The big squeeze: Should you consider VCTs as part of your retirement planning?
A total of £429m of new money was raised by Venture Capital Trust (VCTs) managers in 2014-15 – the fourth highest yearly figure ever.
Introduced back in 1995, these listed investment vehicles enable investors to access pooled funds of smaller, higher risk firms in a tax-efficient manner, while providing a crucial lifeline to fast-growing UK firms.
Paul Latham of Octopus Investments says he’s seen increasing numbers of people turning to VCTs over the past few years as part of their retirement planning. But why have they become more popular? And if you’re considering them, what should you bear in mind?
Why popularity is on the up
In addition to offering investors 30 per cent income tax relief on new share subscriptions, as well as tax-free dividends and capital gains, VCTs are an especially attractive option for those who can no longer put anything more into their pension – either because they risk breaching the £1m lifetime allowance, or because they earn more than £150,000 a year, so will be hit by the new “tapering” regime implemented this tax year, explains Jason Hollands of Tilney Bestinvest.
This will reduce the annual pension allowance from £40,000 to as little as £10,000 for those earning £210,000 or more. In contrast, you can invest up to £200,000 a year into VCTs, but you must hold your shares for five years in order to retain the tax relief.
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Moreover, an enduringly low-rate environment has meant that investors are increasingly on the hunt for tax-free income, says Michael Probin of Livingbridge. And Latham says that VCTs are also providing an alternative for “people who may have gone for more aggressive planning in the past, but have been scared off by tax avoidance claims”.
VCTs invest in small, unquoted, or Aim-listed UK firms, and fall into three broad sectors: generalist (which covers private equity), Aim-specific, and those that deal with specialist sectors, like tech or healthcare. While they might deal with riskier, early-stage firms, like all investment firms, they have boards of directors and strict rules for management teams.
The supply squeeze
Yet while VCTs are looking increasingly appetising, rule changes for the industry have shrunk the range of businesses that can receive investment from the vehicles. Most significantly, VCTs are no longer able to invest in firms that are more than seven years old; some transactions, like management buy-outs, are no longer permitted; and VCTs can’t put more than £12m into any one company.
There is also a list of excluded activities. From the beginning of the 2016-17 tax year, this included energy generation – a historically popular investment area for VCTs, because it’s frequently underpinned by government subsidy.
As Hollands puts it, this means that “future deals will be focused on development and growth capital”. Driven by EU state aid rules, Probin explains that the changes are primarily about the government refocusing VCT funds towards the target population of small, high-growth companies.
“We’re used to changes in this industry, and you can understand why the government wants to get value for money on every £1 of tax relief it’s given. In the past, there may well have been managers who tried to offer VCTs with lower risk profiles to investors. So investors would be getting the reliefs without taking the level of risk to match,” he says.
But there are some serious questions about what the consequences of the combination of heightened demand and restrictions on supply will be. “An impact of all this in my view is that, next year, there will be a demand/supply mismatch,” says Hollands. As investors look for alternatives, VCTs will raise more modest amounts of new money, reflecting a narrower opportunity set.
Latham explains that the “structural barrier to entry” that the new rules have imposed means there hasn’t been a new VCT to market recently. Moreover, a brand new vehicle might not be able to pay out a dividend for, say, three years, he points out – “that’s unattractive in a market where others are paying out dozens”.
Investor fallout
Probin says he doesn’t believe there is a significant supply/demand mismatch right now, but “some of the longer standing VCTs that would normally be raising funds haven’t been in the market”.
On the other hand, others have increased how much they’ve raised, which has given investors the opportunity to top-up existing VCTs. While those planning for retirement may well be content waiting a few years for a dividend to be realised, for those already in retirement, topping up means instant access to a mature, dividend-paying investment portfolio.
The important thing about VCTs, Probin says, is their medium to long-term nature. While this may make them a robust complement to your other retirement savings, it’s vital to appreciate the time lag.
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What is more, many VCTs look at firms that aren’t pro-cyclical and, because the minimum investment period is five years, “people should be looking at it as a 10-15 year investment at least. Whatever is happening now, therefore, may not have much of a bearing on your investment.”
One of the consequences of dealing with younger businesses is more erratic dividend payouts. But VCTs, unlike a conventional fund where yield reflects any underlying dividends, can distribute realised profits from exits as a tax-free dividend, explains Hollands.
This “translates capital returns within the portfolio into income for shareholders in a highly tax efficient manner,” he adds, making them a good option for supplementary income during retirement. The more early-stage the company, however, the longer it may take to realise an exit.
And because selling a business is not a particularly predictable journey, Probin explains that the managers of the Baronsmead VCTs, which are managed by Livingbridge, have, like others, taken the decision to smooth dividend payouts for shareholders after selling a business. i.e. two to three years of dividends are held in reserve after an exit, in order to deliver a consistent flow to investors.
While the structure of a VCT will invariably fall into one of the three groups described above, the investment strategies employed by managers will differ enormously.
It’s important, says Probin – particularly given the further constraints managers are now under – that, as an investor, “you look at the manager’s ability to find, invest in, manage and sell within the target population that now qualify as VCT investments”.
Still unusual
All of this should serve as a reminder that VCTs are still niche investments. While a good option for top-rate taxpayers approaching retirement, and “a good supplement to pensions, they should not be thought of as a replacement,” says Probin.
Of course, the range of investments can be wide – while some VCTs will concentrate on the more mature, Aim-listed firms, others will be specifically early-stage. The tax relief might be common to the vehicle, but the way investors’ money is used will invariably be different – “that’s what people have really got to look into,” Probin adds.
There are functional ways a VCT can mitigate risk. “Generalist and limited life VCTs [the latter aim to return the initial investment to the investor at the end of five years] typically invest through loan notes and preference shares, which sit higher up a company’s capital structure than ordinary shares,” explains Hollands.
Some VCTs focus on asset-backed deals, where a stipulation of their raising money for a business is that they will take legal charge of an asset, like a freehold property. “In the event that the investment sours, they will take ownership of the asset and sell it. That provides some downside protection,” he adds.
And, though listed on the London Stock Exchange, VCTs are fairly illiquid investments – there is hardly a secondary market at all. Hollands explains that this is owing to the fact that the 30 per cent income tax credit is only on new share subscriptions.
Moreover, if you sell the shares within five years, you’ll have to pay the taxman back. If your investment horizon is long-term, this needn’t be a big issue, but it does mean that “all VCT shares trade at discounts and, in the past, these could be quite deep. The good news is that pretty much all VCTs now have share buyback facilities in place,” Hollands adds.
However, compared to many mainstream investment funds, the costs of VCTs are high for investors. This is because of what it costs to run them. “Investment in unquoted companies requires considerable due diligence and negotiation, and then the VCT managers will often place directors on the boards to actively manage their investment and advise management teams on executing their business plan towards an eventual exit,” says Hollands.
Investors may also find they have to pay performance fees, with annual costs around 2-2.5 per cent. There are also often upfront costs which investors should be aware of, which involve the issuing of prospectuses and commissions, and can be up to 5.5 per cent.
Probin recommends that investors, particularly if they’re new to the VCT world, consult a financial adviser before doing anything. VCTs can generate tax-free monthly income, supplementing pensions, but “it’s really important that people know what they’re buying into. There’s nothing worse than realising a few years down the line that you didn’t understand something.”