As the UK raises taxes, where do venture capital trusts fit in?
Investment vehicles that have certain tax advantages over time are more popular when certain entities, such as pensions, come under pressure as governments attempt to increase revenue. The author of this article makes the case for venture capital trusts.
As pension tax breaks are cut by a government desperate for income but also (somewhat inconsistently) claiming to want to encourage investment, what options do wealthy investors have in the UK? One segment that continues to air is the venture capital trust market. CDVs date back to the early 1990s and, with some tweaks to their tax status and rules, have been part of the landscape ever since.
We carry the following guest commentary written by Jack Rose, director of strategic sales at investment house Triple Point. The editors are happy to share these views and invite responses. Remember that the usual editorial disclaimers apply to the opinions of guest contributors. E-mail
UK start-ups have performed remarkably well during the pandemic with a quarter of UK ‘unicorns’ being created in 2021. In particular, tech start-ups were booming with £26bn ($35.3bn). dollars) raised, doubling the previous year’s numbers and creating a record number of unicorns. (1) Indeed, periods of great change often create opportunities for accelerating innovation, as we also saw from 2007 to 2009.
Investors wishing 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 capitalize on the optimism of economic recovery and support high-quality companies at attractive valuations to generate strong returns. And, with inflation jumping to 5.4% in December, the highest level in nearly 30 years, income-seeking investors may find VCTs’ ability to pay tax-free dividends particularly appealing. (2)
Rising taxes lead to increased funding
While the skills of VCT managers are key to generating strong returns, the tax advantages of these investment vehicles are significant and are also a factor for investors committing capital to the sector. With an additional 1.25% 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% of VCT investors say tax breaks are the main reason for investing in them. (4) Indeed, they remain a very tax-efficient investment solution, allowing investors to claim income tax relief in advance to the value of 30% of the amount invested, up to to an investment of £200,000, and earn tax-free dividends and capital gains. .
Those looking to capitalize on the benefits of VCT have an array of options. For example, generalist VCTs offer the opportunity to invest in a variety of sectors while specialized VCTs focus on a specific sector. Each investment objective offers different disadvantages and advantages – the lack of diversification of a specialized VCT can sometimes create increased risk, for example. Alternatively, AIM VCTs offer investors exposure to stocks issued by AIM companies, but come with the trade-off of potentially increased volatility compared to other VCTs. Selecting the appropriate investment strategy and focus is key to managing some of the risks associated with VCT investing.
A crackdown on pension tax exemptions for high earners in recent years has drawn money into the sector, and the new tax on dividends and investors’ relentless appetite for yield could funnel even more funds into the sector. sector, with VCT collecting 4% more in 2020/21 than the previous year. (5) By early January this year, investors had already invested a record £580m in VCTs, more than double the £280m invested in 2021, signaling that 2022 could be a record year for VCT fundraising. (6)
Choosing the right VCT strategy is essential
However, while VCTs can provide an attractive and tax-efficient opportunity to invest in high-growth businesses, it is also crucial that investors consider the risks. Investing in startups can involve significant risk – share prices can be volatile and investors must hold shares for five years to retain tax relief. While some large VCTs have seen their stock prices jump 20-30% over the past five years, others have fallen more than 30%. For this reason, VCT investments are long-term investments that should be carefully considered. It is essential to ensure a thorough evaluation of the strategy that CDV managers use.
It must be remembered that many startups fail. Some 20 percent do so in their first year and that figure rises to 60 percent in their first three years. (7) Difficulties with cash flow or hiring the wrong staff are often to blame, but research from CB Insights indicates that the top reason for startup failure, cited in 42% of cases, is lack of of market need. (8)
However, startups in certain industries also tend to have a higher chance of success, especially B2B tech companies. There is a greater proportion of high-growth companies with a B2B model than those with B2C models, and there are generally more exits by B2B companies, accounting for 77% of all exits in 2019. (9)
As a result, VCT funds that invest in pre-Series A B2B tech start-ups tend to offer better valuation at entry and better returns for shareholders. It is also crucial to implement a strategy that seeks to mitigate the risks of investing early in B2B companies by selecting those that are actively solving business challenges and have established support for their product or service, thereby addressing the thorny issue of lack of market need.
VCTs are still a relatively specialized investment sector, which means that there are also limits to the amount of money it can absorb. It is essential to pay close attention to the amount of money a CDV raises. With VCT qualification rules focused on ensuring rapid capital deployment, too much money raised can put pressure on managers to deploy capital, which can impact selectivity. Given the large size of offerings this year for many VCTs, there is an argument for investors to consider some of the smaller offerings such as Triple Point to selectively ensure deal flow. The biggest is not always the best.
Likewise, there are other alternative investments to consider. For example, EIS investing can also offer the crucial tax relief provided by VCTs, as well as other benefits. Unlike VCTs, EIS offer a “carry-forward” feature to offset the tax relief on income tax from previous years. In addition, EIS investments may qualify for commercial relief which may provide further relief from inheritance tax. However, both offer a key opportunity to invest in start-up companies and therefore carry the risks of investing in these companies. Ultimately, investments in VCTs and EIS must be carefully scrutinized to ensure that investors receive the high rewards that come with these high-risk strategies.
Supporting UK tech innovators
Despite economic uncertainty, Brexit and investor anxiety in other sectors, venture capital funding continues to flow into the UK tech sector in record amounts. In 2021 alone, tech investors backed UK start-ups with £20 billion in funding, meaning investment has nearly doubled in the past three years. (ten)
Venture capital funding offers investors the opportunity to take advantage of this exciting growth. For example, of the 100 on the Fast Track list of UK tech companies with the fastest sales over the last three years, VCTs have invested in 15 of them. (11) Since 2015, VCTs have been required to invest in younger companies and as such are a great way to provide smart startups with access to capital in the early stages of their growth. More than four-fifths of VCT investors agree, believing they help UK entrepreneurs with their investing. (12)
In the instability of the post-pandemic world, it is all the more urgent to invest in companies that want to adapt, evolve and innovate in order to help refresh the economy and stimulate recovery. CDVs can provide the opportunity to do this while mitigating future tax increases. However, investors should be careful to prioritize the right strategy and consider the risks associated with investing in start-up companies. If they do, investors can reap the rewards of such an investment strategy.