VCTs are shedding their reputation as a high-risk, speculative investment and advisers need to ensure they are looking at this asset class for their clients
VCTs have ‘come of age’ and are not only providing value for money for taxpayers but attractive investment returns.
VCTs were introduced in 1995 by John Major’s Conservative government, and under the direction of then Chancellor Kenneth Clarke, and in that time there has been myriad changes to the rules and investor reaction to this type of investment. Although the reputation of VCTs has improved, there is still some scepticism in some quarters.
David Golding, an independent financial adviser at Charterhall Associates in Essex, says there are some advisers that will not recommend VCTs.
“Although [the investment sector has] got better, there is good and bad, and there have been a lot of bad investments in the past,” he says.
While it may have taken a long time for VCTs to hit the mainstream and shake off a reputation that has seen many deem the investments as too high risk, John Glencross, Chief Executive and Founder of VCT and EIS provider Calculus Capital, says they have come into their own.
“VCTs [were] introduced almost 25 years ago [and] have come of age as an investment class,” he says.
“There are some sensible investment managers managing VCTs. It’s true to say that there has been change since they were introduced, and very significant changes in 2015 and in the last 2017 Budget. However, the leading VCTs have shown a capacity to adapt to changing legislation when it happens.”
Glencross says that pre-2015 most VCTs were invested in “management buyouts (MBOs) and management buy-ins (MBIs)”, and “financial engineering was a large element of the returns – there was a large debt element built in”.
However, the 2015 Budget ended VCT’s ability to do MBOs and MBIs, which Glencross says was “a large change for [the VCT industry] to work through”.
“[VCTs] investment teams were more familiar with MBOs than growth investing, there are different skills [involved],” he says.
There were more significant changes to come in the 2017 Budget due to concerns about whether VCTs and EIS, which are given generous tax breaks to help drive the UK economy were actually investing in and supporting growth companies.
“There was growing unhappiness in the Treasury with what they felt was misuse of the tax benefits,” says Glencross. “Very significantly in EIS, they said two-thirds [of the money invested via EIS] was directed towards capital preservation, and that’s not what they felt it was about.
“But they also felt VCTs were not abiding by the spirit of the legislation. They then introduced requirements, which now focus VCT and EIS investment on growth investing.”
Glencross says the Treasury is “very focused on value for taxpayers’ money”, particularly under the current Chancellor Philip Hammond, which is why he has introduced the principle-based test that requires VCTs and EIS to ensure they are investing for growth and in growth companies.
VCT managers also have to invest money raised faster; 30% within the first accounting period following the period in which the subscription was made.
“There is an onus on VCTs to put the money to work, which is especially challenging for VCTs with large amounts of money,” says Glencross.
“The challenge for VCTs going forward is to achieve the same level and consistency of returns from growth investing that they were achieving from smaller MBOs and MBIs.”
Although there are challenges ahead, Glencross is confident that VCTs can “accommodate the changes”, but admits that some VCTs “for which the challenges are greater”.
“At Calculus, we have always been growth investors, as we started out as EIS investors,” says Glencross.
“It has not had a particular impact on us, but the VCT industry is having to face changes, greater scrutiny, and while there are benefits to the economy, there are new challenges to VCTs.”
Regardless of the rule changes around VCT investments, they still remain attractive and have benefits to clients’ portfolios.
Jeannette Cottrell, Associate Director at financial planning business Tilney Group, says that the upfront income tax break of 30% is of particular benefit to clients, “especially given the limits on ISAs, and then the £1 million [lifetime allowance] cap on pensions”.
She adds that buy-to-let investors have also seen the wind taken out of their sails as they have had the ability to claim tax breaks on mortgage interest removed, adding to the list of investors looking for a new home for their money.
Cottrell says VCTs are offering “an attractive income stream” with an “average yield of about 4.5% tax-free”.
“Then, you have an investment… where historically the results, at least in the last five years, have been good,” she says.
“People are seeing [VCTs] in a different light. It looks like a safe investment, the returns are better.
Those types of returns are attractive. Capital gains are taxfree, no implication income, and upfront tax break, which you only have to hold for five years.”
Glencross said a 4.5% taxfree yield is “significant” but unfortunately for investors whilst there have been new issues by existing VCTs, there have not been any new VCTs to invest in over the past five years.
“It’s interesting why there have been no new VCTs for five years, it’s because they can’t pay dividends immediately,’ he said.
“Compare that with an EIS, the drivers for EIS are that you get income tax relief, inheritance tax is a relief that you can capture through EIS, but also, capital gains are tax-free, and it’s easier to realise than a VCT in a way. Also there is the capital gains deferral, and attractive loss relief support – for EIS the inheritance tax relief is quite the driver.”
The nuances and differences in tax treatment between EIS and VCTs are still misunderstood by both advisers and clients, which is why education about tax-efficient investments is so crucial.
“It comes back to education, helping [people] to understand how these tax-enhanced investments work,” says Claire Olsen, Calculus Capital Head of Marketing and Investor Relations.
“Look at what the manager is doing, look under the bonnet, look at how much they disclose in their documentation, because I think some of the perceptions of risk are not wholly appropriate now for the right investor, but it’s important that the adviser and the investor understand what the manager is doing with their money.”
Education could help dispel the stigma that is still attached to alternative investments, of being purely high risk and speculative, and only useful for the tax breaks they offer, not as a viable investment in their own right.
Golding says that “people perceive them as being higher risk” and there are some advisers out there that refuse to participate in EIS or VCT raises.
“Whatever [advisers] put into high risk environments, that’s going to reduce the amount of money they’re putting into funds,” he says.
“More work, more risk, more paperwork. Firms won’t do it – it will be a big culture change to switch across”
However risky alternative investments may seem to some clients, and advisers, the restrictions on pensions – which have seen annual and lifetime allowance whittled down to £40,000 and £1 million, respectively – mean that more high-net-worth clients are at the pensions limit and looking for new, tax-efficient homes for their money.
“Pensions are problematic,” says Golding. “It’s a shame, because we tell people to make enough provision for their environment, then restrict them.”
Lack of education may not be the only reason why advisers are not recommending VCTs, they may feel their ability to advise on alternative investments is hampered by external regulatory and insurance pressures, particularly the cover offered under their professional indemnity (PI) policies.
Tilney’s Cottrell refers to a document published by the Association of Investment Companies (AIC), which is the trade body for closed-ended, listed investments such as investment trusts and VCTs, that says advisers are concerned about PI.
“They mention that a lot of IFAs don’t offer VCT advice because they have to mention it, and it drives up their insurance,” she says. “You have to assess how viable offering this service is…you do feel it has an impact on whether they can be truly independent or are restricted.”
Glencross says that advisers have to ensure they are able to talk to clients about VCTs and offer them options as the more this type of investment moves into the mainstream, the more clients will ask about them.
“People read about [VCTs}, and they’re asking their advisers about these investments, so you have a potential tension if clients are interested and advisers are not able to take care of them in that respect,” he says.
“It’s a difficult position for an IFA to find themselves in.”
Paul Wilson, a former wealth manager and Founder of IFA Magazine publications, says the interest “reflects that [VCTs] are now seen as a mainstream investment”.
“I had a healthy scepticism in the past, but now they are activity-led, and the tax breaks support that, rather than them being tax breakdriven,” he says.
“The underlying performance is the thing, and that has changed. To me, they are no different than an ISA; it’s something somebody should have, it just depends how big [a part of the portfolio] it is.”
Glencross says that it is important that advisers and investors “understand the nature of the investments” they are putting their money into, whether that is a FTSE tracker or a VCT.
“It’s important not to take for granted what’s going on under the surface, and that you understand the nature of investments,” he says. “The way the environment is changing too, that might have an implication on returns and the nature of fundraising.”
In order to understand what is going on under the bonnet of an investment and ensure that all implications are understood, the adviser has to be able to engage with the fund manager.
“It’s very important to be comfortable with who’s managing the money,” says Glencross. “The VCT community is mature, we can take comfort from that, there are changes taking place and they are likely to feed through to smaller fundraisers going forward.”
But advisers will have to understand VCT offerings and move quickly to invest their clients as smaller raises – caused by the need to invest VCT money more quickly – will mean there will be less capacity in the VCT universe.
“You might find that your preferred fund won’t have the capacity,” says Glencross. “Those that have the biggest marketing models and budgets are not necessarily the ones to select.