Investment vehicles that have certain tax advantages over time are more popular when certain entities, such as pensions, are squeezed as governments try to raise revenue. The author of this article makes the case for venture capital trusts.
With tax reliefs on pensions being squeezed by a government desperate for revenue, but which also claims (somewhat inconsistently) to want to encourage investment, what options do high net worth investors have in the UK? One segment that continues to get an airing is the market for venture capital trusts. VCTs date back to the early 1990s and have, with some adjustments to their tax status and rules, been a feature of the landscape ever since.
We carry the following guest commentary written by Jack Rose, strategic sales director at Triple Point investment house. The editors are pleased to share these views and invite replies. Remember, the usual editorial disclaimers apply to the views of guest contributors. Email firstname.lastname@example.org
UK start-ups have performed remarkably during the pandemic with a quarter of the UK’s “unicorns” created in 2021. In particular, tech start-ups were booming with £26 billion ($35.3 billion) raised, doubling the previous year’s figures and creating a record number of unicorns. (1) Indeed, times of great change often create opportunities for accelerated innovation, as we also saw in 2007 to 2009.
Investors wanting to take advantage of this could potentially find an answer in VCTs. If chosen carefully, VCTs can offer investors key benefits that allow them to capitalise on the optimism from economic recovery and back high-quality companies at attractive valuations to generate robust returns. And, with inflation jumping 5.4 per cent in December, the highest level in almost 30 years, income-seeking investors may find VCTs’ ability to pay tax-free dividends particularly compelling. (2)
Rising taxes prompt surge of funding
While the skills of VCT managers are key to delivering strong returns, the tax advantages of these investment vehicles are considerable and are also a factor for investors who commit capital to the sector. With an additional 1.25 per cent tax hike on dividends and national insurance contributions coming into play next year, tax relief is a top priority for many investors (3) and, indeed, 72 per cent of VCT investors say that tax breaks are the primary reason for investing in them. (4) This is because they remain a highly tax-efficient investment solution, allowing investors to claim income tax relief upfront worth 30 per cent of the amount invested, up to an investment of £200,000, and earn tax-free dividends and capital gains.
Those seeking to capitalise on the benefits of VCTs have an array of options available to them. For example, generalist VCTs offer the opportunity to invest across a variety of sectors whilst specialist VCTs focus on a specific sector. Each investment focus offers different drawbacks and benefits – a specialist VCT’s lack of diversification can sometimes create an increased risk, for example. Alternatively, AIM VCTs offer investors exposure to shares issued by AIM companies but they do come with the trade-off of potentially increased volatility vs other VCTs. Selecting the correct investment strategy and focus is key to managing some of the risks associated with VCT investment.
A clampdown on tax exemptions for high earners’ pensions in recent years has driven money into the sector, and the new dividend tax along with relentless investor appetite for yield could funnel even more funds into the sector with VCTs raising 4 per cent more in 2020/21 than the previous year. (5) By early January this year, investors had already put a record £580 million into VCTs, more than double the £280 million invested in 2021, signalling that 2022 could be a record year for VCT fundraising. (6)
Selecting the right VCT strategy is key
However, while VCTs can offer an exciting, tax-efficient opportunity to invest in high growth businesses, it is also crucial that investors consider the risks. Investing in startups can carry significant risks – share prices can be volatile and investors need to hold shares for five years to keep tax relief. While some large VCTs have seen their share prices jump between 20 and 30 per cent over the last five years, others have dropped over 30 per cent. For this reason, VCT investments are long-term investments which must be carefully considered. Ensuring thorough evaluation of the strategy VCT managers are using is critical.
We must remember that many startups fail. Some 20 per cent do so in their first year and this figure rises to 60 per cent within their first three years. (7) Cashflow-related difficulties or hiring the wrong personnel are often to blame, but research by CB Insights indicates that the number one reason for start-up failure, cited in 42 per cent of cases, is the lack of market need. (8)
However, startups in certain sectors also tend to have greater chances of success, particularly B2B technology businesses. There is a larger proportion of high-growth companies with a B2B model than those with B2C models, and there are typically more exits by B2B companies, accounting for 77 per cent of all exits in 2019. (9)
As a result, VCT funds that invest in pre–Series A B2B technology start-ups tend to give better valuation on entry and better returns for shareholders. It is also crucial to implement a strategy which aims to mitigate the risks of investing early in B2B companies by selecting those that are actively solving corporate challenges and have established backing for their product or service, thereby addressing the thorny issue of lack of market need.
VCTs are still a relatively niche investment sector, and this means that there are also limits to the amount of cash it can absorb. Paying particular attention to the amount of money a VCT is raising is critical. With VCT qualifying rules focused on ensuring a timely deployment of capital, too much money raised can place managers under pressure to deploy capital which can impact on selectivity. Given the large offer sizes this year for many VCTs there is an argument for investors to consider some of the smaller offers such as Triple Point’s to ensure selectively on dealflow. Bigger is not always better.
Equally, there are other alternative investments to be considered. For example, EIS investment can also offer the crucial tax relief provided by VCTs alongside other benefits. Unlike VCTs, EIS offer a “carry back” facility enabling the tax relief to be offset on income tax from previous years. In addition, EIS investments can qualify for business relief which can offer additional inheritance tax relief. However, both offer a key opportunity to invest in early-stage companies and, therefore, carry the risks of investing in these businesses. Ultimately, both VCTs and EIS investments must be carefully considered to ensure that investors receive the high rewards that accompany these higher-risk strategies.
Backing UK tech innovators
Despite economic uncertainty, Brexit, and investor anxiety in other sectors, venture capital funding continues to flow to the UK tech sector in record amounts. In 2021 alone, tech investors have backed UK start-ups with £20 billion in funding, meaning that investment has almost doubled in the last three years. (10)
Venture capital funding offers investors an opportunity to tap into this exciting growth. For example, out of the 100 on the Fast Track list of UK tech firms with the fastest-growing sales over the past three years, VCTs have invested in 15 of them. (11) As of 2015, VCTs have been required to invest in younger companies and, as such, are an excellent way to provide smart startups with access to capital at the earliest stages of their growth. More than four-fifths of VCT investors agree, believing that they are helping UK entrepreneurs with their investment. (12)
In the instability of the post-pandemic world, it is an even more urgent priority to invest in businesses that want to adapt, evolve and innovate in order to help refresh the economy and drive recovery. VCTs can offer the ability to do so while mitigating upcoming tax rises. However, investors should be careful to prioritise the right strategy and consider the risks associated with investing in early-stage companies. If they do, investors can reap the rewards that such an investment strategy can deliver.