VCT vs Private Equity: what are the key similarities and differences?

If you’ve invested through Wealth Club before, you probably know a thing or two about Venture Capital Trusts (VCTs). And you might have invested in a handful.

Fewer people know exactly what Private Equity is – and, more importantly, what it could add to a portfolio.

Could you be missing out? VCTs and Private Equity funds have the potential to play important complementary roles in an experienced investor’s portfolio. In this article we look at the key similarities and differences to help you make better-informed decisions.

VCTs and Private Equity – some key differences

At their core, both VCTs and Private Equity funds are a way to invest in a portfolio of private (or non-listed) companies. In both cases, managers seek to add value to their portfolio of companies – aiming to sell for a profit at a later date.

However, there are five crucial differences – each of which we’ll expand on below.

In short, companies that VCTs invest in are significantly smaller and younger – hence riskier – than those held by Private Equity funds. To somewhat compensate for the risks, VCTs offer valuable tax reliefs.

For their part, Private Equity funds can tap a vast universe of opportunities – often large and mature companies generating hundreds of £millions in revenue – and these funds have historically delivered significantly stronger performance than VCTs and listed investments alike, although past performance is not a guide to the future.

The first and most obvious difference between VCTs and Private Equity relates to the maturity and size of the companies they invest in.

VCTs are a government-backed scheme set up to spur investment in young, innovative and promising UK startups. Such businesses are normally looking to accelerate growth or launch new products and services. However, they are also largely unproven and often not yet profitable.

Moreover, there are strict rules around the age and size of a company that can qualify for VCT investment. This restricts VCT managers to a fairly small set of relatively young and small investable companies.

By comparison, the companies that traditional (buyout) Private Equity funds invest in tend to be far larger – in many cases larger than some listed companies – and often profitable. Importantly, no qualifying restrictions apply, giving Private Equity funds access to a vast universe of potential opportunities.

To illustrate, there are over 140,000 private companies that generate revenues of more than $100 million per year. That compares with just 19,000 public companies. If you’re only focused on listed shares – and not considering Private Equity – you could be missing out on a huge piece of the total global equity market.

Both Private Equity funds and VCTs seek to add value to the companies they invest in, but there are some differences.

VCTs can only take a minority stake in the companies they invest in. This reflects the inherently risky nature of startups, the fact that most founders prefer to keep a controlling share of their business, and restrictions from HMRC on VCT investments.

A typical established VCT invests in a portfolio of 30-70 companies, which are overseen by a team of 30 or so investment professionals. They don’t usually get deeply involved in the day-to-day running of each portfolio company. The VCT manager generally provides guidance and mentorship, helping these businesses scale.

In contrast, Private Equity firms usually take a more hands-on approach. Investment giants like Apollo, Blackstone and KKR can draw on vast resources and specialist teams to add value to their investments. They usually aim to acquire majority stakes of up to 100% in their target companies – allowing them a high degree of control over day-to-day operations and strategy.

Private Equity managers seek to unlock previously untapped sources of growth or improve the operating performance of underlying businesses – and use a myriad of strategies to achieve this. For example, hiring new executive teams, fuelling international expansion, engaging in restructuring, and/or making bolt-on acquisitions.

Another fundamental difference is the tax treatment of these two types of investment.

VCTs offer generous tax reliefs put in place by the UK government to incentivise investment in young, high-risk startups. When you invest in a VCT you could be eligible for:

• Income tax relief of up to 30% – so an investment of £200,000, the full VCT allowance, could provide a £60,000 saving on that year’s tax bill.
• Tax-free dividends – VCT dividends are paid tax-free, with VCTs commonly targeting a dividend of around 5% of their net assets per year, though dividends are variable and not guaranteed.
• Tax-free growth – any capital gains made by the VCT will also be capital gains tax (GCT) free.

Tax relief can help magnify returns when things go well and alleviate the impact of failures, which are to be expected when investing in early-stage companies. Note that tax rules can change and benefits depend on circumstances.

Private Equity funds, on the other hand, don’t offer any tax reliefs and any gains or income they generate will usually be taxable.

Both VCTs and Private Equity funds are illiquid investments. There is no continuous or reliable secondary market (see next section). You should only invest in VCTs or Private Equity funds if you have a wider portfolio – including some liquid assets – to fall back on if things don’t work out.

The underlying companies that VCTs invest in are generally far riskier than those owned by Private Equity funds. VCTs invest in small young companies, which often don’t have a proven business model or customer base at the point of investment. They are more likely to fail than their larger counterparts.

VCTs try to mitigate this by investing in a large portfolio – usually a basket of 30 to 70 companies, and in some cases 100 or more. This helps limit the impact of one failure on overall performance. What’s more, if a few of these go on to be runaway successes – like Zoopla, Graze and other recent examples – this should pull up portfolio returns.

In the case of Private Equity, the risks related to portfolio companies can be lower, since these are usually established businesses with stable cashflows. They’ve typically been around for decades and weathered several market cycles. Outright failure is rarer, but you can still lose what you invest. Moreover, Private Equity tends to use debt, e.g. in leveraged buyouts. The use of debt magnifies both positive and negative returns.

For investors willing and eligible to tolerate the risks, the potential returns from Private Equity can be significant. Over the past 25 years, buyout funds have delivered annualised returns of 12.7% (see chart) – past performance is not a guide to the future. This is about double global listed equity funds and substantially higher than VCT industry averages.

A final important distinction between VCTs and Private Equity funds relates to the limits and restrictions placed on these investments.

VCTs are closed ended funds which open to raise money – usually once a year. Fundraises happen at the discretion of the VCT manager and will start and end on a set date, or once a target amount is reached. You can only invest in new shares whilst the offer is open and once your shares are allotted you get exposure to the VCT’s existing portfolio.

When it comes to selling, although VCT shares are listed on the London Stock Exchange, trading volumes are thin and there can be large discounts to net asset value. However, most VCTs offer a share buyback facility – a periodic offer to buy back shares at a set discount to net asset value (usually around 5%). Buyback facilities are offered at the discretion of the VCT’s manager and are not guaranteed. A specialist broker will have to facilitate the sale (you can read more about how Wealth Club can help).

The maximum tax-efficient investment in a VCT is £200,000 per tax year. Minimum investments are typically £3,000 to £6,000. Note that the minimum holding period to retain income tax relief is five years, and tax reliefs only apply to new share purchases.

Meanwhile, new semi-liquid Private Equity funds are evergreen. Eligible investors can invest any time – there are usually monthly or quarterly trading dates. Minimum investments start at £10,000 via Wealth Club. Once the investment is completed, an investor will receive exposure to the fund’s existing portfolio of investments.

To sell the investment, an investor will have to make a redemption request. This is normally possible once a month or quarter. Settlement could take several months and other restrictions may apply.

Unlike VCTs, there is no minimum holding period, however both VCTs and Private Equity are long-term investments and are only for experienced investors who can fully understand the risks and afford any losses.

In addition, semi-liquid Private Equity funds are subject to restrictions on promotion. So, for instance, to see full details of the Private Equity funds we offer on our platform, you will have to qualify as a high net worth or sophisticated investor first. You can do so by filling out the form below.