Annabel Brodie-Smith, Communications Director at the Association of Investment Companies, examines why VCT fund-raising has been so strong
It’s been a highly eventful time with the Brexit decision and political shenanigans dominating the news agenda (and everything else!) It will inevitably be a while before the dust settles and we understand the long-term implications of the referendum result.
Despite the market volatility in the first quarter of this year, the VCT sector raised £457.5 million in the 2015/2016 tax year – the third highest total on record. This compares to £429 million in the 2014/15 tax year, which itself was a strong year for fundraising and was the fifth highest on record.
So why was the 2015/16 tax year quite so strong for fund raising? Well the current chancellor’s pension revolution has had an important impact on demand for VCTs. First came the ‘freedoms’: Lamborghinis, the death of annuities, pensions as ATMs. Then, the turn of the screw: annual and lifetime allowances both cut, plus a tapering away of the annual allowance for high earners to as little as £10,000.
Top Earners
Though top earners are the most affected by all this, it’s surprisingly easy to reach the lifetime allowance over a career – pension savings of £418 a month over 40 years, at a growth rate of 7%, will see you hit the £1 million jackpot (or rather, HMRC hits the jackpot, because an investor becomes subject to tax of up to 55% on the excess).
One possible way to counter this is to use VCTs to supplement pension savings and this partly accounts for the recent popularity of VCTs. The tax benefits are comparable to pensions, with upfront income tax relief of 30% on new VCT shares provided they are held for five years. But the contribution limits are much more generous: up to £200,000 a year, and no lifetime limit. There’s also no tax on the way out: both dividends and capital growth are tax-free.
Of course, the risks of VCTs are clear: the companies they back are small and some will fail. But average VCT performance over the long term has been respectable, with a total return of 75% over the past 10 years, which excludes the 30% tax relief, and the average yield is 8.4%, largely generated from the profits VCTs make when they sell businesses. All this is very welcome at a time when the benefits of pensions are increasingly constrained.
Demand for VCTs
It’s thought-provoking to hear managers’ views on the demand for VCTs. Stuart Veale, Managing Partner of Beringea LLC and Manager of ProVen VCTs says: “Private investors are turning to VCTs in ever greater numbers, attracted by the sector’s strong historic performance, including regular tax-free income, enhanced by the initial 30% income tax relief.”
Paul Latham, Managing Director of Octopus Investments says: “Investors are increasingly using VCTs to complement their existing portfolios and to take advantage of the tax incentives available, which we believe is demonstrated by the 74% increase in £50,000+ VCT applications Octopus received in 2015 compared to 2013. This also seems to be an indication that the government’s recent efforts to address tax avoidance, has moved many investors towards government-approved schemes that are recognised as a vital source of funding to grow the UK economy.”
VCTs haven’t been immune from Treasury rule changes – in fact, there have been frequent alterations to the scheme since it was launched in 1995. In the Budget last year, the chancellor announced that VCT money could no longer be used to support companies that made their first commercial sale more than seven years ago – effectively limiting the scheme to young companies, although there were a number of exceptions to this rule.
Knowledge-based companies
The exceptions include a longer time period of up to 10 years which will apply for ‘knowledge-based’ companies. In addition, no time period will apply where the total amount invested represents more than 50% of the annual turnover (averaged over 5 years) of the investee business. Management buy-outs, or any other deals in which the control of a business changes, were also outlawed. The chancellor has also introduced a lower than expected lifetime investment limit, which will be £12 million rather than the £15 million previously announced. An exception will be made for investment in ‘knowledge-intensive’ companies, where the limit will remain at £20 million.
While any restrictions on what VCTs can do are unwelcome, it’s worth remembering that VCT managers are experienced in dealing with moving goalposts. In 2006, for example, there was a radical change in the size of companies VCTs could invest in, with the gross asset limit slashed from £15 million to £7 million and the maximum headcount of an investee company from 250 to 50. Concern was expressed, but VCTs still found worthwhile companies to invest in until the changes were reversed in 2012.
Some advisers’ clients may be interested to know that the money they invest in VCTs is used to grow UK businesses, especially if they have run and grown businesses themselves. The Association of Investment Companies estimates that the average company securing VCT investment has gone on to create 51 jobs and grow average turnover by £12.7 million comfortably returning HMRC’s ‘investment’ in the form of national insurance contributions, corporation tax and other business taxes.
Industry Survey
Looking in greater detail at the AIC’s latest VCT industry survey there are a number of economic benefits. The top sector for VCT investment was technology and IT, followed by business services, and manufacturing and engineering. Interestingly, the technology and IT companies that have received VCT investment boast a 212% increase in employment levels. The majority of VCT investment (55%) was invested outside London and the South East across the UK. While London continued to attract the largest share of VCT investment in 2014 (26%), it is particularly significant that Scotland received 20% of VCT investment in comparison to an average of 8% in previous years. The North of England also benefitted from an increase with 13% of investment, up from an average of 11% in previous years.
The survey also clearly highlights VCT’s ability to address the ‘finance gap’ affecting SMEs seeking funding between £250,000 and £5 million. The average size of the initial VCT investment in an SME is £2.32 million which rises with follow-on investments to an average of £3.01 million. The benefits of VCT investment are often immediate and analysis of SMEs that received initial investment in 2013 show that 77% of companies increased their turnover by an average of £1.5 million the following year. In Scotland alone there was an increase in turnover of 34% for investee companies. It’s interesting, post the referendum decision, that in 2014 39% of VCT investee companies generated turnover from exports. This figure is higher than the previous year and higher than the average for SMEs across the UK. Overseas markets accounted for 30% of the turnover of exporting investee companies.
The perception that VCTs deliver value for money is one reason they have survived several changes of government and rules since being launched by then Conservative chancellor Ken Clarke 21 years ago. Interestingly, the VCT scheme has even been studied by other EU nations, including France, as an example of how growing businesses can be supported by channelling tax relief.
VCTs an interesting vehicle
All of this makes VCTs an interesting vehicle to supplement a pension in these uncertain times and it’s not surprising that fund raising was so high this tax year in light of the pension changes. Both are long-term – pensions by definition, VCTs because of the nature of the asset class and the structure of the tax wrapper. VCTs are inherently risky – otherwise tax breaks wouldn’t be available – but experienced managers and diversified portfolios of companies go some way towards mitigating those risks.
