VCTs and EIS might appeal to high earners, but it’s vital investors understand the risks and fees involved, explains Alex Davies, founder of broker Wealth Club.
Sections
Why consider VCT and EIS
How a VCT works
Venture Capital Trusts
A Venture Capital Trust is a company listed on the stock market that invests in unlisted businesses.
It is most akin to an investment trust.
It has a fund manager who invests in a basket of unquoted and/or AIM companies and helps them grow.
Upon investment, you acquire shares in the trust, not in the underlying companies.
Every so often the trust will raise new funds under a new share offer.
Those funds will then be deployed by investing in new businesses or by providing follow-on funding to existing portfolio companies.
VCTs have been around since 1995 and were the brainchild of Chancellor Ken Clarke.
To date, more than £7.3 billion has been raised in VCTs.
Well-known fund managers include the likes of Northern, Octopus and Maven. Last tax year a near-record £728 million was invested.
High-profile companies that have received VCT funding including Zoopla – the first VCT-backed £1 billion company – GO Outdoors and Secret Escapes.
Whilst some VCTs initially had a shaky start, over the last 10 years performance has been good.
The average VCT has outperformed the FTSE 100 over five and 10 years, and better-performing funds over 10 years will have doubled investors’ money with dividends re-invested.
VCT tax relief
The risks of VCT
Investing in smaller businesses is riskier than investing in large ones.
Statistically, they are more likely to fail and can be illiquid.
That said, a typical VCT has a portfolio of between 30 and 60 companies, generally in a few sectors, which gives you some diversification.
What’s more, we would always suggest investors spread their annual contribution over a number of VCTs.
If you invest in three you could easily have a spread of 100-plus investments.
In addition, when you invest in a VCT you get exposure to the whole portfolio.
In many cases, this includes historic investments in larger, more mature and therefore less risky companies than current rules allow.
Finally, there is the matter of fees.
These can be extraordinarily high in this sector – it’s even been claimed that one in four investors shell out more in charges than they get back in tax relief – so it’s vital you understand what you’ll be paying before committing.
How an EIS works
Unlike a VCT, when you invest in EIS you invest directly into a particular company or basket of companies.
You can choose the companies yourself or invest through a fund run by a discretionary manager who will typically spread your money into five or six companies.
Successful companies that have benefitted from EIS funding include software company Tracsis, now valued at £200 million, Brewdog with a valuation of more than a £1 billion and the recently floated City Pub Group with a valuation of more than £100 million.
EIS tax relief
Risks of investing in EIS
EIS funds tend to invest in a limited number of companies, so they tend to be less diversified than a typical VCT.
In addition, many EIS investors choose single companies.
Having said that, the maximum loss you can make through EIS is heavily reduced by the tax breaks on offer.
So for the right type of investor, EIS investments are far from insanely risky.
And, of course, if you make the right decisions, the returns could be very juicy, giving you many multiples of your original investment.
Who are VCT and EIS suitable for?
If you have sufficient assets elsewhere, you have already used your pension and ISA allowances, and have a certain level of financial sophistication, VCTs and EIS are likely to be a sensible option for you to consider.
Conversely, if you can’t afford to lose money, these investments aren’t for you.
As a rule of thumb, VCTs should represent no more than 10% to 15% of your total portfolio.
Which is more suitable?
In my opinion, it is not a question of choosing one over the other, many of our clients have both VCTs and EIS.
Broadly speaking, if income is your priority, VCTs are a more obvious choice.
If you prefer potential long-term capital growth, and perhaps you have capital gains as well as income tax liabilities, EIS could be more advantageous.
Alex Davies is the founder of broker Wealth Club.