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Many investors are keen to embrace UK businesses at the cutting edge of innovation, but a large number of these companies are hard to identify and have yet to come to the stock market – meaning venture capital trusts (VCTs) can be an attractive way to gain exposure to these potentially high-growth stocks. 
VCTs were introduced by the government in 1995, following the launch of the Enterprise Investment Scheme in 1994 and in the same year as the opening of the Alternative Investment Market (AIM). All three initiatives were designed to help channel investment into the UK’s smallest companies.
Despite VCTs’ 20-year history, investors may be more familiar with unit trusts or open-ended investment companies. But Stuart Lewis (pictured), VCT business line manager at Octopus Investments, says that if they are aware of investment trusts, it should not be too difficult for investors to get to grips with VCTs.
“Investment trusts are one of the oldest forms of collective investing – they've been around for centuries – and just like you'd have a China investment trust or an India investment trust, you can have a very specific form of UK smaller companies investment trust that's called a venture capital trust,” Lewis explained.
“The types of companies that are supported by a venture capital trust are usually under-served by traditional finance methods and are businesses into which the government is keen to encourage investment in order to drive UK economic growth, job creation and so on.”
Octopus Investments, which was established in 2000 and launched its first VCT in 2002, is now the UK’s largest VCT provider[1], with its flagship product being Octopus Titan VCT, the UK’s biggest VCT.[2]
Like investment trusts, VCTs aim to generate a return by building a portfolio of other companies’ shares. While their own shares trade on the London Stock Exchange, typically the underlying companies they invest in are either listed on AIM or are not listed on any stock exchange.
Like most investment trusts, this means that a VCTs’ shares can theoretically exchange hands at a price significantly above (premium) or below (discount) the value of the underlying holdings depending on demand. For VCTs however, the majority of shares are sold at a discount of around 5 per cent to the value of the underlying holdings.
There are, however, some key differences between VCTs and investment trusts that make VCTs a unique offering for an investor’s portfolio – though investors should be aware that VCTs are not suitable for everyone.
The most obvious differentiating feature is their tax efficiency. Lewis stated: “In exchange for accepting the risks of investing into the UK's smaller companies, VCT investors can expect some pretty attractive tax benefits.”
The government offers up to 30 per cent upfront income tax relief on VCT investments which can only be retained if the investor holds their shares for at least five years. This upfront tax relief only applies to subscriptions of newly issued VCT shares and not on VCT shares bought on the secondary market.
Therefore, an investor who has bought £10,000 worth of qualifying VCT shares could receive £3,000 from the taxman – either as an ongoing reduction to their monthly income tax payments or as a one-off rebate. It is worth noting that the amount that can be received is limited by the amount of income tax actually paid.
Other tax benefits offered by VCTs include exemption from capital gains tax when shares in VCTs are sold, as well as the ability to pay tax-free dividends that don’t need to be declared on an investor’s tax return. Unlike income tax relief, these benefits apply to both newly issued shares as well as second hand shares that the investor may have bought on the open market.
Of course, it is worth keeping in mind that the tax benefits applicable to an individual will depend on their individual circumstances and may change in the future. It is also important to understand that tax reliefs depend on the VCT maintaining its VCT-qualifying status.
So why does the government offer attractive benefits like the above to VCT investors? Lewis explains that it is to help encourage investment into this vital area of the economy and a reflection of the risks involved with investing in smaller companies.
“The companies we invest in are exactly the types of companies the government is trying to direct funds to, as they have the potential to grow rapidly but often need access to funding to enable them to do so. A lot of these companies are not listed on any stock exchange, although some VCTs do focus on companies listed on the Alternative Investment Market,” he said.
“The government is using VCTs to direct money to younger, exciting companies that have the potential for transformational growth. This area has been the bread and butter of Octopus Titan VCT since it was launched in 2007. It has a solid track record of investing into young start-up companies and watching them grow into household names – the likes of Zoopla, Graze, Secret Escapes and, most recently, SwiftKey”. Although, investors should always remember that past performance is not a reliable indicator of future results.
In order to qualify for VCT investment, businesses need to have a permanent presence in the UK and either be listed on AIM, or not listed on any stock market. Furthermore, the gross assets of the company must not exceed £15mi and it must have no more than 250 employees. A focus on these kinds of companies means that for the right investors, a VCT can play a useful role as a diversifier within a portfolio.
In addition to the tax benefits already discussed, smaller companies have the potential to offer investors significant capital growth, although individually they typically have a higher failure rate than larger companies.
Investors should be reminded that the value of investments could fall or rise in value more than shares in more established listed companies. Small company investors should be comfortable with having a long-term investment horizon, and remember that in order to retain the 30 per cent upfront tax relief available through a VCT, investments must be held for at least five years.
VCTs have the potential to be attractive to income investors thanks to their tax-free dividends, and whilst dividends are never guaranteed, they are increasingly finding a place in retirement portfolios alongside other investments.
“Most VCTs, because of their ability to pay tax-free dividends, will end up trying to create a regular tax-free income stream for investors, and this can be very attractive to people looking for alternative income streams in their retirement planning," Lewis said.
However, Lewis explains that investors should closely look into the details of a VCT before adding it to their portfolio noting that the early stage, high growth focused Octopus Titan VCT, for example, is likely to appeal to a different kind of investor than the income-orientated Octopus Apollo VCT.
“You have varying VCT strategies that are looking to invest in different industry sectors and at different stages of companies' growth and development,” he stated. “Like with any investment, this means people should do their research on the specific VCTs on offer before choosing to invest.”
The above article was prepared in partnership with Octopus Investments and should not be taken as investment advice.
Important Information:
The value of an investment, and any income from it, can fall or rise. Investors may not get back the full amount they invest. VCT shares may also be harder to sell than listed shares. Personal opinions expressed in this article may change and should not be seen as advice or recommendation. We recommend investors seek professional advice before deciding to invest. This advertisement is not a prospectus. Investors should only subscribe for shares based on information in the prospectus, which can be obtained from octopusinvestments.com. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London EC1N 2HT. Registered in England and Wales No. 03942880. Issued: February 2016.
[1] Source: Tax Efficient Review 2015
[2] Source: Association of Investment Companies, January 2016