straight off the bat. But for the uninitiated, welcome to the world of venture capital trusts (VCTs).
Venture capital trusts are funds that allow investors to claim up to 30% income tax relief on an investment of up to £200,000 a year.
You need to hold the investment for at least five years, but any dividends will be tax free and you will have a capital gains exemption on disposal.
Such funds are currently enjoying a boom in demand, with investors putting £731m into VCTs in 2018-19, the second highest amount on record.
And no wonder. As well as the 30% tax break, VCTs can be an ideal accompaniment to your portfolio. You get a wealth of tax benefits without the product needing to be held in an ISA, so you can use that wrapper to make other tax-efficient investments.
While it sounds great, it is important to note that VCTs are not for everyone and there is a higher price to be paid than for other investments.
Initial charges for VCTs are typically in the region of 4%, on top of an approximate 2% annual management charge and possibly other fees for administration costs, running costs and performance fees.
Arguably these costs reflect the complexity of the space and the need to make sure investments qualify for the relevant tax relief.
But for those who don’t mind risk and have time to lock their money away as it potentially grows, VCTs can be a useful option.
HOW DO THEY WORK?
You put money into a closed-ended fund which invests in more risky, early-stage companies and get tax benefits as a reward.
You can’t get your money back for five years, unless you pay back the tax relief. The idea is that you are helping Britain’s exciting, entrepreneurial businesses to grow.
‘VCTs have been around for decades with governments of all different flavours,’ says Paul Latham, managing director of Octopus Investments. ‘They are basically investment trusts but with extra bells and whistles.’
There are typically three types of VCTs – those that invest in companies not listed on the stock market, ones that invest in AIM-quoted stocks, and limited life VCTs, which have a goal of capital preservation.
The majority usually have a dividend yield of around 5%, which is considered by most VCTs managers as a sustainable payout, according to Amati Global Investors’ CEO Paul Jourdan.
‘We still pay 5% in the down years, and we still pay 5% in the good years,’ he says. ‘We recognise that many of our investors want that reliable income from our product, and we think 5% is a good dividend that’s sustainable across market cycles.’
One of the largest vehicles by assets is the £1bn Octopus Titan VCT (OTV2), which invests in unquoted early stage companies that may generate revenue but are probably not making a profit yet.
For those concerned about investing in risky companies, Latham says these risks are managed best in a VCT than any other investment vehicle.
‘We have an established and well-diversified portfolio,’ he says. ‘A few of those companies will fail, but they’re balanced out by the ones that do succeed.’
Among the success stories he picks out from the Titan VCT are well-known names like property site Zoopla and specialist travel play Secret Escapes.
Golden rules for buying and selling
You should buy VCTs direct from the fund manager or a specialist VCT broker during the offer periods to get all the tax benefits.
You can buy VCTs on the open market (also known as the secondary market) but you would lose the 30% income tax relief.
You will lose significant tax benefits by selling before five years is up, regardless of the type of VCT product originally purchased. Selling a VCT in this first five years should only be done as an action of ‘last resort’.
If you do sell before the first five years is up, you would need to tell the taxman HMRC and reimburse the relevant income tax relief amount.
NOT ALL VCTs ARE THE SAME
Not all VCTs invest in the same way. For example Amati AIM VCT (AMAT) invests in AIM-quoted stocks.
‘AIM is an easy way to value companies,’ says Jourdan. ‘If you’re investing in private companies, the pressure builds to find a trade buyer and make your exit, but for us, we can genuinely be long-term investors.’
Given most VCTs have been around for a long time – they were first introduced by the Conservatives through the Finance Act 1995 – they tend to invest for the long-term.
One of the Amati VCT’s most prominent investments, which it still holds, has been identity management firm GB Group (GBG:AIM), which the VCT backed in 2011 when it listed on AIM and now has a £1bn market value.
Jourdan says he looks for companies with a ‘very strong business proposition’, as well as management teams that have ‘the right skillset to succeed on AIM’, something that not all of them possess.
One other consideration VCT managers highlight when selecting businesses is not to be bamboozled by jazzy startups in niche areas. Promises of a complex, proprietary offering which could be the next big revolutionary thing that changes our world and makes you a fortune should be treated with care.
More often than not, those are the companies that will end up failing.
‘Medtech, fintech – if we don’t understand it, we don’t invest in it,’ says Andrew Wolfson, managing director of the Pembroke VCT (PEMV), which invests in the hospitality and consumer-facing brands often ignored by other VCTs.
‘That’s the easiest way to lose money,’ he adds. ‘It looks good, but you don’t really understand what it does.’
Pembroke’s portfolio includes companies such as the UK arm of American fast food chain Five Guys and a fashion label launched by model Alexa Chung.
WHAT ABOUT LIQUIDITY?
While there are a lot of success stories from VCTs, most of the companies in which they invest are still very small and so – particularly post-Woodford – there is a concern over liquidity, and whether investors may not be able to get their money back even if they did want to pay the penalty charge and redeem their investment early.
‘If everyone asked for all £1bn back, we wouldn’t be able to do that’, says Latham, ‘but that wouldn’t happen anyway, and there is activity within the VCT which means we can fund (redemptions).’
For those with the risk appetite to invest in VCTs, we now take a look at three products which are currently open to new investors.
The experts view.
‘VCT season is in full swing. While there is a lot of choice in the market, the most popular VCTs tend to close ahead of tax year end. As a result, we’ve seen inflows come earlier in the tax year, as investors don’t want to settle for their second choice.
‘The VCT sector continues to grow and we’ve seen an uptick in demand over the last few years, driven by further restrictions to pensions and buy-to-let. Investors have always looked for ways to supplement their retirement, especially tax-efficient ones that can complement their pension and ISAs.
‘VCTs offer a great way to do this, and since they invest in UK smaller companies it also adds an asset class investors wouldn’t normally have access to. However, the value of a VCT investment, and any income from it, can fall or rise and investors may not get back the amount invested. VCT shares can fall or rise in value more than other shares listed on the Main Market of the London Stock Exchange and may be harder to sell. Tax reliefs are dependent on a VCT maintaining its qualifying status and tax treatment depends on personal circumstances and is subject to change.’
Richard Barnes, VCT product manager at Octopus Investments
The UK’s largest VCT, Octopus Titan focuses on tech-enabled businesses with high growth potential and has a portfolio of around 67 early stage companies in a wide range of sectors.
As well as Zoopla and Secret Escapes, other success stories include SwiftKey and graze.com, and it has sold stakes in some of the start-ups it has backed to the likes of Amazon, Google, Microsoft and Twitter.
The VCT targets a dividend of 5p a year, and special dividends may also be paid if portfolio companies are sold at a significant profit.
It has delivered a 32.7% total return over the past five years.
Amati AIM VCT
The Amati AIM VCT has a portfolio of more mature, revenue-generating companies along with earlier-stage life science and software investments.
The VCT typically invests in stocks with a market cap above £50m, which Jourdan says is all about liquidity – ‘it’s an expression of confidence. If markets become anxious, investors might feel there’s not as much liquidity if they have a market cap below £50m.’
The fund has delivered 66.7% total return over five years.
Pembroke owner Oakley Capital is a well-established name in venture capital investing, meaning the investment team at Pembroke has a strong background in this area.
This VCT has a distinctive investment strategy, with investments focused on scalable consumer brands, ones which investors can walk down the high street and see.
Its lack of successful exits so far means the VCT, which launched more recently than most of its peers, has delivered a negative five year share price total return of 2.6%.
Its shares are trading a 26% discount to net asset value.