Venturing for dividends

David Prosser examines the income characteristics of VCTs.

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The Bank of England’s decision this week to keep base rates on hold hardly came as a surprise. But while any move away from the current all-time low for interest rates would have been a shock given the backdrop of the impact of Covid-19 on the economy, the Bank’s announcement is yet another reminder of the desperate times that income-seeking investors face.

For many advisers seeking innovative responses to this crisis, the venture capital trust sector offers an increasingly happy hunting ground. Launched 25 years ago, VCTs were traditionally regarded as long-term bets on capital growth – investors hoped the immature companies in which the funds invest would ultimately deliver substantial gains as they fulfilled their potential. Increasingly, however, it is the sector’s income profile that is catching the eye.

VCTs did not start out as an income-oriented investment because the early-stage companies in which they invest do not generally pay dividends. Over time, however, as VCT portfolios have matured, more of their constituents have started to pay an income. Moreover, as investment companies, VCTs are allowed to distribute capital gains in the form of income – so when a successful portfolio company is sold, this profit can be paid out as extra dividend income or as a special dividend.

Bear in mind too that the attractive tax incentives on offer from VCTs include the exemption from income tax of dividends. A VCT that pays a dividend of 5% is therefore offering the equivalent of a 7.41% pay-out to investors who would normally pay higher-rate income tax on their dividends, rising to 8.1% for additional-rate taxpayers.

In practice, many VCTs are even more generous than that. The AIC’s statistics show that most funds in sector currently offer yields of more than 5%; many are offering closer to 10% and in some cases there is even more yield available.

The attractiveness of this income has skewed the structure of the industry in recent times. VCT managers know that investors want to invest in new shares because purchases made on the secondary market do not qualify for the upfront income tax relief that VCTs also offer. In previous times, that meant launching new funds each tax year – but brand new VCTs need time to deploy their capital and will usually find it difficult to start paying dividends for several years. For this reason, most new VCT shares are additional fund-raisings from existing funds, which gives investors immediate exposure to a portfolio with proven dividend potential.

Indeed, of the 15 or so VCTs currently raising money from investors, around three-quarters are share issues from existing funds rather than new launches. Those VCTs that do fall into the latter category do not expect to begin paying dividends until 2023 or 2024.

Arguably, investing in an existing share issue is a less risky option than backing a new fund. Advisers and investors have an opportunity to assess the fund’s portfolio, its performance track record and the resilience of its dividend stream while still benefitting from all the tax advantages that VCTs have to offer.

This is not to suggest advisers should ignore the question of risk. VCTs do invest in early-stage businesses with a higher risk profile and investors need to be prepared to accept that. Still, in a market where income is so difficult to find, it seems likely VCTs’ fan base will continue to broaden.