With another tax year now gone, I think it is worth reflecting on the state of the venture capital trust industry. After the boom years of 2004/05 and 2005/06, last tax year was always going to struggle to compete following the changes in tax benefits.
The predicted meltdown only half happened, with around £230m raised during the year compared to with £1.2bn over the previous two years. I would hardly call that a disaster.
The most interesting aspect of last tax year was the collective quality of VCTs on offer. In my opinion, it was one of the best in years. Many of the providers which launched in the previous tax years which just jumped on a bandwagon decided against coming out last year!
Until the last few weeks, it did look as if the amount of money raised was going to be far below even the lowest expectations. The second half of March saw a substantial spike in fund flows, although, mainly due to the meddling hand of the Chancellor in the Budget.
The last few years have seen continual tinkering and revision of the VCT rules, both from an investor’s viewpoint and also from a manager’s. Tax rates have changed, holding periods lengthened and, perhaps most crucially, VCTs are becoming more restricted as to where they can invest.
The recent rule changes mainly relate to the size of the underlying company. However, there are actually four different regimes under which VCTs operate, three of those relating to changes made in the last twelve months.
For funds raised before April 5, 2006, the underlying company can have a maximum of £15m in gross assets prior to investment and £16m after.
For VCT money raised from April 6, 2006, the investments can have a maximum of £7m gross assets before and £8m after investment by the VCT. The latest changes restrict this even further for money raised after April 6, 2007. From this point, the underlying company can have a maximum of 50 employees and can receive up to £2m in funding from VCTs in a 12month period.
It needs to be stressed that the rules from April 6, 2007 will not affect monies previously raised. Each rule change on its own over the last few years probably would not have made a huge difference. It is the cumulative effect of one restriction after another that is creating problems and causing investors to lose confidence.
Since the Budget, VCT managers have been assessing their portfolios with a fine-tooth comb trying to ascertain how many companies would have been affected.
Unsurprisingly, after the initial panic by VCT managers saying no investment would proceed, now the reverse is true, with many saying that only a few of their investments would have been affected. I imagine the truth is somewhere in the middle.
VCT managers are an ingenious bunch and previous rule changes have not really affected their ability to make investments and make money. However quick the Chancellor and the taxman are changing the rules, VCT managers do come up with ways of getting around them.
What is pretty clear is that Aim VCTs will struggle far more than VCTs that invest in unquoted companies. Companies listed on Aim are generally later-stage, have more employees and often require more than £2m in funding.
It is clear the risk profile of VCTs is increasing at the same time as the tax benefits have decreased. This means investors are less likely to invest. I also think there will be fewer managers raising money with the chances of new managers launching looking pretty slim.
It will save the taxman money in the short term as the amount of new money being invested will fall. However, the long-term damage could be to the smaller companies sector – the very sector VCTs were set up to help in the first place. A short-term view to save tax may lead to the rebirth of the funding gap.
Ben Yearsley is senior investment manager at Hargreaves Lansdown.