Will Fraser-Allen, deputy managing partner at Albion Ventures, discusses the “need to know” elements of Venture Capital Trusts.

Will Fraser-Allen, deputy managing partner at Albion Ventures, discusses the “need to know” elements of Venture Capital Trusts.

Venture Capital Trusts have become an established feature in the UK’s investment landscape since they were introduced by the then Chancellor of the Exchequer Ken Clarke in 1995. They are particularly suitable for high net worth investors owing to their tax efficiency and proven ability to deliver regular income. VCTs have also enjoyed the support of successive governments because they provide valuable funding to smaller companies and generate a welcome fillip to the economy.

A VCT is an investment company listed on the London Stock Exchange. VCTs are normally managed by specialist investment managers under the governance of an independent board of directors. As of the 2012 Budget, VCTs can now invest in aggregate up to £5 million in individual companies with assets worth up to £15 million (around $23 million) and a maximum number of 250 employees, increasing their relevance as a source of much needed finance for UK SMEs.

Unlike most other funds, managers of VCTs play an advisory role to the investee companies, helping to increase their value with a view to crystallising gains via exits after a number of years. Any profit is paid out to the VCT as a tax-free lump sum and the capital can be reinvested.

Investing in companies at an earlier stage of their development means the risks are higher, but this also makes the potential returns much greater. It is important that investors in VCTs are happy to take a longer-term view.

Ten key points

So what are the ten key things a high net worth investor should know about VCTs?

1. The taxman will rebate 30 per cent of the initial investment into a VCT to UK taxpayers. This means an investment of £100,000 will cost just £70,000, provided the investor is liable to at least £30,000 of UK tax.

2. All dividends paid out by a VCT are tax-free and do not have to be included in your tax return. This makes them worth considerably more than their face value to HNW individuals. A tax free income of £60,000, for example, is equivalent to a taxable income of £120,000 to a 50 per cent taxpayer and £109,091 when the rate reduces to 45 per cent next April.

3: Any eventual sale of VCT shares is free from capital gains tax. The shares must be held for a minimum of five years to benefit from income tax relief.

4: Some VCTs, including those managed by Albion, offer dividend reinvestment schemes, enabling investors to compound their income further.  The scheme works by reinvesting dividends in the form of new shares, allowing investors to benefit from a further 30 per cent tax relief on the value of the dividend received and, with regular investment, the potential to compound capital growth.

5: The performance of VCTs has been sound even before the income tax relief is taken into account. The best VCTs launched in the 1990s have returned 6-7 per cent per annum, comfortably above the FTSE 100 return over the same period, while even the worst have not done as disastrously as so many of the banks and property companies. 

6: VCTs have been very successful at generating income. This makes them stand out in the current investing environment, in which many investors have turned to income rather than capital gains to secure returns.  For example, Albion targets a 5 per cent tax free yield, equivalent to 7 per cent on net cost after income tax relief of 30 per cent and has paid a dividend every year since its first VCT was founded 14 years ago.

7: As income generators, VCTs are excellent retirement vehicles. This is especially true for high net worth investors who may have invested in their pension schemes to the allowable limit or who are looking for alternative, longer-term investments to provide tax-free income in retirement. Prior to retirement, investors can compound their returns by reinvesting their dividends as detailed above.

8: VCTs offer a good choice of investments and diversification, particularly in the "hard to access" unquoted sector. For example, “generalist” VCTs invest in a range of companies and sectors, while some others specialise in the Alternative Investment Market or specific sectors such as technology or healthcare.

9: VCTs help economic growth through innovation and job creation. Venture capital, including that provided by VCTs, is both a supplement to, and a replacement for, bank lending at a time when the government faces an uphill task in persuading the banks to increase lending to SMEs. A recent report by the Association of Investment Companies notes that of a sample of 220 VCT-backed companies employing 15,000 people, employment was growing at an average of 16 per cent per annum. This in turn means that HM Treasury’s annual tax take generated by these companies, including PAYE, actually exceeds the initial income tax relief given on the value of the initial amount invested.

10: Generalist VCTs have rarity value in that they are “evergreen”: they reinvest the proceeds of the sale of their investments rather than return the capital to their shareholders. This means that they can take a much longer-term view of investment because their funders are not looking for an early cash return.

There is little doubt, in the present climate, about the attractiveness of VCTs to HNW investors seeking income and the prospect of capital growth.  However, investors should be comfortable with the risks of investing in small companies and be aware of the need to take a long-term view.