Venture Capital Trusts (VCT)
Venture Capital Trusts (VCTs) were introduced by the Government in 1995 to encourage investors to support the growth of small UK businesses. A VCT is a company which is traded on the London stock market. It aims to make money by investing in other companies. A typical VCT may invest in 20 fledgling businesses identified by the VCT manager as offering good prospects for growth.
HMRC rules require that at least 70% of a VCTs assets are invested in 'qualifying holdings'. The main qualifying criteria are that the company must not have net assets of more than £15m and must have fewer than 250 employees.
There are a number of different types of VCT:
Generalist VCTs are the most common and the most popular with investors. They invest in a broad range of companies in different sectors and at different stages of development.
AIM VCTs invest predominantly in companies listed on AIM or those which are about to list on AIM.
Specialist VCTs tend to invest in just one sector, such as technology.
Limited Life VCTs are designed to be lower risk and lower return than other VCTs and aim to wind up and distribute assets to shareholder five to seven years after launch.
To offset the high levels of risk associated with investment in smaller companies of this type, generous tax breaks are available:
30% income tax relief for subscriptions in new VCT fund raisings
No Capital Gains Tax on disposal
A maximum of £200,000 may be invested in each tax year but the amount of tax relief is limited to the amount of income tax you actually pay. The shares must be held for a minimum period of 5 years or else the tax relief is repayable.
The majority of returns from a VCT are paid as tax-free dividends during the life of the VCT. Many VCT managers aim to generate yields in the region of 5% a year, which is equivalent to around 7% for a higher rate tax payer. Dividends may be reinvested and will qualify for further tax relief.
VCTs may pay special dividends to return value to investors when successful and profitable exits have been achieved from investments in their portfolio.
VCTs are an exciting investment proposition but they are inherently higher risk as smaller companies can be prone to failure. VCT shares are difficult to buy and sell. There are very few buyers and sellers of VCT shares in the secondary market and so liquidity is poor. This means that the price you can obtain often doesn't reflect the value of the underlying assets. The value of the shares will fluctuate, income is not guaranteed and you could get back less than you invest.
Shares must be held for five years or else the tax rebate must be repaid. The rebate is only available when you invest in a new issue of shares in a VCT or a top-up, not on any VCTs bought on the open market. VCTs bought on the secondary market count towards the £200,000 allowance for the tax year in which you buy them despite the fact you don't get the income tax break.
All tax treatments are subject to change and can be varied. If the VCT manager fails to meet the relevant investment rules the tax benefits could be withdrawn retrospectively.
VCTs are aimed at wealthier, sophisticated investors who can afford to take a long-term view. The prospectus of each VCT will give full details of the risks and should be read thoroughly before making an investment.
VCTs are high risk and difficult to sell which means they are only really suitable for investors who already have significant portfolios of more conventional investments. Investors must be prepared to accept the risk of losing money and be prepared to take a very long-term view.
The following factors should be considered when choosing a VCT:
How long has the manager been investing into smaller companies? Did the manager invest in private equity before they became a VCT manager? Is their due diligence process robust?
Does the manager focus on more mature, profitable companies or early-stage higher growth businesses?
Has the VCT manager displayed consistent returns against their peer group? In particular, what has the dividend stream been over recent years? The ability to pay out tax-free dividends is one of the most effective ways for VCT managers to return capital to shareholders.
How big is the VCT? Small VCTs can have a high level of fixed costs which will impact on the overall performance of the fund.
How is the shareholder going to be able to realise their investment in the VCT? Does the VCT manager employ an exit mechanism or, if not, do they buy back shares to minimise discounts?
If you sell your VCT shares in the first five years you will have to repay any tax relief you have received.
To realise their investment many investors wait for the VCT manager to offer to buy back their shares (a frequent occurrence) or simply wind up the VCT and return the capital as a final tax-free dividend.
It is possible to sell VCT shares on the secondary market but usually at a significant discount to the Net Asset Value (NAV) of the shares.
HDA conducts ongoing research in the VCT market and is able to offer advice and recommendations in this specialist area. For further information please get in touch.