What is a VCT?
A VCT is a company whose shares trade on the London stock market, just like Barclays or Vodafone. However, rather than banking or telecoms, a VCT aims to make money by investing in other companies. These are typically very small companies which are looking for further investment to help develop their business.
This is a vital area of the economy, and without funding from venture capitalists many companies we consider household names would never have been able to grow their businesses.
A VCT typically invests in around 20 such businesses. These are chosen by the VCT manager – an expert in identifying opportunities amongst fledgling companies, and negotiating attractive deals for investors.
To encourage investment in this crucial area, the government offers generous tax benefits to investors, including tax relief of up to 30% when investing. See below for more details.
Profits are generally paid to VCT investors as tax-free dividends, which are the primary source of return for VCT investors. The VCT manager will also provide expertise to help their chosen firms expand and provide better returns for their investors. They normally look to sell their share of the business three to seven years after investing and reinvest the capital in the next opportunity.
Investing in this dynamic area makes VCTs an exciting investment proposition, but it also means they are inherently higher risk, as smaller companies can be prone to failure. VCT shares are difficult to buy and sell – the market price may not reflect the value of the underlying investments. The value of the shares will fluctuate, income is not guaranteed and you could get back less than you invest. VCTs are therefore aimed at wealthier, sophisticated investors who can afford to take a long-term view. The prospectus of each VCT will give full details of the risks and should be read thoroughly before making an investment.
What do the companies look like?
VCTs invest in small, fledgling companies in need of capital. HMRC rules require that at least 70% of a VCT's assets are invested in 'qualifying holdings'. There are a number of rules surrounding what constitutes a qualifying holding, but the main ones are that the company must not have net assets of more than £15m, and must have fewer than 250 employees.
A number of companies which have benefited from VCT investment have grown to become household names, including the examples below.
Virgin Wines was founded in 2000 and acquired by Direct Wines in 2005. The management team has successfully grown the business to a turnover of £35m, and in October 2013 completed a management buy out, largely funded by an £8.7m investment from Mobeus VCTs.
The online wine market is forecast to grow by 10% p.a. and Virgin Wines is well positioned to take advantage with a niche range of wines and innovative customer loyalty schemes. It generates maintainable profits of £2.4m on sales of £35.4m.
The business is cash generative and management intends to increase marketing and recruitment spending significantly. In turn they expect this to deliver a large increase in customer recruitment, driving improved repeat spending, a larger core customer base and therefore revenue growth.
The deal structure
The deal was structured in such a way as to combine both a loan to Virgin Wines, and also the purchase of a 42% stake in the company. The loan serves to mitigate risk and provide a steady income stream, whilst the 42% share in the company allows the potential for significant capital appreciation.
Mobeus had been looking to make an investment of this type for some time. They believe this is an attractive entry price for a business of this size, which combines consistent profitability, the benefit of the Virgin brand and reasonable growth prospects.
Mobeus expects the company to achieve significant expansion now that it has a focused management team and is no longer part of a larger company. This in turn should provide a strong cash return for Mobeus VCT shareholders, should the business be sold to an overseas trade buyer or as part of a sale to another larger private equity house.
Go Outdoors is an out-of-town retailer of clothing and equipment for a wide range of outdoor activities. YFM Equity Partners (managers of the British Smaller Companies VCTs) originally invested in 1998, when there was just 1 store in Sheffield, and has supported a rapid expansion to 49 stores today and over £200m of turnover.
Go Outdoors had an ambitious and experienced management team, combined with a new approach with an out-of-town superstore selling everything for the outdoors under one roof.
Since YFM's investment, employee numbers have grown from 15 to over 2000 and turnover increased from £2m to over £200m.
The deal structure
The first investment was made in 1998 in ordinary shares to give upside as the business grew, and some redeemable preference shares to provide some capital return along the way. YFM held a 20% stake, with the management team incentivised by holding the majority of the shares.
A minority stake was sold to 3I in 2011, realising £6.5m in cash for VCT shareholders, but a 14% stake is still held. The total return thus far represents 30 times the initial investment.
A new CEO was recruited in 2013 who is a professional and experienced retailer. This has allowed strategic plans to be refocused, with plans set to double the profits of the business again over the next 2-3 years. This will allow the VCT to evaluate again its options for crystallising some or all of its investment. There will be new store openings and a refreshed ecommerce offering this year.
Different types of VCT
There are a number of different types of VCT.
Generalist VCTs are the most common, and the most popular with investors. They invest in a broad range of companies in different sectors and at different stages of development.
AIM VCTs invest predominantly in companies listed on AIM, or those which are about to list on AIM.
Specialist VCTs tend to invest in just one sector, such as technology. Specialist VCTs are becoming less common.
Limited Life VCTs are designed to be lower risk and lower return than other VCTs and aim to wind up and distribute assets to shareholder five to seven years after launch, although there are no guarantees.
What kind of returns can I expect?
It's a common misconception that because VCTs invest in smaller companies, the returns are likely to come in the form of capital growth.
In fact, the majority of returns are paid as tax-free dividends during the life of the VCT. Many VCT managers aim to generate yields in the region of 5% a year, which is equivalent to around 7% for a higher rate tax payer.
In order to achieve a steady flow of dividends, VCT managers often structure investments in the underlying companies in a way that emphasises income generation. They do this by providing a proportion of the investment as a loan with the remainder in shares. The repayments on the loan provide a regular income to the VCT while loans also rank ahead of equity in the event the business fails, making the deal less risky if the business has assets which can be sold.
The capital value of their investment should be a secondary concern for investors. We suggest holding VCTs for the long term – a 10-year plus time horizon is ideal – in order to benefit from the tax-free dividends as the portfolio matures.
How do I sell?
If you sell your VCT shares in the first five years you will have to repay any tax relief you have received. Furthermore, because there are very few buyers and sellers of VCT shares in the secondary market, liquidity is poor. This means that the price you can obtain often doesn't reflect the value of the underlying assets.
To realise their investment many investors wait for the VCT manager to offer to buy back their shares (a frequent occurrence) or simply wind up the VCT and return the capital as a final tax-free dividend.
Who invests in VCTs?
VCTs aren't for everyone.
They are high risk, and difficult to sell, meaning they are only really appropriate for investors who already have significant portfolios of more conventional investments. In short, you need to accept the risk of losses, and also take a very long-term view. We therefore feel that at most they should account for 5 to 10% of your equity portfolio.
Nevertheless, for those who can accept the risks, they can be a rewarding investment, especially for those who need their capital to generate an income – perhaps to supplement their pension in retirement. Indeed they can appeal to a wide variety of investors.
Some case studies are shown below. Remember that if you have any doubts as to whether VCTs are right for you, you should seek expert advice.
Mr Preece - Gwent
"I invest in VCTs primarily for the initial income tax breaks, to assist in sheltering my income from higher rate tax"
Ms Dupras - Surrey
"VCTs enable me to build a tax free revenue stream to add to any pension income I will get when I retire"
Dr Clifford - Yorkshire
"I like to support young and start-up businesses as I think they are the future of our country. If I can do that and there are benefits for me I think that's a good thing."
How to choose a VCT
Many investors start with a generalist VCT as this can give them a broad spread of investments, rather than targeting an individual sector. We generally believe building a diversified portfolio of high-quality generalist VCTs paying attractive dividends is a sensible strategy. This can then be supplemented with different types of VCT if you consider them appropriate for your circumstances.
The following factors should be considered when choosing a VCT:
- Experience and resources of the management team
- Their style – do they focus on more mature, profitable companies; or early-stage higher growth businesses?
- Their track record of profitable investments leading to attractive dividend payments
- The potential of the current portfolio – a mix of mature investments ripe for sale and new investments to drive future growth
- The pipeline of new investment opportunities
- How the manager structures their investments between debt and equity
Full details of the VCTs currently available, with all the information to help you reach a decision, can be found on our offers page.
What are the tax benefits?
To encourage investment in an area vital to the economy, and in recognition of the risks and complexities of VCTs, the government offers certain tax benefits to VCT investors.
This makes them particularly attractive to those seeking to reduce their tax bill and generate income from their capital.
- 30% income tax relief for subscriptions in new VCT fund raisings
- Dividends paid by VCTs are free of tax
- No capital gains tax (CGT) to pay when you dispose of the VCT
The income tax relief means if you invest £10,000 you could either receive a cheque from the taxman for £3,000 or an adjustment in the income tax you pay. This applies to anyone, regardless of the rate of tax you currently pay.
You can invest up to £200,000 in VCTs each tax year and benefit from this tax relief. However, the maximum tax rebate is the amount of income tax you pay (see examples below).
Mr Smith invests £50,000 in a VCT. He will pay £20,000 in income tax this tax year, so he is entitled to the full 30% tax rebate of £15,000.
Mrs Smith invests £50,000 in a VCT. She will pay £10,000 in income tax this tax year, so the maximum tax rebate to which she is entitled is £10,000.
You must hold the shares for five years to keep the tax rebate. The rebate is only available when you invest in a new issue of shares in a VCT or a top-up, not on any VCTs you buy on the open market. However, VCTs bought on the secondary market count towards the £200,000 allowance for the tax year in which you buy them, despite the fact you don't get the income tax break. All tax treatments are subject to change and can be varied. If the VCT manager fails to meet the relevant investment rules the tax benefits could be withdrawn retrospectively.
What happens after I invest?
Claiming tax relief
The first step is to claim your tax relief.
You claim the relief in your tax return for the year in which the shares were issued. There is a section on the form dedicated to VCTs. You will then be repaid the income tax by HMRC via your tax code, as a lump sum rebate or, if self-employed, a reduction in Schedule D tax.
Once your shares have been issued, the VCT will provide you with a tax certificate. This might be required by HMRC as proof of your investment.
Monitoring your investment
The main considerations when assessing the performance of your VCT are:
- The net asset value (NAV) – this will give you a view of how the underlying holdings have performed
- The dividends paid to date
Our website contains information on how all the major VCTs have performed, while the VCT manager's annual report & accounts – the latest version of which is also available via our website – contains information on how the VCT has performed.
Dividends can be received via cheque or be paid directly into your bank account. If you want dividends paid into your back account you should complete the appropriate section on the VCT application form. Dividends from VCT investments are tax-free and do not need to be included on your tax return.
Realising my investment
A VCT must be held for a minimum of five years in order to permanently keep the tax relief. At any time after this point a VCT can be sold on the open stock market, just like any other UK-listed share or investment trust. For full details on how to sell your VCT shares in this way, including the associated charges, please contact our dealing desk on 0117 980 9800.
However, before selling on the open market you should also contact the VCT manager who might be able to buy back the VCT shares from you at a better price. Because VCTs are specialist investments which are not widely held by investors the share price can often be significantly lower than the value of the underlying assets (this is known as trading at a discount to NAV).
In order to make it easier for investors to sell their shares many VCT managers periodically offer to buy them back at a better price than is available on the open market – typically at a 5% to 10% discount to NAV, although this is not guaranteed.
How to invest
VCT managers periodically seek to raise new money from investors. Investments made during these offer periods qualify for 30% income tax relief on the amount invested. Because VCT managers seek to raise a fixed amount of capital and shares are allocated on a 'first come first served' basis, the most popular VCTs often sell out quickly. We therefore recommend acting quickly to avoid disappointment. Investors can keep up to date with details of forthcoming VCT launches by signing up to our VCT alert service. As one of the UK's largest VCT brokers we have negotiated a range of discounts on leading VCT offers, usually in the form of extra shares.
To apply for your chosen VCT please download the prospectus (which must be read before investing) in the current VCT offers section, complete the application form at the back, and return it along with your cheque to Hargreaves Lansdown.
View current VCT offers
While VCTs can be purchased on the open market we generally don't believe this is a good idea. The 30% income tax relief is not available for VCTs purchased on the open market, but they still count towards the £200,000 limit for the tax year in question. Furthermore, because there are very few buyers and sellers of VCT shares in the secondary market, liquidity is poor.