17 March 22

How advisers can adapt to a shifting VCT market

  • To understand how VCT investing is evolving
  • To learn about the opportunities and risks associated with VCT investing
  • To understand how to use VCTs in the advice process

By Triple Point's Jack Rose. 

It is no secret that venture capital trusts have experienced success this year. So far, more than £800mn has been raised, already eclipsing the record of £779mn in 2005-06.

Changes to pensions taxation and rising inflation have certainly increased investment appetite, as has the opportunity to back high-quality exciting start-ups at attractive valuations.

But what is really driving the rising demand?

Rising demand for VCTs stems from a variety of factors rather than any single one.

The current economic climate is a significant contributor. With inflation hitting 5.5 per cent in January, the highest level in 30 years, and predictions suggesting it could reach as much as 8 per cent by April, investors are increasingly seeking alternative sources of income, not least because more will face the annual and lifetime allowance limits on tax-free pension saving.

The lifetime allowance is currently £1.07mn and has been frozen until 2025-26. The annual allowance is £40,000 but is tapered for high earners, effectively reducing the amount of money they can contribute to a pension. For every £2 of adjusted income above £150,000 a year, £1 of annual allowance will be lost.

In addition, with the 1.25 percentage point rise in tax on dividends and national insurance contributions fast approaching, tax relief is becoming a top priority for many investors.

VCTs present a tax-efficient investment solution by allowing investors to claim upfront tax relief worth 30 per cent of the amount invested, up to an investment of £200,000, and earn tax-free dividends and capital gains.

However, perhaps the most significant reason for this growing demand has been highlighted in recent data, which showed that the average age of the typical VCT investor has dropped by 11 years since 2017.

Data gathered by the Venture Capital Trust Association showed the average age of the current VCT investor is 56, down from 67 in 2017.

Shifting market

With the VCT market now more than 25-years-old, it presents a more reliable option as it has developed and matured.

There is now a core group of managers who have been able to demonstrate strong track records of delivering investor returns through multiple market cycles.

Investors can now access more mature and reliable portfolios while also having the opportunity to access new and exciting companies that will grow over time.

And the emerging younger investor may actually be more suited to VCT investment.

For example, these investors may have less pressing income requirement needs, as they are not planning for an immediate retirement, which may make the potentially irregular dividend payments of early-stage company investment a more suitable option.

What should advisers be aware of?

While this growing demand for VCTs is promising for advisers, this is not the VCT landscape they may be used to.

With increased amounts of money flowing into VCTs, there are a variety of considerations for advisers to manage these investments as well as a few pitfalls to be aware of.

Younger investors often use VCTs as a supplementary pension planning product, therefore an important consideration for advisers will be diversification.

The benefits of diversification are already firmly established in terms of spreading the risk and limiting exposure to any single asset.

However, portfolio diversification can also improve the yield and consistency of income as different assets experience varying performances at different times. Advisers should stress the value of spreading investment to reduce risk.

Advisers should also continue to engage more with platforms that allow investors to invest in and hold VCTs .

Younger investors are likely to invest smaller amounts on a more regular basis.

Platforms can help advisers manage this increased administrative burden and allow reporting on performance as well as monitoring and selling VCTs to become much easier.

Equally, the increased digitisation they offer provides a more efficient process with the convenience of, for example, dematerialising share certificates.

Platforms can also help with the exit and sale process for shares, which is normally quite complex as you typically need a stockbroker.

In addition, younger investors will increasingly expect their financial advice process to be digitised.

In a reflection of the wider digitalisation of financial services, a Financial Conduct Authority report found three in four (74 per cent) adults now bank online, while nearly six in 10 (58 per cent) bank using a mobile app.

While investment platforms do come with costs, if advisers are increasingly encountering younger, and therefore longer-term, clients, platforms will become an increasingly useful tool for managing portfolios and engaging with this new investor.

Another key thing for advisers to be aware of is the importance of paying attention to the amount of money a VCT is raising.

VCT investment is still a relatively niche sector, meaning there are limits on the amount of capital it can absorb.

Furthermore, with VCT qualifying rules requiring a timely deployment of capital, if too much is raised by managers there can be significant pressure to invest capital quickly.

This can leave investors paying a premium on valuations and more room for errors. Therefore, VCT investors will be making sure management houses have a solid deal pipeline to deploy the capital sensibly.

We know that in the current inflationary environment, bigger is not always better. A more selective and smaller VCT manager could offer investors a better and more sensible solution in the current market.

How investors can capitalise

For investors looking to capitalise on the current appetite for VCTs, there are a variety of factors they may want to consider.

For example, with millennials planning to retire later in life, capital growth becomes more important than obtaining dividends instantly. As a result, investors should pay more attention to the VCT reinvestment schemes on offer in order to compound their returns.

Equally, making use of the ability to recycle between VCTs offers reduced equity risk and compounds returns providing an additional source of uplift. These considerations could be key to capitalising on the full potential of VCTs for long-term pension planning.

Additionally, any VCT investor must be aware of the risks associated with investing in early-stage companies. Investors need to hold shares for five years to capitalise on the tax relief, and should be mindful that investing in start-ups can carry risks with the potential for volatile share prices.

For this reason, investing in VCTs is best seen as a long-term investment that must be carefully considered. Selecting the right VCT strategy is often the key to mitigating these risks.

Investors should also always remember that many start-ups do fail – about 20 per cent will fail in their first year with this figure rising to 60 per cent within the first three years.

While there are a variety of reasons for these failures, research by CB Insights suggests the primary reason for failure in almost half of cases is the lack of market need.

Traditionally, venture capitalists have tended to focus on researching a broad cohort of companies with the aim of identifying businesses that are likely to be successful. This research then underpins investment choice with the hope, rather than the expectation, that the market will validate this investment.

However, start-ups in certain sectors can provide greater chances of success. For example, high-growth B2B businesses accounted for 77 per cent of all exits in 2019.

VCT funds that target pre-Series A B2B technology start-ups tend to give better valuation on entry and, therefore, better returns to shareholders. 

A solution can be selecting VCT funds that work with larger corporates to identify the problems they are facing in order to allow the identification of start-ups that are offering a solution to these very real problems. This approach can be crucial to solving the all-important issue of market need and reducing the risks of investing in early-stage businesses.

If investors pay careful attention to the VCT strategy being employed, this form of alternative investment can offer significant benefits.

A huge opportunity

The growing UK tech sector presents a huge opportunity for investors to back high-quality, better-capitalised companies with lower valuations. And VCTs can enable investors to capitalise on this sector: out of the 100 companies on the fast track list of UK tech companies with the fastest growing sales over the past three years, VCTs have invested in 15.

As we transition out of the pandemic, it will become an even more urgent priority to invest in business that are looking to adapt and evolve. VCTs offer investors the opportunity to support this innovation while also capitalising on key income benefits.

However, with the market set for a record year amid the shifting VCT landscape, advisers and investors must take into consideration a variety of factors to ensure they are capitalising on current demand.

If VCTs are thoroughly considered, advisers and investors alike can reap the significant rewards that this alternative investment strategy can yield.

Jack Rose is Head of Retail Sales at Triple Point

This article was originally published in FT Adviser