Venture Capital Trusts (VCTs) are now purely focused on growth investments, but can investors still expect to receive dividend payments from a portfolio of early-stage companies?
Due to legacy investments, the answer in the short-term is likely to be ‘yes’. But dividends in the future are likely to be far less predictable.
Chancellor Philip Hammond’s 2017 Budget imposed more stringent rules on VCTs and Enterprise Investment Schemes (EIS).
The so-called ‘risk-to-capital condition’ means that providers of these products must now purely focus on growth investments, avoiding any hint of a ‘capital preservation’ strategy.
Aside from 30% income tax relief, and portfolio returns free from capital gains tax, VCTs can pay out tax-free dividends. The ability to do so is a key differentiator from EIS portfolios.
‘VCT portfolios are, by and large, underpinned by investments made before the rule changes that are cash-generative. That gives them an engine to pay out dividends on a consistent basis,’ explained John Glencross, chief executive at Calculus Capital.
‘Two to three years out, when VCTs are replaced completely with growth investments, there will likely be more volatility in dividends. There will be more marked winners and losers, and maintaining a consistent dividend policy will become more challenging, as there will be less consistency in performance,’ he added.
VCT providers are still allowed to retain their investments made in previous years, even if they no longer qualify under the new risk-to-capital rules. This could make it harder for new VCT entrants to compete, as they will not have a pool of legacy companies to pay a dividend from.
Ian McLennan, a partner at Triple Point, told Wealth Manager: ‘We have enough reserves to pay dividends for two years, regardless of the performance of the portfolio companies. After those two years, dividends will depend on realised capital gains, and we can’t predict those with certainty. Investors should expect dividends to be a bit lumpier.
‘Before the rule changes, we were able to generate dividends from cash-generating businesses, such as infrastructure and renewable energy projects.’
Triple Point’s VCT targets an annual dividend of 3p per share.
With the increased volatility now present in growth-based VCT portfolios, paying a consistent dividend has become a challenge for providers.
Will Fraser-Allen, managing partner at Albion Capital, said: ‘We haven’t changed our dividend aspirations. We target a 5% yield. The way we pay dividends is changing, it’s now completely driven by exits.’
He was keen to add that the VCT beat its 5% target this year, but do not plan to pay out a special dividend. The managing partner believes it is crucial to have a diversified portfolio of companies within a VCT, and to aim for exits every year.
McLennan added: ‘We wouldn’t expect any dividends directly from the growth companies in our VCT portfolio. We’re hoping to exit these companies within three to seven years. It’s only from net gains on exits that we would pay a dividend.’
A painful transition
The recent Spring Statement set out further hurdles for VCT providers. VCTs must now invest 80% of the portfolio in qualifying investments (up from 70%). In addition, 30% of the fund must be invested in qualifying assets within the first 12 months.
‘VCTs that took advantage of the large demand for the product may face challenges. They are under pressure to put money to work quickly under the new rules. The faster the transition is to growth investments, the more pressure they will be under to maintain dividends out of profits, and there may be some paying out of cash drag,’ Glencross said.
Although it is not ideal to pay dividends from cash drag, he points out there is still significant market demand for consistent tax-free dividends.
He adds that most VCTs have re-engineered their investment teams because they were previously focused on smaller management buyouts. Today, they are focused on growth investments.
Exiting a VCT
Dividends are all well and good, but recovery of investors’ capital becomes paramount – particularly in relation to higher risk investments. One major drawback associated with VCTs is that investors have to hold shares for a minimum of five years to retain the income tax relief benefits.
The vast majority of VCT providers will offer a share buyback option, usually at around a 5% discount to the net asset value (NAV). Selling a VCT share on a secondary market is a much less popular option, as there is no income tax relief available on VCT shares bought on an exchange (although tax-free dividends are available).
It is also worth noting that VCTs tend to trade at a significant discount to their NAV on the secondary market.
Looking ahead, investors will need to adapt their expectations when investing in VCTs, particularly as the industry adjusts to the new rules.