Venture capital trusts (VCTs) make a huge contribution in providing funding to the UK’s SMEs and, since their introduction in 1995, over £8bn ($10.9bn, €9.6bn) has been provided to this critical part of our economy, writes Matt Currie, investment director at Seneca Partners.
Rule changes in 2018 shifted the emphasis to growth capital to help young aspiring companies create jobs, prosperity and boost economic growth in the UK.
There are three clear tax benefits which set VCTs apart as an asset type, however, it should always be remembered that VCTs are investments first and foremost and tax advantages should be a secondary consideration.
Ultimately, they are investments in smaller, growing companies and in that context, they do carry risk.
The favourable tax components reflect the risks that investors are taking.
What can investors expect their money to be invested in?
Ordinarily, an investors subscription will be invested in a portfolio of companies which may be a mixture of AIM quoted and private companies.
There are a wide range of different VCTs in the market, each specialising in different ways.
Some will be exclusively invested in AIM quoted companies, others will be exclusively invested in private companies, and some offer a mix of both.
Additionally, some VCTs have a sector or geographic bias.
Many seasoned VCT investors will spread their money across a mix of two or three VCTs seeking to blend a number of these features.
How long will investors’ money be tied up?
In order to benefit from all of the tax advantages, it is advisable to remain invested for a minimum of five years.
However, VCTs themselves are quoted investments with market prices that allow investors to sell if needed, although this may result in tax benefits being lost.
Notwithstanding specific reasons investors use VCTs as part of their tax planning, they can also be a valuable and complementary addition to an investor’s general portfolio.
They offer an exposure to small private-equity-type investments that investors might not ordinarily be able to access.
The opportunity for tax free growth and tax-free dividends is a rarity in investment terms and, therefore, may be more appealing than simply looking to the available initial income tax relief.
Many investors will immediately look to VCTs with a long track record, but covid-19 has changed the landscape significantly.
Apart from the damage inflicted on certain sectors, many established companies have needed to use financial planning and support measures introduced by the UK government.
These loans will eventually need to be repaid and some of the longer standing VCT managers may be raising funds this year to support existing portfolio companies.
Growth and dividend prospects for these companies could, therefore, be adversely impacted and so it may be worth looking to some of the smaller VCTs who haven’t got the same extent of legacy issues to deal with.
Following on from the above point, there is likely to be a degree of caution amon investors, but fundamentally the attractions of VCT investing remain sound.
It is often said that volatility creates opportunity as well as threats and this year may be a case in point.
Clearly, there are likely to be tough times ahead particularly for certain sectors but equally, there have been many businesses who have and will continue to benefit from the effects of the pandemic.
The newer VCTs or ones that are still holding cash for investment will be investing with the benefit of all this knowledge rather than having to manage existing investments through their problems. Knowledge might well be power in that respect.
Are VCT dividends likely to suffer as a result of the effects of covid?
Having got back to a point where companies were able to restore dividend payments, any lengthy omicron impact may well result in companies keeping cash to one side to help navigate any upcoming bumps in the road.
Essentially, dividends derive from having distributable reserves available and cash on account from which to pay them. If this cash is needed to support existing investments, then dividends could be affected.
It may even suit existing investors to see their portfolios supported in this manner, but this is far less likely to hold any appeal for new and incoming investors. The newer VCTs, perhaps with fewer legacy positions to deal with and ‘new’ cash to invest, may be better placed to drive better value investment deals.
Are VCTs at the higher end of the risk spectrum?
Tax reliefs are generally made available to compensate and encourage investors to support younger, growing businesses.
The fact that they are young makes them inherently riskier because many don’t have the overall financial or operational resilience at this point in their life cycles.
However, many of the most successful businesses went through the same life stage.
Investing early with the tax breaks available, while posing clear risks, also offers good growth potential. It is, therefore, necessary for investors to consider the depth and strengths of the VCT manager in the SME sector before they decide.
Questions asked before investing
Most VCT managers will have already set their investment strategies for the current tax year and are likely to be well into the due diligence stage with the companies they expect to invest in.
It is perfectly reasonable to obtain these details as basic pre-investment information.
It is also useful information to know details of the share buy-back policy of the VCT manager. Diversifying across a range of different VCT types is a common and sensible philosophy.
This article was written for International Adviser by Matt Currie, investment director at Seneca Partners.