Darius McDermott, Managing Director of Chelsea Financial Services, looks at VCT opportunities in the market and why advisers need to keep their eyes peeled
During the last tax year, VCTs raised the second highest amount of capital since their inception, and the highest ever amount since the 30% income tax relief was introduced 12 years ago. But why the sudden rise in popularity?
I posed this question to a spokesperson from taxefficient investment specialist Calculus Capital, who told me that there are several reasons behind the “huge growth in popularity” of VCTs. Firstly, she said adviser and investor confidence in VCTs has grown as the asset class has matured and proven itself over time. She also pointed out that, as of last year, high-rate taxpayers’ pension contributions are tapered; for every £2 of income earned over a salary of £150,000 per year, the allowance falls by £1. This means that those who were lucky enough to make the full contribution are looking to invest the remainder of their savings.
“Whilst VCTs are not a substitute for pensions, they are an attractive product to sit alongside,” she reasoned. “In November 2017, VCTs also saw an increase of flows in the lead-up to the Chancellor of the Exchequer’s Budget, thanks to rumours that the 30% income tax relief would be slashed.”
The rumours proved unfounded – for now at least – but VCT offers filled up quickly.
Regulation changes have also altered the types of companies which can receive VCT funding. As such, we have noticed that VCTs have been raising capital less frequently, but look to raise larger chunks of money each time. The result of all this is that the investable pool is smaller than it usually is around this time of the year.
How have VCTs performed?
Many VCTs have performed well for several years, even during times when the broader market has struggled. They have also fared well despite Brexit-related uncertainty and the fear that this could impact UK smaller companies. However, UK small-caps (including the sorts of start-ups which VCTs invest in) have performed well.
In my view, this is simply because the UK is lucky enough to house some of the most successful, innovative market leaders in their respective fields, and many of these are further down the cap spectrum.
Not only this, smaller company shares have done well because, in the run-up to the EU referendum in 2016, a lot of small UK businesses were sold off and ended up trading at a 20% discount compared to UK large-caps. Their prices then rose as investors saw this as a buying opportunity.
This, combined with the fact that a weaker sterling made small-caps more attractive propositions for overseas investors to purchase, has stood small UK companies in good stead over the last couple of years. In fact, even though they’ve done well, UK smaller companies are still at a 10% discount compared to their larger peers – another reason they are still attractive.
And there’s an air of optimism among the managers themselves. Richard Hoskins, co-founder of Kin Capital which promotes Pembroke VCT, said he has been seeing an increase in the number of driven, bright, young founders who have steered away from traditional risk-averse employment routes after leaving university.
“More and more graduates are seeing entrepreneurship as a valid career path,” he told me. “They have often teamed with friends who are passionate about their innovative business concept, and approach us for investment after having proved the concept and then driven through initial early-stage growth.”
Here at Chelsea, we see no reason why their strong performance of VCTs can’t continue. We think it’s about the capabilities of the VCT managers themselves, and not just the strong performance of small UK businesses. Even though investing in start-ups and younger companies is higher risk, the level of due diligence we see among many VCT managers is impressive. VCTs can also build up cash reserves, which means that they can still pay out their tax-free dividends to investors during the trickier times.
Because of the rush into VCTs last year, offerings are a bit thin on the ground at the moment; especially when it comes to some of the more mature VCTs. However, there are some younger VCTs which are still open – simply because investors aren’t as familiar with them – which we think are attractive.
One example is Seneca, which closes in April 2019 and was only launched earlier this year. However, the firm has a long track record in managing taxefficient investment vehicles. Also, unlike many new VCTs, it should be able to start paying out tax-free dividends sooner rather than later – this is because Seneca partnered with Hygea VCT and is launching a new B share class. This new share class will be able to dip into the reserves on Hygea’s balance sheet to fund its dividend payments until its own investments are mature enough to pay out income.
John Davies, investment director at Seneca Partners, told me that the recent VCT rule changes are one of the key reasons Seneca came to market with its own VCT offering.
“For the last six years, Seneca has operated and performed well in the growth capital investment space, though its EIS [Enterprise Investment Schemes] growth fund and portfolio service, having invested in excess of £50m in over 70 investment rounds,” he said. “So, whilst the recent rule changes have forced existing VCTs to alter their investment strategy, for Seneca this is simply a continuation of its well-established investment strategy.”
Investors shouldn’t by any means ignore VCTs that are currently closed, either – it’s always a good idea to have VCTs that you like on your radar for when they start raising capital. Another example of a new VCT we like is Calculus, which was launched in March 2016. Despite its short track record, the firm has more than 20 years’ experience investing in small and medium-sized enterprises (SMEs), having launched the UK’s first HMRC-approved EIS fund 20 years ago.
The management team monitors the macroeconomic picture as well as selecting individual companies. This is because a lot of companies that it invests in, while domiciled in the UK, are global-facing. The team particularly likes the technology and healthcare sectors at the moment, because they underpin the UK government’s desire to stay at the forefront of innovation.
“We have been privileged with our deal flow through having very well established channels that bring us deals,” the team told us. “We very rarely find ourselves competing against others, and occasionally when we do, we work successfully together. There are of course challenges but having been a growth investor for 20 years, we have never seen the level of entrepreneurial activity in the UK as it is today.”
To sum up, while VCT offers are limited right now, some thorough research could stand investors in good stead when the next round opens.