Is it time to consider Venture Capital Trusts?

22nd February 2013

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With the smaller companies sector topping performance tables last year, could ploughing capital into tinier, fledgling startup companies through Venture Capital Trusts (VCTs) be the next port of call for investors seeking stellar returns asks Harriet Meyer.

It can prove a white-knuckle ride, as VCTs put money into small, unquoted businesses worth £7m or less, making them high-risk as a proportion of these businesses may fail – but despite this drawback, their popularity is soaring.

By the end of January this year, more than £60m had been invested in VCTs, compared to just £50m by the end of January last year. The biggest inflows into VCTs tend to come at the end of the tax year, as higher earners look to mitigate income tax bills – by last April £330m had been invested in VCTs during the year.

Ben Yearsley, head of investment research at Charles Stanley, said: “VCTs have had a pretty decent time of it over the last few years on the back of the failure of the banking system to lend to smaller companies, as they’ve been able to step into the gap.

“They have taken the opportunity to lend to very small companies on favourable terms. This has helped lead to increased consistency of returns for VCT investors.”

The tax breaks

The risk of investing in VCTs is offset by the generous tax breaks on offer, as investors can reclaim 30 per cent income tax on the funds invested in new VCT shares.

Patrick Connolly, certified financial planner at AWD Chase de Vere, said: “Many high earners, after they have used their annual pension and ISA allowances, should consider VCTs – they are an appealing option, particularly at present.”

For example, if you invested £50,000 before the end of this tax year, and you’re a 50 per cent taxpayer, you would be able to reclaim £15,000 tax. Dividends are also tax-free and don’t have to be declared on tax return, so they’re attractive to income-seeking investors too.

The tax breaks hold big appeal for earners, who have seen the annual pension limit cut from £255,000 to £50,000 today, and this will suffer a cut further to £40,000 by April 2014. Meanwhile, the lifetime pension limit is being cut from £1.5m to £1.25m.

However all advisers would emphasise that anyone deciding to use VCTs must pay close attention to the risks. So for example, although an investor who will be hit by the lifetime rules on pensions will have a reasonable sum of money, investments offered by a VCT will be towards the top of the risk scale while pension investment can be anywhere on the risk scale.

The basics of VCTs

You can invest up to £200,000 a year in a VCT and they are typically held for three to five years. VCTs were launched in April 1995, and are designed to encourage individuals to invest in small firms. They are listed on the stock exchange, similar to investment trusts, and are run by fund managers.

There are two kinds of VCTs: evergreen, and planned exit. If you want to shelter income from tax, then a planned exit or limited-life VCT may be most suitable.

Alternatively, evergreen funds invest in fledging companies with growth potential, often taking a significant stake in the firm and participating in its management. However, these do not have a wind-up date, so there is a liquidity issue.

Connolly said: “If investors then want to exit their investment, they will find that there is a very limited second-hand market, meaning that many trusts stand at a sizeable discount to their net asset value – in some cases, more than 30 per cent. This discount acts as an effective exit penalty for investors, and even though some VCT providers offer buy-back policies, investors can still expect to face a minimum 10 per cent charge if they want to get out.

“The liquidity issue is important. While investors may benefit from 30 per cent initial tax relief on the way in, this doesn’t sound so appealing if they are looking at a 20 per cent charge when they leave.”

Who offers VCTs?

The key players in the VCT market include Baronsmead, Albion and Northern.

Connolly said: “These managers have provided consistent capital gains and tax-free dividends over a relatively long period. They run generalist well-diversified portfolios that will be more secure than other specialist or higher-risk funds.”

He favours Albion VCT Top Up Offers and Baronsmead VCT, while Yearsley recommends Mobeus, which is open for investment.

Patrick Reeve, Albion Ventures’ managing partner, told the Daily Telegraph in a video interview: “Our VCTs appeal to investors both pre and post–retirement, with the latter often treating them as a pension supplement by accessing a strong income stream while preserving capital. The former regard it as a long–term savings plan and mostly reinvest their dividends to get a further 30 per cent income tax relief on the value of their dividend. After retirement they can start taking the cash instead.”

However, it’s never wise to let the tax tail wag the investment dog, as VCTs are high-risk investments – but in these changing times, they certainly hold significant appeal, and company minnows need a helping hand.

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