Four questions to ask when choosing a Venture Capital Trust

If you want a great British success story, look no further than venture capital trusts (VCTs). For more than two decades, VCTs have been providing long-term finance to some of the UK’s brightest smaller companies. For the 2017-18 tax year, the total raised by all VCTs was more than two-and-a-half times the sum raised five years earlier[1]. At the same time, VCT investors can claim valuable tax incentives in exchange for embracing the high-risk nature of smaller company investing.

Before we start, it’s worth highlighting some of the key risks associated with investing in a VCT. VCT shares are by their nature high risk, more volatile than shares listed on the main market of the London Stock Exchange and may be harder to sell. The value of a VCT investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they originally invested.

An investor’s tax treatment will depend on their individual circumstances and may change in the future. The tax reliefs also depend on the VCT maintaining its VCT-qualifying status.

As with any type of investment, there is a wide range of choice in the type of VCTs available. So it pays to ask some key questions to determine which VCT is most appropriate for your clients. Here are four questions you may want to consider:

  1. What’s the VCT’s structure?
  2. Does the VCT have a strong and experienced management team?
  3. How much support does the management team offer to portfolio companies?
  4. Does the VCT have a history of delivering for investors?

 

1. What’s the VCT’s structure?

You can group the different types of VCT into three main categories. When it comes to choosing the right structure, there’s no right or wrong answer. But understanding the differences can help to determine which is the most appropriate for your clients:

Generalist VCTs invest in unquoted companies across a range of different sectors. Most VCTs available today fall into this category. These VCTs have significant flexibility to invest where they believe the best opportunities are, because they’re not restricted to particular sectors the way specialist VCTs are (see below). Because of this, it’s important to note there is a wide variety of investment approaches with varied track records. So it pays to do your homework on those managers with a sound investment strategy and a long, strong track record in early-stage investing.

AIM VCTs invest in companies listed on the Alternative Investment Market (AIM). By having an AIM listing the portfolio companies are required to meet minimum regulatory and governance requirements, and higher levels of reporting than unlisted companies. AIM-listed companies can also be easier to sell than unquoted companies.

Specialist VCTs operate within a specific sector or market, such as environmental, infrastructure, media, leisure and events, and technology. They are often smaller in size, due to the sector restrictions on available investments, and can have higher fixed costs relative to the size of the fund. But they also have the potential to do particularly well if that chosen sector outperforms.

2. Does the VCT have a strong and experienced management team?

With AIM-listed companies, a VCT manager can pore through company reports and accounts, trading updates and reams of company research and analysis. VCTs mostly invest in unlisted companies. This means the management team has a tough job to do in determining the strength of an investment proposition. A VCT manager investing in unlisted companies has to take a different approach. As well as looking at all available data, they must also get to know the company’s founders and the industry the company is operating in. This helps to determine whether the company has the potential to become a long-term holding. As a result, VCT managers often need to have the vision to look beyond a company’s current standing and focus on the long-term potential that could be realised with the right funding.

Investing in small, VCT-qualifying companies is high risk and not every company will prove successful. However, VCT managers worth their salt have a keen eye for spotting those with the qualities they believe could lead to success

3. How much support does the management team offer to portfolio companies?

Turning start-up or early-stage companies into success stories doesn’t happen automatically. Indeed, many will fail. The best VCT managers understand that supporting portfolio companies means more than just investment. Early-stage companies can often need nurturing, and good VCT managers will offer their experience and support. They don’t just make an investment, but also actively participate in the company’s growth plans. It’s not unusual for one of the VCT manager’s team to sit on the board of directors, which allows them to play a prominent role in the company’s ongoing development. Taking this one step further, to help portfolio companies achieve their full potential, fund teams may take an international approach, with offices in the USA, Asia and Europe. This can be particularly beneficial for UK-based companies looking to expand into an unfamiliar new market.

4. Does the VCT have a history of delivering for investors?

A history of backing multiple winners and making successful exits is a signal that a VCT’s management knows what it’s doing. A good performance record signals that managers can find the right kind of deals, that they have good filters in place, that they can run their portfolio in a balanced way.

Of course, track record is far from the whole story, and investors should never rely on past performance as the reason for making an investment. And investing in early stage companies will always be at the high end of the risk spectrum, however talented an investment team might be. Even the best VCTs will make investments that don’t work out and end up losing money.

What you’re looking for are signs that a VCT’s managers can do the things that drive returns for investors. They’re signs, not guarantees.

By helping these companies grow, the value of the investment in the company will also hopefully increase. When the time is right, the managers of the VCT will look to take a profit for investors and sell its holding (known as an ‘exit’).

The proceeds of the sale, including any capital growth, are then usually distributed to investors, in the form of tax-free dividends rather than letting the share price of the VCT increase in value.

As well as being used to pay dividends to investors, some of the proceeds of an exit can be put back to work. A VCT can either invest in new companies or put more money into ones it already holds. In recent years, VCT investors have benefited from some of the most high-profile early-stage exits in the UK. In fact, some of the world’s biggest and most innovative technology companies, such as Google, Microsoft, Amazon and Twitter, have acquired businesses that used VCT investment to fuel their growth.

In addition to investment performance, it’s also important to look at the track record of a VCT in buying back shares from its investors, and thus its ability to provide liquidity to investors. This is a crucial and often overlooked factor when assessing different VCTs.

It’s always worth remembering that the tax benefits associated with investing in a VCT are there, in part, to offset the higher risk associated with investing in small UK companies. The value of a VCT investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they invest.

An enterprising future…

It’s a truly exciting time for VCTs. Many advisers now consider them to be a powerful planning tool, and can be used by investors as a tax-efficient way to complement and diversify their existing investment portfolio. According to the Association of Investment Companies (AIC), VCTs raised £728 million from investors in the 2017-2018 tax year (an increase of 34% from the previous year) and there is now a total of £4.3 billion invested in the VCT market. As the demand for VCTs continues to grow, it really pays to do your homework, ask the right questions and look for those established VCT managers with a good long-term track record in early-stage investing.

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Paul Latham, Managing Director of Octopus Investments

[1] Source: https://www.theaic.co.uk/aic/news/press-releases/vct-fundraising-for-201718-close-to-all-time-high

Personal opinions mentioned in this blog may change and should not be seen as advice or a recommendation. VCTs are not suitable for everyone and any recommendation should be based on a holistic review of your client’s financial situation, objectives and needs. Additionally we do not offer investment or tax advice and we recommend that investors seek professional advice before deciding to invest. 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: November 2018. CAM07637-1811

For UK professional advisers only. Not to be relied upon by retail investors. Octopus Investments Ltd is authorised and regulated by the Financial Conduct Authority.