Going for growth

David Prosser discusses why VCTs offer much more than a 'tax wheeze'.

Another year, another record-breaking fund-raising season for venture capital trusts. By the second week of March, the 35 or so VCTs raising new money from investors in the 2017-18 tax year had picked up £557m – that’s well ahead of the £542m raised by the end of the 2016-17 tax year some 12 months ago.

In theory, fund-raising could go above £700m by 5 April, with more than 20 funds still open for investment. That wouldn’t quite challenge the all-time record for VCT fund-raising, which topped out at £779m in the 2004-05 tax year, but that was an outlier; that year, investors flooded into the industry because additional tax incentives were offered on top of the already generous reliefs available.

In normal times for VCT tax treatment, this year’s fund-raising is already the best ever; last year was the previous high-water mark. So why have investors and advisers become so fond of these closed-ended companies? VCTs certainly aren’t for widows and orphans: their portfolios consist of small, early-stage companies which at the time of investment must be less than seven years old and be worth no more than £15m.

There can be no denying that the tax breaks VCTs offer are part of the picture: the combination of upfront income tax relief worth 30 per cent of your investment plus tax-free income and growth is highly attractive.

It’s also the case that VCTs are increasingly seen as a good alternative to conventional private pensions when it comes to retirement saving. A series of reductions in recent years in the amounts savers may contribute to pensions, and build up in pension rights, has left high earners in particular looking for other ways to invest for later in life. The Government’s annual and lifetime allowances are the pension industry’s loss and VCTs’ gain.

It would be unfortunate, however, if VCTs were seen simply as a tax wheeze. The relief is all well and good but will be of only limited consolation to investors if the long-term returns generated by VCTs disappoint. What we really want from these funds is investment performance over time that reflects the additional risk implicit in exposure to small and immature companies.

In a sector that has now been going strong for two decades, extensive past performance figures are available. These are useful to advisers studying which managers have a track record of delivering good returns, though less meaningful for individual funds, given that the investment rules governing VCTs have changed over time; in any case, investors must buy new VCT shares to qualify for the upfront tax relief.

It’s also worth studying the performance of the businesses likely to form the mainstay of VCT portfolios. The data here underlines the importance of the diversification that VCTs offer. Research from Beauhurst, which specialises in analysing early-stage businesses, suggests that of the 500 businesses that have raised equity capital over the past six years, 73 have already gone out of business; on the other hand, even taking these failures into account, the 500 businesses delivered average annualised returns of 30 per cent.

Those figures are encouraging. Investors in VCTs need to be aware of the risks, prepared to hold on for the long term, and motivated by more than just a tax break. But the evidence of VCT and start-up performance in years gone by is that there is a genuine investment case to make for this sector.