Venture Capital Trusts (VCTs) are tax efficient, UK closed-ended collective investment schemes designed to provide capital for small expanding companies, and income in the form of dividend distributions and/or capital gains for investors.
They’ve been around since 1995, and today the Venture Capital market is worth around GBP7bn and have become an increasingly popular way for investors to gain access to early-stage companies, particularly in the technology sector, which has been growing rapidly in recent years. Overall, Venture Capital Trusts can be a good investment idea for investors who are comfortable with the risks involved and who are looking for tax-efficient ways to invest in early-stage companies.
Though there are many good reasons to think about investing in Venture Capital Trusts, the main draw for most people is the generous tax relief. The typical VCT investor will have maxed out their ISA and their pension allowances – much easier to do, for higher earners, since the annual allowance taper was introduced in the 2016/17 tax year.
VCTs offer 30% income tax relief upfront: so, if you invest GBP10,000, you get GBP3,000 off your income tax bill for that year. However, there are two important conditions: you must invest in new VCT shares (not buy existing ones through the stock market) and you must hold the VCT shares for five years. There’s also a GBP200,000 limit on how much you can invest in VCTs in a year and still receive tax relief.
In addition to the upfront tax relief, VCTs pay tax-free dividends. These can be quite chunky, with yields in the mid-single digits, because VCTs tend to pay out most of their capital profits as dividends. Any capital gains are tax-free too.
Apart from the tax relief, there are other important differences between VCTs and investment trusts. To begin with, VCTs need to follow a strict set of rules about what they can and can’t invest in. From HMRC’s perspective, these rules are designed to make sure that tax relief is going to worthy recipients: namely, UK companies that are too small and risky to get funding from other sources.
From the investor’s point of view, VCTs lock you in for at least five years if you want to keep the tax relief. In a way that’s academic, because if you don’t have at least five years to invest you probably shouldn’t be investing in early-stage companies anyway.
Probably more significant is the way you buy the shares and the way you sell.
As we’ve said before, you must buy new VCT shares to get all the tax reliefs. Most new Venture Capital Trust shares are ‘sold’ via financial advisers, but you can subscribe for them yourself via some investment platforms, through a service called WealthClub, and direct from some VCT managers. Pretty obviously, you can only subscribe for new shares in a VCT if that VCT has a share offer open. For the most sought-after VCTs, share offers fill very quickly, sometimes in days or even hours.
As mentioned, the average VCT has produced decent returns over time, though some Venture Capital Trusts have done better than others. The AIC website allows you to research the past performance, yields and dividend histories of all VCTs, always remembering of course that this is no guarantee of future performance.
Financial advisers tend to use VCTs as a supplement to pensions, especially for those high-earning clients who have been hit by the annual allowance taper. A key attraction is the stream of tax-free dividends (again, not guaranteed). Some VCTs have dividend reinvestment schemes that allow you to reinvest these dividends while claiming fresh tax relief on the reinvested amount.
Beyond this, many VCT investors like to feel that they are helping businesses grow. These businesses create jobs, spur economic growth across the UK and help us compete internationally by exporting products and services. Because VCTs inject new money into businesses (rather than simply trading their shares, as most funds do) they actually make a difference. It doesn’t end with the money either – VCT managers roll up their sleeves and get much more involved with the nitty gritty of each business than an ordinary fund manager would.
That very active involvement means that VCTs have higher costs than conventional equity funds: annual management charges of around 2% are common, plus a performance fee if certain hurdles are exceeded. Again, you can find and compare these charges on the AIC website.
Investing in early-stage companies is a risky business: many fail altogether, others deliver multiples of the original investment. The portfolio approach of Venture Capital Trusts dampens down these risks quite a lot: each VCT offers access to dozens of companies. But they don’t eliminate it completely.
For example, if a severe downturn hits the UK economy, it is likely that many of the underlying businesses in VCTs’ portfolios will be affected. The last time this happened was in the financial crisis. Generalist VCTs, which invest in a mix of usually unquoted companies, lost 19% on a total return basis in 2008. AIM VCTs, which as their name suggests invest in companies quoted on the Alternative Investment Market, lost 48%.
VCTs’ performance in the pandemic was robust, because their portfolios were tilted towards the kind of tech-enabled businesses that did so well in 2020 and 2021. However, 2022 broke a 13-year run of positive annual returns for VCTs. Generalist VCTs lost 4% on a total return basis and AIM VCTs (which respond much faster to changes in sentiment) lost 28%.
