<p>Venture capital trusts (VCTs) were created in the mid-1990s to provide much-needed capital for small, fast-growing companies. A pretty dazzling array of tax reliefs are offered to lure investors into this high-risk area. But the rules are shifting and the VCT landscape is changing.</p>
<p><!--more--></p>
<p>I own one venture capital trust &#8211; the original Baronsmead fund &#8211; having first invested in it back in 2005. I&#8217;ve added to it five times since, taking part (I think) in every subsequent fundraising it has had. Like many of my investments, I chose it because of its steady record over a prolonged period. Other folks can try to shoot the lights out.</p>
<h2>Climbing the risk ladder</h2>
<p>VCTs are curious beasts and a niche pursuit. In the risk stakes, I&#8217;d say they are a level up, perhaps even two, from most normal investment trusts. They primarily invest in private and AIM-listed companies, so their performance can vary widely from trust to trust and from year to year. Some have produced excellent returns. Others have stunk the place up.</p>
<p>They tend to quite small in size, most having assets of £100m or less. This means their ongoing charges tend to be very high. 3% a year is typical, compared to 0.6% for the average global investment trust.</p>
<p>My Baronsmead fund is looking to raise fresh money early next year, and I&#8217;m debating whether to add to my position again. Since 2015, there have been numerous rule changes regarding what VCTs can invest in, giving me pause for thought. Some of these changes are in place now, while others will take effect soon.</p>
<p>To add to my dilemma, a couple of weeks ago, a change of ownership for Baronsmead&#8217;s fund manager, Livingbridge, was announced. What I thought would be a straightforward top-up decision now seems a lot more complicated!</p>
<h2>The tax benefits of VCTs</h2>
<p>VCTs trade on the stock market like other investment trusts. But, as far I know, not that many people buy them this way. They normally buy in when a VCT raises new money by issuing shares, as investing at this stage provides an additional tax benefit.</p>
<p>Here&#8217;s how the tax reliefs for VCTs work: any dividends you receive or capital gains you make from a venture capital trust are tax-free. So, that&#8217;s one less thing to worry about when it comes to your tax return.</p>
<p>In addition, when you subscribe to a brand new VCT or buy new shares being issued by an existing VCT, then there is 30% income tax relief available (on investments of up to £200,000 in any given tax year).</p>
<p>Therefore, if you invested £10,000 you can reclaim £3,000 via your tax return, assuming that you have paid that much income tax in the first place. To keep the tax relief, you must hold your VCT shares for five years.</p>
<p>There&#8217;s a potential sting in the tail to consider as well. Should a VCT no longer comply with all the relevant regulations, then the tax protection its investors enjoy would vanish. I haven&#8217;t heard of an example of where this has happened, but it&#8217;s not something I have researched in any detail.</p>
<h2><a id="rules"></a>What can VCTs invest in?</h2>
<p>To keep their VCT status, these funds are required to have 70% by value of their investments in &#8216;qualifying holdings&#8217;. Here&#8217;s just a flavour of what that means:</p>
<ul>
<li>should be a UK-based company;</li>
<li>must not be in financial difficulty when it receives the investment;</li>
<li>the investment should be used to grow or develop the business, and not to acquire another business or fund a management buy-out;</li>
<li>the total venture capital funding received in the company&#8217;s lifetime must not exceed £12m or £20m if it&#8217;s deemed to be a &#8216;knowledge-intensive&#8217; company;</li>
<li>there is a £5m annual limit on all venture capital funding, raised to £10m for knowledge-intensive companies.</li>
<li>must be a trading business. Property, most financial services, hotels, nursing homes, farming, coal and steel production, and shipbuilding are among the types of business that are specifically excluded;</li>
<li>must have received its first venture capital funding within the seven years of making its first commercial sale (extended to ten for knowledge-intensive companies);</li>
<li>can&#8217;t be quoted (but can be on AIM);</li>
<li>should have gross assets (i.e. the total of its property, equipment, stock, debtors and cash) of £15m or less before an investment is made and £16m or less immediately afterwards; and</li>
<li>have less than 250 employees (or 500 for knowledge-intensive companies) when the investment is made.</li>
</ul>
<p>Phew! And there are many more technical rules that need adhering to. Obviously detailed, and no doubt costly, compliance records are needed for each investment a VCT makes.</p>
<p>The 70% minimum limit for qualifying holdings is being increased to 80% for accounting periods starting on or after 6 April 2019. My Baronsmead investment has a year end of 30 September, so the first year the increased limit applies should be the year ending 30 September 2020.</p>
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<h2><a id="tail"></a>How the tax tail has wagged the dog</h2>
<p>The money raised by all VCTs has varied a lot from year to year. Fundraisings are very common, too. In most years, about half of existing VCTs have raised new money.</p>
<table id="iti" width="400px">
<tbody>
<tr>
<th>Tax year</th>
<th style="text-align: right;">Amount raised (£m)</th>
<th style="text-align: right;">Funds raising money</th>
<th style="text-align: right;">Funds in existence</th>
<th style="text-align: right;">Tax relief</th>
</tr>
<tr>
<td>1995-96</td>
<td style="text-align: right;">160</td>
<td style="text-align: right;">12</td>
<td style="text-align: right;">12</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>1996-97</td>
<td style="text-align: right;">170</td>
<td style="text-align: right;">13</td>
<td style="text-align: right;">18</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>1997-98</td>
<td style="text-align: right;">190</td>
<td style="text-align: right;">16</td>
<td style="text-align: right;">26</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>1998-99</td>
<td style="text-align: right;">165</td>
<td style="text-align: right;">11</td>
<td style="text-align: right;">34</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>1999-00</td>
<td style="text-align: right;">270</td>
<td style="text-align: right;">20</td>
<td style="text-align: right;">43</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>2000-01</td>
<td style="text-align: right;">450</td>
<td style="text-align: right;">38</td>
<td style="text-align: right;">61</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>2001-02</td>
<td style="text-align: right;">155</td>
<td style="text-align: right;">45</td>
<td style="text-align: right;">70</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>2002-03</td>
<td style="text-align: right;">70</td>
<td style="text-align: right;">32</td>
<td style="text-align: right;">71</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>2003-04</td>
<td style="text-align: right;">70</td>
<td style="text-align: right;">31</td>
<td style="text-align: right;">71</td>
<td style="text-align: right;">20%</td>
</tr>
<tr>
<td>2004-05</td>
<td style="text-align: right;">520</td>
<td style="text-align: right;">58</td>
<td style="text-align: right;">98</td>
<td style="text-align: right;">40%</td>
</tr>
<tr>
<td>2005-06</td>
<td style="text-align: right;">780</td>
<td style="text-align: right;">82</td>
<td style="text-align: right;">108</td>
<td style="text-align: right;">40%</td>
</tr>
<tr>
<td>2006-07</td>
<td style="text-align: right;">270</td>
<td style="text-align: right;">32</td>
<td style="text-align: right;">121</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2007-08</td>
<td style="text-align: right;">230</td>
<td style="text-align: right;">54</td>
<td style="text-align: right;">131</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2008-09</td>
<td style="text-align: right;">150</td>
<td style="text-align: right;">46</td>
<td style="text-align: right;">129</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2009-10</td>
<td style="text-align: right;">340</td>
<td style="text-align: right;">68</td>
<td style="text-align: right;">122</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2010-11</td>
<td style="text-align: right;">350</td>
<td style="text-align: right;">78</td>
<td style="text-align: right;">128</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2011-12</td>
<td style="text-align: right;">325</td>
<td style="text-align: right;">76</td>
<td style="text-align: right;">124</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2012-13</td>
<td style="text-align: right;">400</td>
<td style="text-align: right;">65</td>
<td style="text-align: right;">118</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2013-14</td>
<td style="text-align: right;">440</td>
<td style="text-align: right;">66</td>
<td style="text-align: right;">97</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2014-15</td>
<td style="text-align: right;">435</td>
<td style="text-align: right;">57</td>
<td style="text-align: right;">94</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2015-16</td>
<td style="text-align: right;">445</td>
<td style="text-align: right;">45</td>
<td style="text-align: right;">80</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2016-17</td>
<td style="text-align: right;">570</td>
<td style="text-align: right;">38</td>
<td style="text-align: right;">75</td>
<td style="text-align: right;">30%</td>
</tr>
<tr>
<td>2017-18</td>
<td style="text-align: right;">730</td>
<td style="text-align: right;">n/a</td>
<td style="text-align: right;">n/a</td>
<td style="text-align: right;">30%</td>
</tr>
</tbody>
</table>
<p><sup>Source: HMRC and AIC for 2017-18</sup></p>
<p>There are spikes around the year 2000, presumably relating to an increase in technology-related funds, and in the mid-2000s when the tax relief was raised to 40% for a couple of years. VCTs are heavily promoted by financial advisers because of their tax benefits.</p>
<p>Demand for VCTs has also been particularly strong in the last few years. Many people suspect this is because the rules on pension contributions have become more restrictive. Some folks may have turned to VCTs instead to reduce their tax bills.</p>
<h2>For the few, not the many</h2>
<p>Let&#8217;s break down the numbers on VCT subscriptions. The latest available numbers are a little dated but the pattern seems similar from year to year.</p>
<h3>VCT subscriptions in 2015/16</h3>
<table id="iti">
<tbody>
<tr>
<th>Invested up to (£)</th>
<th style="text-align: right;">Number of investors</th>
<th style="text-align: right;">Total invested (£m)</th>
</tr>
<tr>
<td>1,000</td>
<td style="text-align: right;">1,210</td>
<td style="text-align: right;">0.5</td>
</tr>
<tr>
<td>2,500</td>
<td style="text-align: right;">620</td>
<td style="text-align: right;">1.0</td>
</tr>
<tr>
<td>5,000</td>
<td style="text-align: right;">1,350</td>
<td style="text-align: right;">6.0</td>
</tr>
<tr>
<td>10,000</td>
<td style="text-align: right;">2,530</td>
<td style="text-align: right;">21.9</td>
</tr>
<tr>
<td>15,000</td>
<td style="text-align: right;">1,185</td>
<td style="text-align: right;">15.7</td>
</tr>
<tr>
<td>20,000</td>
<td style="text-align: right;">1,275</td>
<td style="text-align: right;">24.2</td>
</tr>
<tr>
<td>25,000</td>
<td style="text-align: right;">765</td>
<td style="text-align: right;">18.1</td>
</tr>
<tr>
<td>50,000</td>
<td style="text-align: right;">2,130</td>
<td style="text-align: right;">82.1</td>
</tr>
<tr>
<td>75,000</td>
<td style="text-align: right;">635</td>
<td style="text-align: right;">39.5</td>
</tr>
<tr>
<td>100,000</td>
<td style="text-align: right;">635</td>
<td style="text-align: right;">59.7</td>
</tr>
<tr>
<td>150,000</td>
<td style="text-align: right;">325</td>
<td style="text-align: right;">40.8</td>
</tr>
<tr>
<td>200,000</td>
<td style="text-align: right;">615</td>
<td style="text-align: right;">120.4</td>
</tr>
<tr>
<td><strong>Total</strong></td>
<td style="text-align: right;"><strong>13,280</strong></td>
<td style="text-align: right;"><strong>430.0</strong></td>
</tr>
</tbody>
</table>
<p><sup>Source: HMRC</sup></p>
<p>Contrast the numbers above with the 10m cash ISAs and 2.5m stock and shares ISAs taken out that same year. In terms of the amount invested, the £80bn in ISAs was nearly 200 times greater than for VCTs. I did say it was niche!</p>
<p>Around half of VCT investors put in £15,000 or less, which was the ISA limit (or thereabouts) in 2015/16. But half of the money subscribed came from a small group of 1,500 heavy hitters who put in £75,000 or more.</p>
<h2>The rules they are a-changin</h2>
<p>The fact that a lot of the tax relief was going to just a few people may have spurred the government to take a closer look at VCTs.</p>
<p>The 30% level of tax relief has been unchanged for many years now, as has the £200,000 maximum. What has changed, however, is the underlying rules VCTs must comply with, making it harder to see what&#8217;s going on. Check out <a href="https://www.gov.uk/hmrc-internal-manuals/venture-capital-schemes-manual">the full rules here</a>, if you have a year or two to spare.</p>
<p>The first round of changes came in 2015 and mostly related to complying with EU state aid rules. This primarily stopped VCTs investing in companies that looking to finance an acquisition or to fund management buy-outs.</p>
<p>In other words, the emphasis shifted to making sure VCTs were funding young, growing companies. That seems fair enough to me. The argument is that VCT investors need to be taking on a decent level of risk if they are entitled to the generous tax reliefs these funds offer.</p>
<p>The 2017 Budget tightened up the rules still further, incorporating recommendations from the snappily titled <a href="https://www.gov.uk/government/publications/patient-capital-review">Patient Capital Review</a>. The two main changes introduced at this time were:</p>
<ul>
<li>from 6 April 2018 onwards, 30% of funds raised in an accounting period should be invested in qualifying holdings within 12 months after the end of the accounting period; and</li>
<li>the proportion of VCT funds that must be held in qualifying holdings increased from 70% to 80%, with effect for accounting periods beginning on and after 6 April 2019.</li>
</ul>
<h2>What does it all mean?</h2>
<p>In short, there is now a smaller pool of available companies for VCTs to invest in. And the smaller pool consists of riskier investments.</p>
<p>It&#8217;s a bit concerning that a greater amount of money has been raised these past few years, just as the size of the pool has been shrinking and getting more perilous to fish in. While it&#8217;s good for the companies getting money from VCTs (they should get a higher price), it may reduce returns for VCT investors.</p>
<p>Most VCTs have welcomed the changes and say they are in a good position to adjust the way they invest. Baronsmead, for example, seems quite <span data-dobid="hdw">blasé, with scant references to the changes in its recent reports</span>. The trouble for VCT investors is that it&#8217;s hard to really know how significant these changes will be, given that we&#8217;re not at the coal face.</p>
<p>What&#8217;s more, these changes will take a while to work their way through and make an impact on fund returns. Many VCTs pay out dividends using the cash they raise from selling companies. This can be several years after the initial investment.</p>
<p>It&#8217;s also possible that now the rules are becoming a lot more complex, the chances of a VCT losing its status due to non-compliance are greater (although they are probably still small I suspect).</p>
<h2>Fewer, but bigger funds</h2>
<p>You might have noticed from the first table that the number of VCTs has been shrinking for a while, even before these recent changes were announced. In fact, there are around 60 VCTs now, less than half the amount there were a decade ago.</p>
<p>That&#8217;s because funds have been merging and generally getting bigger. My Baronsmead fund merged with Baronsmead 2. Baronsmead 3 and 4 joined forces, too. There is even a fund called Octopus Titan with assets of over £600m that&#8217;s looking to raise up to £200m this year.</p>
<p>The idea is that larger funds will have more flexibility to absorb the peaks and troughs in performance that investing in more risky companies entails.</p>
<h2>What I&#8217;m doing</h2>
<p>I&#8217;ve got several weeks to decide on Baronsmead&#8217;s next fundraising, as it&#8217;s due to take place in early January.</p>
<p>Right now, I&#8217;m minded to add a little more, but perhaps less than I&#8217;ve done for past fundraisings. Given that it&#8217;s one of my smaller holdings, the additional risk should be fairly minimal.</p>
<p>But I&#8217;ll be keeping a closer eye on Baronsmead in future and may attend the next AGM in February 2019 to learn a little more about how it&#8217;s coping with the new rules.</p>
 
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<p>Please note that I may own some of the investments mentioned above -- you can see my current holdings on <a href="https://www.itinvestor.co.uk/portfolio/">my portfolio page</a>. </p>
<p>Nothing on this website should be regarded as a buy or sell recommendation as I'm just a random person writing a blog in his spare time and I am not authorised to give financial advice. Always do your own research and seek financial advice if necessary!</p>
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