VCTs were created over 20 years ago. They allow investors to support some of the UK’s smallest businesses by providing the capital they need to grow and develop. To encourage investment in this crucial and higher risk area, the government offers generous tax benefits to investors.
To ensure VCTs achieve their objectives; are compliant with European and UK legislation; and remain eligible for tax relief, VCT managers must adhere to a number of rules, some of which were recently amended.
What is changing?
The amendments impose stricter limits on the investments which may be made by VCTs. They are designed to encourage VCTs to only make investments intended to grow and develop small businesses at an early stage of their life.
As with any legislation the full details are complex. The most significant changes include VCTs no longer being able to invest in companies more than 7 years old; certain types of transaction, including management buy-outs (MBOs - where VCT funds are used to help existing management buy shares from a founder or other major shareholder), are no longer permitted; and VCTs cannot invest more than £12 million in any one company.
What is the impact?
The broad effect of these reforms will mean some VCTs are forced to invest in smaller businesses at an earlier stage of their development. Younger companies don’t tend to generate the same profits and cash flows (from which dividends can be paid) as more mature companies. Indeed, some are likely to be unprofitable and while some might achieve impressive success others will be more prone to failure.
In effect, this refocuses VCTs on the types of business it was always intended they should help. However, less consistent returns from underlying companies could mean less consistent returns from VCTs. VCTs are able to smooth dividends by holding back some gains in successful years, but in future NAVs and dividends could be more volatile.
Preventing certain types of transaction, such as MBOs, and business acquisitions will also prove restrictive for some VCT managers. It potentially reduces the number of investment opportunities they have to choose from.
As for the £12 million investment limit, we don’t expect this to materially affect the ability of VCT managers to make investments.
The new rules only apply to investments made from November 2015. Investments made prior to this are unaffected so there should not be an immediate impact on existing VCT portfolios. In future, all VCT managers will have to abide by the new rules and some will have to change their approach. The impact will vary between VCTs and any changes to existing portfolios will take place over a number of years as new investments are gradually made.
Which VCTs are affected?
We would stress that each VCT will be affected differently and the lists below are not exhaustive.
Some VCT managers already invest almost exclusively in early-stage companies and don’t engage in the types of transaction that have been prohibited. These VCT managers should be less affected by the rule changes, although they could see more competition for the best investments as other managers start to target similar companies.
VCTs which currently fall into this camp include those managed by: Elderstreet, Octopus (Octopus Titan VCT), Pembroke, Beringea (ProVen VCTs), Albion and Downing. AIM-focused VCTs are also likely to see their investment universe reduced to a degree.
For other VCT managers the amended rules are more restrictive. Those focused on investing in more mature and established companies; and engaging in certain transactions types (such as MBOs) will need to take a different approach going forward and there could be a smaller universe of companies for them to choose from.
VCTs managed by NVM (Northern VCTs), Mobeus, Maven, YFM (British Smaller Companies VCTs) and Living Bridge (Baronsmead VCTs) are among those likely to be affected to a greater extent. These VCTs could therefore become riskier as their managers adapt to the new rules.
What should investors do?
VCT managers have adapted to rule changes before and we expect them to do so again on this occasion. That said, the changes are significant and create uncertainty for some.
As noted above, the immediate impact on existing VCT portfolios should not be material. For existing investors, including those who have held their VCTs less than five years, we do not think there is any need for immediate action.
Those looking to make new VCT investments might wish to wait until the dust has settled following the regulatory changes and different VCT managers have clarified how they are affected and the approach they will take going forward. We also continue to believe holding a selection of VCTs from different managers is sensible as it increases diversification.
The tax breaks investors receive for investing in VCTs – including up to 30% income tax relief and tax-free dividends – remain unchanged.
HL view
VCTs have always been higher-risk investments, although some VCT managers reduced this risk slightly by backing more mature and established companies. It will take time to determine who will adapt best to the new rules and during uncertain times we prefer a cautious approach.
With less certainty that money raised will be successfully invested we view smaller fundraisings as sensible and we anticipate some VCT managers not raising any money at all this year.
In total, £429 million was raised by VCTs during the 2014/15 tax year. We think it could be in the region of £300 million in 2015/16.
VCTs continue to provide investors with the opportunity to back small, growing companies and receive generous tax breaks. As usual we will provide research on this year’s main VCT offers, including our Guide to VCTs, which will be available on our website towards the end of this year.