When to invest in venture capital trusts

In the 2023-24 tax year, venture capital trusts (VCTs) raised a total of £882mn. While nothing to sneeze at, it was almost £200mn less than the previous 12-month period, equivalent to a decrease of 18.2 per cent. This partial decline did not come as a shock to sector commentators such as Jason Hollands, managing director of Bestinvest. “The key drivers for the dip in fundraising were the macroeconomic environment and changes to pensions," he says.

One headwind is the tough environment for small UK companies. “While the recession arrived much later and was considerably shallower than many forecasters had predicted, the headwinds early-stage businesses faced from sluggish growth, cost inflation and rising financing costs dampened investor appetite,” Hollands says. 

But the most significant change has been the abolition of the lifetime allowance (LTA), which de facto applied from April 2023, albeit the finer points of the policy are still being ironed out. The allowance limited the total amount of money someone could hold in a pension without facing a tax charge to £1,073,100. That pushed people who were close to the threshold towards other tax-efficient investments, including VCTs. 

The removal of this limit means that VCTs are likely to be a less attractive vehicle for certain people in the near term. But others will still find them a useful tool in their financial planning arsenal.

VCTs vs pensions

Pension contributions are generally the principal option for mitigating income tax, because you can claim full tax relief on them. For example, if you are a higher-rate taxpayer contributing £20,000 to a pension, you automatically receive tax relief of £5,000 for the first 20 per cent of income tax, and can claim back an additional £5,000 through self-assessment. You can then invest the money in a wide range of assets with different risk profiles and let it grow tax-free, although anything you draw from the pension at a later date will then be subject to income tax at your marginal rate.

If you are a VCT investor, you receive income tax relief of 30 per cent on your investment as long as you stay invested for at least five years, and also enjoy tax-free dividends and capital gains. While this is attractive, VCTs are higher-risk investments that are not suitable for everyone, and typically rank behind pensions as the preferred port of call for income tax mitigation. You can invest up to £200,000 a year in VCTs.

Luke Barnett, head of tax-advantaged investments at St James’s Place, explains: “A lot of people who would have previously reached their LTA limit would have probably looked at VCTs to top up their pension pot. But as the income tax brackets have been frozen, despite recent inflationary pressures, more people are finding themselves being shifted into higher-rate tax bands, and as a result VCTs will still be of interest to higher earners.”

Despite the abolition of the LTA, there are still limits to what you can contribute to your pension while receiving tax relief. The annual allowance is set at £60,000, but this may be lower if you have already accessed some of your pension pot or if you are a very high earner. For example, the money purchase annual allowance (MPAA) of £10,000 applies if you take an income through drawdown or uncrystallised funds pension lump sums (UFPLS) from your pot. If your income is above £200,000, your annual allowance can be tapered to a minimum of £10,000.

There is also a question of whether the LTA will be reintroduced if Labour wins this year’s general election. Hollands notes that the window for those with large pensions to maximise their contributions is likely to be limited as a result, and that “VCT demand could be a short-term casualty”. But as we recently discussed, it might take some time for the LTA to be reintroduced, and its return could be at a much higher level, which could impact the VCT market for longer.

Mind the liquidity

“A VCT is typically attractive to someone who is a high earner, has already utilised their pension and other allowances, such as the Isa allowance, and wants an alternative investment to achieve some tax-relief,” says Megan Rimmer, chartered financial planner at Quilter Cheviot. “Due to the higher risk, they aren’t for everyone – but there is certainly a place for them within a financial plan, for the right person."

If you fit the bill, VCTs have some advantages. Barnett notes that they provide private investors with access to an asset class that is typically the domain of institutional investors, and unlike investments made via the enterprise investment scheme (EIS), also offer a decent level of diversification through a mixture of mature and early-stage companies. While most people don’t need venture capital in their portfolio, it can provide a degree of diversification to the more standard mix of equity and fixed income and gives you the option to support some exciting new companies. Barnett also says that the venture market in the UK is becoming more established.

Most of the returns come from the tax-free dividends, with many VCTs yielding in the region of 5 per cent – although this is not as attractive as it was at a time when interest rates were near zero. Being a high-risk investment, VCTs can easily underperform other investments, but thanks to the income tax relief, “investment returns do not need to be stellar to make this worthwhile, providing you at least get out what you originally subscribed through dividends and capital”, says Hollands.

But you should keep in mind that VCTs are not a very liquid investment. While they are listed on the London Stock Exchange, secondary shares do not offer income tax relief, and as a result are not widely exchanged. VCTs themselves offer buyback facilities that are typically the only exit option. “Generally this works quite well, but when there are periods of low levels of exit or where there is limited liquidity within the vehicle, the level of buybacks may be impacted,” says Barnett. VCTs’ returns can also be quite lumpy, because within the portfolio there might be various businesses that don’t do particularly well, alongside one big success story that brings a sudden uplift.