Venture Capital Trusts (VCTs) are seeking a record £850 million of funding this year, with 15 open offers, six already closed and another three due to be launched. This is ahead of last year’s record fund raising of £728 million. It comes at a time when rule changes are pushing the sector towards smaller, higher risk businesses. Is there a danger of too much money chasing too few deals and this having a knock-on impact on long-term performance?
VCTs invest in earlier stage businesses. To encourage this, the government has put attractive tax incentives in place. For those investing in a new issue, there is income tax relief of 30% up to £200,000. This is given as a tax credit against total income tax liability, though the shares need to be held for at least five years to keep the relief. Any dividends from the VCTs are paid out tax free and there are no capital gains tax to pay either.
For investors in recent years, this has looked like a good deal. Not only have they garnered all the tax incentives, the trusts themselves have performed well. Of the 55 trusts with a five-year track record, just three have lost money, while six trusts have delivered returns of over 100%. Even over the last 12 months, a tough year for all types of asset class, VCTs have held up well. Just seven trusts fell more than the FTSE 100, which dropped 7% over the same period.
This benign combination of tax incentives and performance may come under pressure in the next few years. Jason Hollands, managing director of business development and communications at Tilney Bestinvest, says: “There have been a lot of changes in the sector over the last three years, all with a similar theme; restricting the type of deals and changing the risk profile. There are many people investing in VCTs every year who have done it for the tax-free dividends, following certain managers that have delivered well in the past. However, the types of deals VCTs do from here will be very different and there is a danger than dividends become more erratic.”
Rules Restrict Company Size and Deal Type
Those changes include restricting the size of the company: new VCT investments must now go into companies with fewer than 150 employees that have started trading within the past seven years. The new rules also restrict deal size and push VCT managers to get money to work faster. At the same time, VCT managers can no longer extend loans to smaller businesses and pay dividends from the interest payments – they must take an equity stake in the business. The aim is clear: if the government is to provide tax incentives, capital must be at risk.
This is not an immediate change. VCTs will have plenty of the older style companies in their portfolios for the time being, even if new capital is being pushing into the newer style capital. However, not all had the skills in place to deal with the change and some have had to go on a hiring spree. Hollands says investors need to consider whether a group’s track record reflects their current investment approach and whether they have the right team in place.
At the same time, if there is more money sloshing around the sector from greater fund-raising, there will inevitably be more VCTs chasing fewer good deals. This could be a problem for groups still adjusting to the changes, but puts others at a notable advantage. Alex Davies, founder and chief executive of Wealth Club points to the Octopus Titan and ProVen VCTs: “Having always focused on early-stage businesses, the Titan VCT hasn’t been affected by the new rules. Titan has, to date, been extremely successful at picking and nurturing tomorrow’s winners – from Zoopla, the first VCT-backed £1 billion company, to graze.com and Secret Escapes … Unlike the managers of many VCTs of the same vintage, the ProVen team haven’t had to do a strategy U-turn to adapt to new VCT rules. On the contrary, the new rules play to its strengths.”
In addition to these large generalist trusts, those specialising in certain areas or regions are likely to be able to sustain access to the right deals at the right price. Will Fraser-Allen, deputy managing partner at Albion Ventures, says that the group has focused on technology, particularly in healthcare, and this helps with deal flow. He says that the group’s trusts have become more diversified as a result of the changes, and they are also more likely to back companies progressively as they grow – drip-feeding funding every 18 months to two years. He believes that the increasing popularity of entrepreneurship is creating more opportunities, which is preventing any ‘funnel’ effect in deals.
While VCTs remain an option for investors who have exhausted other tax wrappers, such as Isas and pensions, the current climate may be causing investors to reappraise their risk appetite. Hollands believes that not all of the £850 million will be raised, with investment down 40% on the same time last year. This should prevent the worst of the bottle-necks. However, investors should be cautious who they invest with at a time when the rules are changing.
