Since the introduction of Venture Capital Trusts (VCTs) in the 1990’s, the attitude to VCT investment has generally ranged from ‘a tax efficient way of losing money’ to an interesting but speculative investment. While this has certainly had some justification historically, I believe it now to be an unfortunate and inaccurate perception, and that quite conversely there is a strong argument for VCTs to form a part of mainstream financial planning.
Let us first consider the political background. It was the Conservative Government in the 1990’s who felt it appropriate to offer substantial tax benefits to private investors in the support of start-up and early-stage unquoted businesses – the UK’s acorns.
There is no doubt that there have been disappointments but, as evident by the Government’s determination to encourage such an initiative, some few years ago the qualifying conditions for a permissible investee company were relaxed, with an increase in the maximum number of employees from 50 to 250, and an increase in the amount of net assets from £7,000,000 to £15,000,000. These are not insubstantial businesses and an enterprise which has quickly gone from start-up to employing up to 250 people must be doing something right.
There are two potential rationales for VCTs but, in my view, both must be present to warrant investment. One is of course the enormous tax benefits; and the other, the fundamental investment potential. Taking the tax benefits first, no other investment provides substantial tax relief on the investment – a 30% income tax credit, irrespective of the tax rate of the investor; tax exemption on the gain; and tax-free dividends (all providing the investment is held for a minimum of five years).
However, perhaps even more interesting is the investment opportunity. Crudely speaking, VCT investments have two characteristics – they are small businesses, and they are privately owned. This screams out risk, and certainly illiquidity. But that is to assess VCTs from the perspective of fear and a more dispassionate assessment may conclude that the same two characteristics are reasons why VCTs may perform well.
In the world of investment, small really is beautiful. There is overwhelming evidence that, generally, over the long-term good quality small businesses outperform good quality large businesses, although there may be many exceptions. The reason for this is intuitively obvious – at one extreme, the world’s largest businesses find it very difficult to substantially grow their market share. They tend therefore to be cash cows with a key attraction being their dividends, not share price growth. Small businesses, particularly in such a fast-changing world, are often disruptors having developed new technology, products and services. They can grow their market share dramatically without the market barely noticing. And we are at a time of great change.
Now let us consider ownership. Qualifying VCT businesses must be privately owned – in other words, not listed on a public market. While that does make them illiquid, there is no reason whatsoever why that might adversely impinge on performance. To the contrary, it could be argued that being a public company puts short term pressures on its management which may adversely affect managements strategic decision making, placing the short-term interests of third-party shareholders above long-term potential. For this very reason, there has actually been a move away from becoming listed, with many businesses now giving up the public ownership in favour of private equity ownership. There are approximately twice as many companies owned by private equity than there are publicly owned ‘listed’ UK businesses. Over a 20-year period ending 30 June 2020, private equity produced average annual returns of over 10% per annum compound, outperforming even the S&P500 – but patient long-term investment is critical.
VCTs are in essence a form of private equity, obviously at the very early stage of a business’ development. But, given the enormous tax benefits, that may make it one of the most interesting times to invest, and a reason why a well-diversified portfolio of VCTs should form part of a diversified investment approach.
Nonetheless, picking the proverbial winner in early-stage businesses is far from straightforward. For this reason, diversification is critical. A VCT will typically own a few dozen companies. The success rate we look for is no more than one in three of those companies to be successfully realised (sold or listed) – typically on a five-year timescale. A successful exit means a realisation resulting in a return of two or more times the initial investment, implying an IRR of c20% per annum compound upwards. This compensates for the inevitable disappointments. However, that does not mean to say two out of three will fail – they simply may not trade successfully enough to be capable of being realised at these levels of return.
Counterintuitively, I have long promoted a VCT programme to my clients as a tax efficient income play, not a speculative growth gambit. Diversification does much to control investment risk, but obviously dilutes the return potential by spreading risk and dampening down volatility. Diversification does this effectively, providing a high probability that over the medium to longer term, the portfolios capital value will at least be maintained, and generally some growth.
The real benefit, having said all of the above, is the tax-free dividends. Again, it is counterintuitive to think of high dividends being derived from early-stage businesses. They usually have ferocious appetites for cash in developing their fast-growing business. While that is certainly the case, the reason why VCTs can pay attractive dividends is because the manager can retain cash from successful exits to support a dividend strategy. Again, diversification is key and generally the VCTs we deploy can boast strong dividend paying track records, with dividends varying from 3% to 7% per annum. A well-diversified portfolio will typically average tax-free dividends in excess of 5% per annum (although of course this is not guaranteed).
Due to the unfortunate perception that VCTs are high risk investments, they are very often only promoted to very wealthy individuals who are likely to be higher rate taxpayers. However, to a basic rate taxpayer a 5% tax-free dividend is the equivalent to an income return of 6.25%. Adjusting for the 30% income tax credit, the income return rises to nearly 9% per annum. The comparable figure for the higher rate taxpayer is circa 12% per annum.
Building a portfolio over a period of years to an agreed asset allocation improves the client’s post tax income each year through a combination of the 30% tax credit and growing dividend stream. Once complete, the portfolio is likely to generate an attractive, tax-free dividend income over the long term.
In summary, deploying VCTs to generate long term income creates a risk-controlled gambit capable of generating income at levels inconceivable from alternative initiatives.
This article has been produced for information purposes only. It is not intended to be an invitation to buy or act upon the comments made. All investment decisions should be taken with advice, given appropriate knowledge of the investor’s circumstances and one must satisfy certain investor criteria before being considered eligible to invest. Any forward-looking statements and forecasted returns represent the current views of Mattioli Woods plc and may be subject to change. Your capital may be at risk and past performance is not a guide to future returns. Mattioli Woods plc is authorised and regulated by the Financial Conduct Authority.