Were the Budget changes actually bad news for VCT investors? Annabel Brodie-Smith of the AIC still sees very strong value for advisers’ clients investing in this attractive asset class – as long as they are prepared for risk
A collective sigh of relief could be heard after the Autumn Budget when it became clear that rumours doing the rounds that the Chancellor would change the tax reliefs on venture capital trusts (VCTs) were speculation rather than reality.
All told, 2017 proved to be a good year for the VCT sector. There was strong fundraising, performance and confirmation that the VCT tax reliefs were to remain in place for investors. Now, at the start of 2018, the outlook remains positive for VCTs and for those who consider investment in this asset class.
The pre-Budget rumours, however, had their effect on fundraising. From the beginning of the current tax year to the end of December 2017, VCTs have raised £462.5m. That is more than they raised in either of the whole tax years ending April 2014, April 2015 and April 2016. It’s not far away from the fundraising figures for the entire 2016/17 tax year, which raised £542m, the second highest amount ever. Clearly some advisers have made sure that their clients subscribed for their VCT shares early to avoid any potential changes to tax reliefs but the figures evidence the strong demand for VCT shares.
The Budget did herald another set of significant rule changes for VCTs. These changes will mainly be introduced in 2018, with a few held back to 2019. They come close on the heels of the last rule changes in 2015. Like those 2015 changes, they affect EIS and VCTs alike. The rules are designed to prevent VCTs investing in ‘capital preservation’ type businesses and focus on the amount of time VCTs have to invest their money. These are important so let’s take a closer look at what’s being proposed.
Through the looking glass
First, there is a new principles-based test for VCT qualifying investments, designed to boost investment in companies where there is long-term growth and development which means significant risk. This will be introduced before the end of the tax year when the legislation receives Royal Assent. Whether the test is met will depend on taking a ‘reasonable’ view as to whether an investment has been structured to provide a low risk return for investors. The condition will have two parts: whether the company has objectives to grow and develop over the long term and whether there is a significant risk that there could be a loss of capital to the investor greater than the net return.
The headline grabbing change was a boost to the annual investment limit for knowledge-intensive firms which will be doubled from £5 million to £10 million for investments made by VCTs. This is clearly designed to boost investment in innovative and higher-risk companies. Knowledge-intensive companies, just as a reminder, have to invest significantly in R&D and either create intellectual property or have a high percentage of the workforce with higher education degrees. VCTs can invest in knowledge-intensive companies up to ten years old rather than the usual seven years for other companies. From 6th April, there will also be greater flexibility over how the age limit of ten years is applied.
The times they are a changin’
There was another significant rule change which will increase VCTs’ exposure to investee companies (qualifying investments). For accounting periods beginning on or after 6th April 2019, the percentage of funds VCTs must hold in investee companies will increase to 80% from 70%. In addition, from 6th April 2018, VCTs will be required to invest at least 30% of new money raised in investee companies within 12 months, after the end of the accounting period in which the funds are raised.
Back to basics
These changes are clearly designed to ensure VCTs invest in the ambitious, ‘innovative companies that are the backbone of the economy’. VCTs will have more exposure to these companies, which start small but have the potential to grow into household names in the future, helping to create jobs and growth. The important news is that the generous tax benefits remain to compensate investors for the risks they take. It’s interesting to know that the majority of VCT investors tend to invest smaller amounts into VCT funds. In the 2015-16 tax year, 43% of investors made a claim for an investment of £10,000 or less.
So what’s the impact on investors? The first point to bear in mind is that, as with the 2015 rule changes, the impact will be gradual rather than a cliff-edge scenario. This is because most VCT money is raised by existing VCTs. Existing VCTs already have investments they made before these rule changes, which continue to sit within portfolios and account for much of the return investors will receive in the future. But any new investments by these VCTs will be made entirely under the amended rules and this applies to any new share classes launched by existing VCTs.
Risk v return
Taken together, the 2015 and 2018 rule changes move VCTs (and EIS) up the risk scale, because they eliminate the possibility of certain safer kinds of investment. Of course, some VCTs have never sought to conduct this sort of investment, and their strategies will be little changed. Octopus Titan VCT is a case in point: it has always focused on early-stage companies. The impact is perhaps greater on EIS: the government’s Patient Capital Review consultation found that a majority of EIS ‘funds’ had capital preservation type objectives, versus about a quarter of VCTs.
VCT managers are very adaptable. Since the 2015 rule changes we have seen some, such as NVM, hiring new staff to refocus their businesses on the kind of areas demanded by the new rules. We’ve also seen some managers (especially those who were focused on lower-risk investments) reduce their fundraising targets, or choose to raise nothing at all, if they don’t think they can put the money to work effectively.
It’s likely that the new requirement to invest money faster will add to this caution: raising too much, too quickly could make your performance suffer, and hence your reputation: no VCT manager wants that. It’s more important than ever for advisers to be alert to when fundraisings are being launched – smaller ones from popular managers will fill up in days, not weeks.
At the AIC, we’ll continue to liaise with the government and industry to ensure that this latest set of changes is implemented in a way which reflects commercial reality. However, it’s reassuring to know that, at nearly 22 years old, the VCT industry has the benefit of highly experienced managers who have adapted to change in the past and continue to deliver good returns for shareholders. Over the past ten years, the average VCT has returned 89.5%, without accounting for the upfront tax relief. Performance in 2017 has also been encouraging. From the beginning of the year to the end of November, the average VCT returned 7.1%. Much of this return is in the form of tax-free dividends.
Advisers are clearly aware that when considering VCTs for inclusion in clients’ portfolios, they have always been higher-risk. The generous tax reliefs on offer shouldn’t blind anyone to the nature of the underlying investments, which are small, ambitious UK businesses that won’t all succeed. But the VCT structure makes it easy to access a professionally managed, diversified portfolio of these businesses, with the transparency of a London-listed investment company and the reassurance of an independent board.
Advisers can also reassure clients that they are putting their money to work where it is really needed, helping UK businesses to grow and create jobs. An HMRC investigation in 2016 concluded that VCTs and EIS were operating as originally intended ‘in terms of how investments are used, bridging finance gaps and wider effects on investees’. An AIC report released last year showed that VCT-backed businesses had created 27,000 jobs since the first investment by a VCT, a figure likely to be much understated because data was not available for all businesses. Let’s hope 2018 continues to be a strong year for VCTs and their investors, ultimately benefitting the UK’s smaller companies.
About Annabel Brodie-Smith
Annabel Brodie-Smith is Communications Director at the Association of Investment Companies (AIC). Her role is varied but chiefly focuses on communicating the uses and features of investment companies to the media, opinion formers, advisers and private investors. Annabel heads up the AIC’s training and information programme for advisers and wealth managers. This aims to increase awareness and understanding of investment companies through seminars, conferences and online training tools.
Prior to joining the AIC in November 1997, Annabel worked at Hill & Knowlton, the PR Agency. She obtained a B.A in Geography from LSE/King’s College, and an M.A from Syracuse University in New York.