Venture Capital Trusts
Briefing
Note BN002/2005
Updated - 17 May 2006
In March, we highlighted Venture Capital Trusts (VCTs) as a potential risk to consumers. We announced that we would perform further work to quantify and, where appropriate, mitigate those risks.
Specifically, we looked at the distribution channels for, and investor profiles of, VCTs. That review reassured us on advised sales and we are planning no further work in this area. However, we noted a marked shift of sales of VCTs to a direct, non-advised, basis. This led us to review the VCT website promotions of intermediaries. The conclusions of this latest work are disappointing and we are now following up on these findings and taking appropriate action.
This briefing note covers:
- 2006 Budget changes to VCTs.
- The findings from our review of web-based VCT promotional material of intermediaries, the actions we expect of firms in response to these findings, and the actions we will take.
- The background to our work on VCTs and the results of earlier reviews on distribution channels for VCTs and investor profiles. We are not proposing any further work in this area.
- The risks and benefits related to investing in VCTs.
2006 Budget changes to VCTs
In March 2004, the Budget introduced a two-year temporary increase to the rate of income tax relief available to VCT investors from 20% to 40%. This applied to investments made before 6 April 2006. There were further announcements on VCTs in the 2006 Budget. The changes for VCTs are as follows:
- A change in the income tax relief to 30%.
- An increase in the miminum period for which VCT investors must hold their VCT shares in order to retain the tax relief to five years.
- A change to the gross assets test. The companies which are being invested in have to meet certain criteria to qualify, and one of the criteria relates to the gross assets the company (or group of companies) has. The Budget has introduced a change by reducing the amount of gross assets the company (or group of companies) can have from £15 million to £7 million immediately before the investment, and from £16 million to £8 million immediately after the investment.
These new measures are effective from 6 April 2006. However, there is one further change which takes effect from 6 April 2007:
- A VCT must have 70% by value of its investments represented by shares or securities in qualifying holdings to gain and retain Inland Revenue approval. It must also have no more than 15% of its total investments in a single holding in any company. The Budget has introduced a change so that any money that a VCT holds (or is held on its behalf) after 6 April 2007 will be treated as an investment for the purpose of these tests.
Findings from our review of web-based VCT promotions
We recently reviewed the web-based VCT financial promotional material of 11 intermediaries. Several shortcomings were identified. We describe these below, together with an indication of future work we intend to do on these findings.
Detailed findings
Did the promotion provide a straightforward description of the product? Most of the promotions reviewed did not contain a satisfactory explanation of how a VCT works, and some sites gave no explanation at all.
Did the promotion provide a balanced overall impression of the risks and benefits? All the promotions we reviewed emphasised the principal tax benefits, and advertised the discounts available. However, most of the promotions did not include a prominent indication of all the main risks associated with VCTs. These are explained in more detail in the findings below.
Was it clear that investors must hold the shares for three years or the 40% tax relief on the initial investment has to be repaid? Some websites did not prominently mention that the investment must be held for the full three-year period to qualify for the tax relief. Please note that from 6 April 2006 investors must hold their shares for at least five years to qualify for income tax relief and the rate of income tax relief available to investors is 30%.
Was it clear that VCTs invest in small companies, which may not produce hoped for returns and investors could get back less than they invested? Some websites did not mention that the investment was in small companies. Most did mention it, but failed to take the next step to explain the risks associated with investing in small companies. In a couple of instances, the risk was adequately described but hidden in the middle of other text or in risk warnings at the bottom of the page. In addition, we saw one website which played down the risks associated with investing in VCTs. Please note that from 6 April 2006 the gross assets test for VCTs has changed and the gross assets a company (or group of companies) can have immediately before the investment may not exceed £7 million (previously the amount was £15 million). This means that VCTs will be restricted to investing in smaller companies than before, which may carry a greater level of risk.
Did the promotion draw attention to the long-term nature of the investment? Most of the promotions failed to mention the long-term nature of the product. Those that did cover this point did not provide a particularly full or complete explanation. Only one website gave an adequate explanation.
Was it clear that there is a limited secondary market? Most of the promotions did not adequately explain the limited secondary market for VCTs, and that most VCTs trade below their net asset value. Some did not explain this at all. There was limited reference to the 'buy back' facility offered by some VCT managers.
Was the level of charges made clear? Few websites provided an indication of likely charges, and even where this was provided, prominence of the information was often an issue.
Findings specific to direct offer promotions: Some of the website promotions we reviewed were direct offer financial promotions. COB 3.9 of the FSA Handbook contains specific rules that direct offer promotions must adhere to. Some of the websites contained appropriate, and prominently displayed, wording about the requirements on advice (that no advice has been given and that if the customer has any doubts about the investment's suitability, they should seek such advice), near to the VCT product details. Other firms located this important information elsewhere in their website. If ordinary investors are having greater access to these types of promotions, and so are able to buy without advice, the promotions must contain the required information. Firms should also ensure that their website design helps them achieve the principle of Treating Customers Fairly – for example, by having clear layout, and making key information prominent, including principle risks and proximity of risks to benefits.
What we want firms to do
We want to work with the industry to ensure that any promotional material is balanced, clear, fair and not misleading. This briefing note is a prompt to firms to review their promotional material. As part of our on-going commitment to ensure that 'Consumers receive a fair deal' we will closely monitor developments in the VCT market, especially the quality of financial promotional material firms issue. And we will act appropriately to reduce the risks to consumers. Following the changes in the 2006 Budget we would expect firms to review their promotional material and consider how they will reflect the changes in new promotions, (especially where the promotion is to existing VCT shareholders).
What we have done
In August 2005, we wrote to several relevant intermediaries and alerted them to the findings of an earlier review of the promotional material of 15 investment firms who manage VCTs and the concerns these raised – see below for more details of this. We also put these intermediaries on notice that we would be reviewing their promotional material ahead of the 2005/06 VCT season.
So we were disappointed to find that, despite this letter, most of the web-based VCT promotional material of these intermediaries still fails to meet the expected standard to a greater or lesser extent.
We will examine the non-compliant financial promotions identified and will take further action where appropriate. Such action could involve asking the firm to amend the financial promotion and/or consider remedial action where consumers may have been misled. Where there are serious or significant concerns, we could issue a Private Warning or refer the case to our Enforcement division.
Background to the FSA's work on VCTs
In early 2005 we saw an increase in activity in the VCT market. The number of listings sought had increased significantly and there had been an increase in marketing activity to investors. There were concerns that some promotional material failed to set out the risks adequately and strike a balance between the positive aspects and the downside risks. We also had some concerns that these products were potentially no longer being aimed solely at high net worth individuals and that less wealthy individuals might be being targeted. The key risks and benefits associated with VCTs are set down below.
In March 2005 we told the industry that we were undertaking work to establish a more detailed picture of the market, including getting data on what types of customers are investing in VCTs and through which distribution channels. We were also reviewing the financial promotional material of 15 investment firms who manage VCTs.
On 24 August 2005 we updated the industry with the findings of our review of these investment firms' financial promotional material (see Financial Promotions). We also gave a progress report on our work on distribution channels (final conclusions of this work are summarised below). This was based on the results of our initial discussions with the industry and suggested that there had been a considerable increase in the proportion of VCTs being sold without advice. This prompted us to write to 11 intermediaries who promoted VCTs on their websites, as described above.
Findings from the review of distribution channels and investor profile
Anecdotal evidence indicated that historically VCTs had, in the main, been sold to high net worth individuals on an advised basis. Our research, which we have discussed with several industry participants, indicates that between 33% - 40% of VCTs are now purchased on execution-only1 basis. Of these, a substantial percentage are bought from 'Discount Brokers2' over the internet.
Our limited review of the sale of VCTs on an advised basis has indicated that advised sales are to high net worth individuals, who have a diversified investment portfolio and appear comfortable with the risks and restrictions associated with VCTs. In line with our need to use our resources in an efficient and effective manner, we do not currently intend to do any further work on the advised market for VCTs.
We are unable to comment on the profile of those investors who bought VCTs on an execution-only basis, but where higher-risk investments are bought on a non-advised basis this emphasises the importance for the promotional material to be clear, fair and not misleading.
As part of our review of the VCT market we also looked at whether there was any evidence of VCTs having any 'cross holdings' in each other. We found no evidence of cross holdings and industry participants assured us that this is unlikely to happen.
1. FSA's glossary defines an execution-only transaction as 'a transaction executed by a firm upon the specific instructions of a client where the firm does not give advice on investments relating to the merits of the transaction'.
2. In this note, Discount Brokers means Intermediaries who rebate/share their initial and/or trail commission with their clients.
Risks and benefits of VCTs
VCTs provide a valuable source of capital for small companies and so help the UK economy to develop. There are also considerable tax advantages offered to investors in new VCTs. They offer suitable investors a tax-efficient way to put money into new opportunities that may bring a high return. While we recognise the potential benefits of VCTs as an investment opportunity, it is important that investors who acquire VCTs have a clear understanding of the risks as well as the benefits associated with investing in them. Important risks associated with investing in VCTs are set out below. We have provided information about VCTs on our Consumer Information website.
Limited secondary market: The secondary market for shares in VCTs is limited and as a result shares in VCTs can trade at a discount to the net asset value. To partially address this issue, some VCT Managers offer a 'Buy Back' facility normally at a discount to the net asset value.
Type of company invested in: VCTs are designed to provide capital for small companies and each VCT will invest in several companies. As such, there is a risk that these companies may not perform as hoped and in some circumstances may fail completely.
Where the 30% Non Qualifying Investments are invested: Traditionally, VCTs have invested the 30% Non Qualifying Investments in money market securities/gilts/cash deposits etc. We are aware that a few VCTs have invested part of the 30% Non Qualifying Investments in more risky investment vehicles.
Withdrawal of tax breaks: The generous tax breaks are one of the major attractions of VCTs. If the investment is not held for five years or if the VCT does not invest 70% in qualifying investments after three years, the initial tax breaks can be withdrawn.
Long-term nature of the investment: Generally, VCTs are considered to be long-term investments.
Charges and performance fees: The levels of charges for VCTs may be greater than Unit Trusts and Open Ended Investment Companies.
Security of capital: As with any asset-backed investment, the value of a VCT depends on the performance of the underlying assets. The value of the investment and the dividend stream can rise and fall. So the investor may get back less than they originally invested, even taking into account the tax breaks.