The Financial Times recently ran a very interesting article (‘The great pensions tax squeeze’, September 2) on the impact of changes to pensions and Venture Capital Trust (VCT) and Enterprise Investment Scheme (EIS) regulations. Definitely worth a read but, if you are not a subscriber, the salient points were as follows:
- – The tax-free amount that savers can contribute to their pensions has been significantly curtailed
- – The investment criteria applicable to VCTs and EIS funds have been tightened such that they must look for earlier-stage companies in which to invest (and some hitherto popular investments, such as management buyouts and renewable energy schemes, are now no longer eligible).
It was posited that the above changes are creating a situation in which:
- – There is increased demand for VCT and EIS funds from savers who would previously have directed their investment into pensions
- – However, VCT and EIS funds are taking in less money because they cannot find enough suitable opportunities to invest in.
VCT and EIS funds benefit from tax incentives (on income, capital gains and/or inheritance) which are not available on investments in general. The justification for this kind of public subsidy is to encourage investment in early-stage (i.e. risker, higher-return) business ventures that might otherwise receive less attention from fund managers. The aim is certainly not to provide tax-enhanced returns on investments that would be made in any event. Of course, markets will always try to find a way to maximise return whilst minimising risk. As a result, historically, many VCT and EIS funds have sought investments that can be portrayed to their investors as ‘safe’ whilst generating an attractive tax-adjusted return.
Examples include VCTs that invested the majority of their capital in asset-backed, interest-bearing securities in order to ‘guarantee’ the return of investors’ capital whilst reserving only a small portion of the fund for genuine risk investments. More recently, EIS funds sought renewable energy investments that benefited from ROCs or feed-in-tariffs, thereby taking advantage of two layers of public subsidy in the same investment. When VCTs did invest in company shares, one of their preferred investment targets was long-established businesses that were undergoing a management buyout. By doing so, they were effectively investing in a (relatively) low-risk business venture that happened to be going through a change of ownership rather than backing business expansion or diversification.
Interestingly, in Turquoise’s experience, direct EIS investments made by ‘sophisticated’ individual investors (as opposed to via a fund) do tend to be in genuinely new businesses whose risk/return profile fits much better with policy objectives of creating intellectual property, new employment, new industries, etc. In principle, individuals should have a lower risk appetite as they are likely to have much less diversified portfolios than a professionally-managed fund; however, in practice, many funds appear to be more focused on loss-avoidance than high returns.
Over time, policymakers have recognised that the market has distorted the way in which tax incentives were intended to operate and, as described in the FT article, have tightened the rules applicable to VCT and EIS funds. It is disappointing to hear that this is expected to result in fewer investments being made due to lack of opportunity. Our experience at Turquoise is quite the opposite – there are more opportunities in the venture capital space than funds available for investment. This suggests that the issue is more to do with some VCT and EIS fund managers being reluctant to move outside their comfort zone.
The tax reliefs made available by government for VCT and EIS can only be justified if such funds are invested in early-stage business ventures that involve real risk and the potential for high returns. If the fund management industry does not deliver that outcome then the rules should continue to be tightened until the policy objectives are achieved. Even though some of the measures used to govern these schemes are relatively crude (e.g. limits on the ‘age’ of eligible companies), it may be that they will have to be even more prescriptive to ensure that investment flows as intended.
Let’s remember that VCTs are supposed to invest in Venture Capital and EIS funds are for backing Enterprise…