Venture capital trusts for high earners

A Venture Capital Trust is a tax efficient, closed-end collective investment scheme which offers retail investors access to small unquoted, growth companies with generous tax reliefs to compensate for the higher risks involved. VCTs are listed on the London Stock Exchange.

To compensate for the higher risk and illiquid nature of investing in VCTs, they have major tax benefits:

Investors receive 30% tax relief on the amount invested up to a maximum of £200,000 each tax year.

All dividend payments are tax free AND Capital gains on encashment are also tax free after 5 years.

VCTs are rapidly becoming a popular investment choice for an increasing number of high net worth individuals due to the generous tax breaks. They offer an attractive alternative for high earners faced with pension restrictions. Tax relief on qualifying pension contributions is now severely restricted so the tax relief on VCT investments provide an attractive option. Also, people with pension funds that exceed the pension lifetime allowance (LTA), currently £1,055,000, are looking for alternative tax efficient ways in which to invest.

Consistent high demand for VCTs reflects the growing recognition of the benefits they provide. In the two decades since they were first introduced, VCTs have become increasingly popular and are now considered as a valuable tax efficient investment wrapper, with the potential to provide tax free income. Overall a total of £6billion has now been invested with a record amount of more than £700 million in the last tax year alone.

It is quite possible for an investor who invests say £50,000 a year, £35,000 after tax relief, into a VCT portfolio to, after a few years, be generating a tax-free income stream of over £20,000 a year based on current dividend yields. Grossed up at 40% for higher-rate taxpayers this is equivalent to an income of £33,000 per annum.

There are of course risks to investing in VCTs, one of the biggest being the fact that the recent change in VCT rules mean they must invest in the ambitious, innovative companies that are the backbone of the UK economy rather than “asset-backed” or “management buy-out” ones. Statistics show that approximately 2 out of 5 such companies fail but the ones that survive can grow to produce high returns for the VCT fund and for Investors. Vibrant small companies are the key to developing employment and the Government wish to encourage investment into this sector of the economy. A further risk is the lack of liquidity. It might be difficult to sell the VCT shares but as the market has matured, most VCT Managers now offer a share buy-back facility.

Some of the successful companies backed by VCTs include Fever Tree, the high-quality mixer drinks company; Zoopla, the property listings website; Secret Escapes, a travel members club; engineering company AB Dynamics and Lineup Systems, a multi-channel advertising and media software company. These investments all produced returns in excess of 500% for the VCT investors, more than compensating for the failures.

Despite political uncertainties, VCT managers have continued to find a host of opportunities. Of course, it is too early to understand the long-term impact of Brexit but usually the growth companies that attract VCT funding are global in their approach and opportunities are opening up in the US, Middle East and Asia.

What then has been the real returns on VCTs?

The Association of Investment Companies (AIC) gives performance figures for most VCTs and shows the overall share price total return from “Generalist” VCTs over the last ten years as 178%. However, some of the better VCTs have returned more than 200% over the same time frame. These figures grossly under-estimate the real returns achieved by investors because they ignore the tax reliefs and tax-free income/capital growth.

Historically, the VCT market has been considered high risk and has been fragmented but the market has now matured and “come of age”. VCT managers are more focused on the type of business they want to invest in and have gained more experience of operating in the small company space. Given the limited availability of tax relief on pension contributions, Clarion believe that VCTs will now begin to play an increasingly important part in our clients’ investment portfolios.

How then do we select the best VCTs in which to invest?

Extensive due diligence is essential. It is also important to focus on the client’s attitude to risk, investment objectives and time horizon.

A starting point is to look at the VCT managers’ track record by using the AIC web site. We don’t recommend any newcomers until they have proven their investment experience over more than 5 years, i.e. they have been through more than one investment cycle. There are plenty of established VCTs so why bother with new issues?

Secondly, we look at the management and overhead costs which can be very high in some VCTs. They usually have management performance fees that can be both very generous and impossible to comprehend due to complexity. We avoid those VCTs where performance fees are based on dividend payouts as dividends can sometimes be paid by VCTs even when there are losses being made on some of the Trust’s investments. In other words, some VCT managers can be paid a performance fee even though they are reporting overall losses.

Thirdly, we are wary of glowing prospectuses covering past performance written by VCT managers, particularly where the company has been subject to restructuring in the past or a limited time period is selected for the performance figures. Some VCTs seem able to raise more equity even though they have poor performance records simply because of recommendations by some IFAs and other promoters.

The easiest, safest way to invest in VCTs is undoubtably via Clarion who will help you to build a portfolio to match your risk profile, investment objectives and time horizon.