Why VCTS are trending at the moment
Nick Britton, head of Training at the Association of Investment Companies (AIC), looks at VCT demand and supply and how recent new rule changes may play out in the market
Venture Capital Trusts (VCTs) are enjoying a surge in demand created by a combination of factors.
Restrictive pension allowances and higher taxation of dividends have made the various tax reliefs they offer more sought-after by the likes of doctors, dentists, solicitors and business owners.
Meanwhile, the fact that VCTs now have a 21-year track of delivering attractive growth and tax-free income (yields average 9.5% as at 28 February) has helped financial advisers feel more comfortable with them.
Funds raised by VCTs in the current tax year totalled £322.9m until 14 March, 26% up on the same period of 2015/16. Most offers are already fully subscribed and as I write, there are only about half a dozen VCTs still seeking money.
But strong demand is not the only talking point in the VCT industry at the moment. The other is the impact of new rules about what companies VCTs can invest in. These rules were introduced by the Finance Act of 2015, so it may seem odd to call them ‘new’. But because of the way VCTs raise new funds to invest, the full effects of the rule changes won’t be felt for some years.
The 2015 rule changes, just like those of previous years, are intended to target tax relief more effectively at UK businesses that need funding to grow. They have ended any VCT investment in management buy-outs (MBOs) and imposed a new age limit of seven years on businesses that receive VCT funding. The latter rule was softened by some exceptions made for ‘knowledge-intensive companies’.
Though the VCT industry has weathered many rule changes over the years, these changes were particularly significant to some VCTs, which had built their strategy around doing MBOs (a kind of deal where the management of an established company is backed by a venture capital investor to grow the business). These VCTs are reviewing their strategies, hiring new people experienced in earlier-stage deals, and in many cases, taking a conservative approach to fundraising. This is one reason why so many fundraisings that were launched this tax year have already closed: a wave of demand has encountered constrained supply.
That said, the supply constraints this year have been much lessened by a £120m fundraising for Octopus Titan VCT, the largest VCT fundraising ever attempted, which has already closed fully subscribed. Octopus Titan VCT has always focused on early-stage deals, so the 2015 rule changes have had little effect on its strategy.
What to look out for
What does all this mean for advisers and their teams researching this area?
First of all, it’s important to keep your eyes open for new fundraisings being launched throughout the tax year, not just in the last couple of months of it. Otherwise your choice will be much reduced.
Second, be aware of the new rules. Taken together, the prohibition of MBOs and the seven-year limit have the effect of targeting VCT money at earlier-stage companies.
From the VCT investor’s perspective, the effect will be gradual rather than dramatic. After all, many VCTs invested in early-stage companies anyway, either exclusively or in part. Even for VCTs that focused wholly on MBOs, the change in portfolio composition is likely to be a slow burn. That’s because when VCTs ‘top up’ their cash levels by raising new funds, investors who participate in those top-up offers get a stake in the entire portfolio, including the MBO-style investments. It takes time for those old investments to be sold and replaced with new ones.
David Hall, managing director of YFM, which runs the British Smaller Companies VCTs, has said that one effect of the new rules may be to make the dividend stream from VCTs more lumpy in future. This is because earlier-stage companies are less predictable than MBO-stage businesses. But he doesn’t expect lower returns or lower payouts overall.
Planners may address this by including VCTs from several different managers in a portfolio, rather than stick to one provider’s products, Hall has suggested. This could help smooth returns and dividend payouts from year to year.
The VCT sector has generally adapted swiftly to rule changes in the past, and our impression is that managers are confident they will continue to find interesting opportunities for investment under the new regime. Admittedly, it may seem counter-intuitive that many VCTs have launched smaller fundraisings this year in the face of strong demand. But if it’s a sign that protecting performance records is being prioritised over growing funds under management, then that has to be a good thing for investors.
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