Octopus: Pension changes positive for VCTs

This quarter has been an auspicious one for the VCT sector. April marked the 20th anniversary since VCTs were created, in a month that also saw the sector pay out the highest level of dividends in its history. Furthermore, VCTs made their debut on an adviser platform when Octopus Investments’ VCT shares were listed on Transact.

Investors have continued to gravitate to the sector, with £429m raised in the 2014/15 tax year, the highest amount since 2005/06. Over the year to 5 April 2015, VCT funds under management rose from £3.22bn to £3.46bn, according to the AIC.

So what have been the main draws of the sector? And after these somewhat halcyon times, is the sector facing any headwinds?

“VCTs will continue to become an attractive proposition for advisers and clients in the UK,” says Richard Wazacz, business line manager for VCTs at Octopus. “The main drivers are a desire to invest in small UK companies and the recent changes to pension legislation. A lot of advisers are suggesting VCTs as an alternative to pensions and ISAs.”

In this year’s March Budget, Chancellor George Osborne announced the lifetime allowance – the amount savers can put in a pension over their lifetime – will fall from £1.25m to £1m in April 2016. Meanwhile, the pension reforms introduced in April this year means pension savers are no longer required to buy an annuity and can take their pension as a lump sum or make withdrawals.

“Because of the changes to pension legislation, more and more investors are being affected,” says Wazacz. “The lifetime allowance is falling to £1m, and younger people could be impacted, so there is the potential demand for VCTs there. We could also see a broader interest from people because of the pension freedoms introduced on 6 April.”

High earners could also be steered towards VCTs on the back of a Conservative manifesto that proposed reducing the tax relief on pensions for those earning more than £150,000, Wazacz says. Currently those earning more than £150,000 pay income tax at 45 per cent, and have an annual allowance of £40,000 for their pension contributions. The Conservatives have proposed gradually reducing this annual allowance for all those earning more than £150,000 down to £10,000 for those earning £210,000.

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“The Conservatives’ manifesto limits tax relief on those earning more then £150,000, so those earning more may look at VCTs for tax relief,” Wazacz says.

With this potential increase in demand for VCTs, could we see a situation where VCTs struggle to find enough companies to invest in?

“There are two issues with VCTs, raising money and deploying money,” says Wazacz. “At the moment there is more supply than demand, but if demand goes up it could be an issue. There are a finite number of small companies in the UK. However, as demand increases, more entrepreneurs will look for funding. I suspect the Treasury is constantly reviewing that, it is in everyone’s interests to be aligned.”

Octopus has four VCTS currently open for investment, each with a different mandate. The AIM VCT was the first VCT to launch 20 years ago, investing in smaller companies. Titan is the group’s largest VCT, and focuses on early-stage investments and seeds, investing in “young British companies with the potential to grow very fast,” such as Zoopla and Secret Escapes. The Apollo VCT’s objective is capital preservation while providing a steady dividend, which it looks to achieve through leveraged buyouts of small, fast-growing companies with a proven business model and a dividend track record. Completing the range is Eclipse, a more vanilla VCT that invests in companies with a proven track record of growth, starting to show their business model works with signs of profitability. Wazacz describes this as “the most competitive VCT area in the world”.

Despite solid fundraising over the past year, Wazacz is not complacent, and says helping advisers and customers understand how VCTs work remains a key challenge.

“These are high-risk, small companies and customers need to understand the risks and benefits of investing in them,” Wazacz says.

Other challenges facing the sector include proposed changes to legislation that could restrict the money going into VCTs.

In the March Budget, Osborne announced changes to ensure VCTs comply with the EU’s latest state aid rules. As a result, VCTs will not be permitted to invest in companies older than 12 years if the companies have not previously received funding, and the amount VCTs can invest will be capped at £15m for the majority of companies and £20m for those with high research and development costs. The legislation is currently awaiting approval from the EU commission.

“I would be speculating on the outcome, but the Budget talked about challenging the state aid rules. I don’t think the government would be so forthright to say it is going back to Brussels with an argument if it didn’t expect it to be successful,” Wazacz says.

He adds: “The state aid rules are not dramatically challenging the VCTs landscape. People have misinterpreted the rules. They affect the deployment of money, not raising money. The rules are restraining, not preventing.”