Investors have flocked to venture capital trusts in recent years because of the high returns and tax benefits, but there are strings attached.
(MorningStar) Private equity and venture capital were investment buzzwords in 2019, but venture capital trust (VCT) investors have understood the attractions of such holdings for many years.
A VCT is similar to an investment trust but has a few more rules attached – as well as some extra perks.
VCTs typically invest into early-stage, unlisted UK companies. The government wants to encourage investment into these firms – having previously called small and medium businesses the “lifeblood of the British economy”. To do this, it offers investors a chunky 30% tax relief on investments into these enterprises made through VCTs. That means if you invest £10,000, you can reduce your next tax bill by £3,000. Plus, any gains made or dividends received are also tax free. You can invest up to £200,000 a year into these vehicles.
Sounds appealing, right? But there are a few strings attached. Businesses eligible for investment into a VCT must have assets of £15 million or less, fewer than 250 employees, and be unlisted (or listed on the Alternative Investment Market, also known as Aim). Furthermore, to qualify for the tax benefit, investors must hold their shares in a VCT for a minimum of five years. It’s risky stuff and many of these businesses will fail.
But where they are successful, the rewards can be astronomical. The top performing Generalist VCT over the past 10 years is the Mobeus Income and Growth VCT (MIG), which has delivered 184% return over that period.
Meanwhile, the top performing Aim VCT over the past decade is Artemis VCT (AAM), which has returned a staggering 275%. Alex Davies, director at Wealth Club, adds: “These performance figures don’t take into account tax relief. When you include the tax relief, returns are considerably higher.”
What do VCTs Invest in?
Many of today’s household names started life as small, unlisted companies seeking investment from venture capitalists. The companies a VCTs invests in will vary according to its focus – some prefer technology or healthcare businesses, for example – but all will be small, private, early-stage businesses.
Historically, VCTs had access to wider pool of investments including more established and secure ones such as renewable energy projects and solar farms, and asset-backed investments such as pubs, care homes and wedding venues. But the rules have tightened up over the years to ensure investors are taking on enough risk to warrant the generous rewards on offer.
Many of the more established VCTs will still hold these assets (they can hold existing investments but just can’t make any new ones), which could help to reduce the risk in the portfolio. Downing ONE VCT, (DDV1) for example, has 14% of its portfolio in alternative energy, according to its half-year report.
Davies likes the £825 million Octopus Titan VCT (OTV2), which has previously invested in the likes of holiday website Secret Escapes and snack firm Graze. “From the start, this VCT has focused on early-stage companies, often in the technology sector, and has a track record of spotting rising stars and achieving high-profile exits,” says Davies. “If any VCT is going to find the next Facebook, it will be this one.”
He also likes Mobeus and Albion. These are long-established VCTs so offer exposure to the older assets which used to be allowed in VCTs such as renewable energy projects, as well as some companies which are at a later, more stable stage of their development.
How do I Invest?
Buying shares in a VCT is a little different to an investment trust where you buy and sell shares through a fund supermarket at any time. To get the tax relief on a VCT investment you must buy the shares when they are issued and from a specialist provider. Providers offering access to these vehicles include some fund supermarkets such as Bestinvest and Hargreaves Lansdown, and those purely focused on tax-efficient investments such as Wealth Club.
Many investors might be nervous at the thought of investing in VCT shares at issue, but this doesn’t mean there is no performance track record. Many of these trusts have been around for years and do a new funding round every year or so to raise money for new investments.
While it is possible to buy shares on the secondary market (i.e. from an investor in the trust rather than when the shares are issued) you won’t get the tax relief on the investment, so few people do this. That means it’s also harder to offload your shares to another investor, but most VCTs will buy back shares from you at a discount (usually around 5 or 10%) so investors should usually be able to sell if they need to. If you do this before five years, however, you will lose your tax relief.
It’s also important to consider the costs of investing – VCTs are more expensive than your average fund, with annual fees typically around 2 or 3% as well as an initial charge. These higher fees reflect the work involved in investing in very small companies – you can’t just read analyst notes on these businesses, manager have to meet them, do their own research and “kick the tyres”. VCT fund managers are also often very hands on and involved in growing businesses, rather than just an anonymous shareholder.
Who are VCTs Suitable for?
Typically, VCTs are more suitable to wealthier investors who have already maxed out their annual pension contribution and Isa allowances, and are looking for alternative places to invest where they can still enjoy tax benefits. Any investor considering a VCT needs to be comfortable investing for the long term, as if they access their money before five years they will lose their tax benefits.
The very nature of the businesses which are eligible for VCT investment makes this a choice only suitable for investors with an incredibly high-risk tolerance; many of these businesses will fail, which can make performance volatile.
As a result, VCTs remain quite a niche part of the investment landscape, with around £210 million invested in 2019. Davies adds: “That said, more and more people are turning to VCTs because the reduced pension annual and lifetime allowance along with the crackdown on buy-to-let and ever-increasing dividend tax, make VCTS one of the last decent tax-efficient investments left. Our youngest client investing in VCTs is 20 and the oldest 100. They invest an average of £36,525 a year.”
What are the Alternatives?
Investors looking to dip a toe into unlisted companies may want to start with a smaller companies or micro-cap investment trust, which has just a small proportion of assets in unquoted businesses. One example is the Marlborough Nano Growth fund, which has a four-star Morningstar rating. The £1.2 billion fund focuses on companies with a market capitalisation of £100 million or less, and current holdings include Zambian mining company Moxico and UK media group Future.
There are also a number of private Equity investment trusts, which focus on this part of the market but typically in more established businesses, which may help reduce the risk of failure, because they’re not beholden to the VCT rules about eligible companies.
Options include 3i Group (III), which has a five-star Morningstar rating. Among its top holdings are holiday firm Audley Travel, glasses and contact lens retailer Hans Anders, and European gym group Basic-Fit. The trust has delivered annualised returns of 16% over 10 years, but its success has made it a popular choice with investors and shares currently trade at a premium to their net asset value of 30%.