By Fiona Henderson Headline returns for venture capital trusts (VCT) often bear little resemblanc...
By Fiona Henderson
Headline returns for venture capital trusts (VCT) often bear little resemblance to the underlying fund performance. The tax breaks and relief available on the trusts are varied and can add up to an investor only paying 40p to get 100p of exposure in the trust. As a result, managers have a whole range of ways in which they can quote returns to investors, sometimes giving an inflated idea of what the portfolio has actually achieved.
On the initial investment into a VCT, an investor can claim 20% income tax relief, which some fund managers translate as the investor having paid 80p for each 100p subscribed. Additionally, if the shareholder has used capital gains to invest in the fund, 40% capital gains tax can be deferred indefinitely. Some fund managers also take this CGT deferral plus the income tax relief to mean that the investor has effectively paid only 40p for each 100p invested.
Ben Yearsley, investment manager at Hargreaves Lansdown, is concerned that a provider's assessment of the performance of its own VCT can be deceptive. He said: "There are countless ways a fund manager can base performance results on. If we took the annualised return and the total return since launch and based both of these on the 40p, 80p and the 100p we would get six very different performance results for the same fund."
He compared the reports of the Baronsmead, Murray Johnstone and Northern VCTs. These are three of the oldest trusts in the market and the performance statistics vary greatly in the way they are calculated, he said.
The Murray Johnstone VCT cited a return of more than 36% for the 12 months to 31 August 2000, which had been calculated after tax on a 40p investment. Yearsley said: "This was presented as a good return, however, the NAV for the fund was 93.3p compared to 97.7p for the previous year, which is clearly a negative."
The last account of the Baronsmead VCT on 25 March 2000 states a total return since launch in November 1995 of 34.6%. This seems to be in the same realm as the Murray Johnstone VCT, but is actually based on the full pound invested, said Yearsley. "Baronsmead also reports returns based on the 40p, which worked out as 68.3% in this case."
By contrast, the Northern VCT report at the end of September 2000 only gave an NAV of 131.8p and did not even bother to offer a percentage return, Yearsley said.
He believes there should be a standard whereby the venture capital trust managers always base results on the full amount of money invested. He said: "Performance statistics should be worked out regardless of any tax breaks. People lose sight of the fact that a pound has still been paid."
Yearsley believes the only amount that can be taken off each 100p invested is the issue costs, which typically range from 56%. The Foresight Technology VCT uses this approach and bases results on 95p for each 100p invested.
Annual charges on a VCT are normally based on the NAV and are sometimes stepped, beginning at 1.5% and increasing to 2.5% after a three-year period, once the VCT is fully invested. He said: "Most are capped at 3.5%, which still seems expensive and would probably be fairer to cap it at 2.5%."
Martin Churchill, director of research at Tax Shelter Report, www.taxshelterreport.co.uk, agrees that there is a disparity between VCT performance calculations but said as long as the way in which individual companies formulate their results is clear to the investor, there should be no problem.
Michael Aaron, technical director at the David Aaron Partnership, added that it is important for investors to look at returns on the same basis for each fund they are trying to compare.
He said: "It is probably fair to take the income tax relief into account as that is the main reason some investors go into VCTs. I would question including the 40% capital gains tax deferral as it is only ever a deferral and will have to be paid at some point, unless the investor dies."
Churchill said: "The fact that the market has barely been going for six years means that there are only a handful of mature trusts. Even the six-year venture capital trusts can only be properly assessed after the initial three-year period, when the trust does not have to be fully invested."
Churchill advises investors not to look at any statistics on their VCT for at least five years after buying the product. He said: "They should be regarded as five to seven-year investments, at which point the market will be older and there will be a greater deal of transparency. As they cannot be assessed and are fairly high risk, they should only ever make up a maximum of 10% of a portfolio."
Churchill believes generalist VCTs will do better than Aim VCTs in the long term. He said: "This is where the strength of venture capitalists lie. On unquoted companies, the VCT team have much more of a stranglehold on the business, with a man on the board and freedom to look at budgets and business plans."
According to Churchill, there is also a lack of standardisation in the way performance fees are calculated. He said fund managers' performance fees range from taking 10% of all returns to waiting until the full 100p or more has been returned before taking a percentage based on the NAV and distributions.
As there is no regulation or limitations on performance fees, in theory the fund managers could base their performance fees on results based on the 40p. This never happens in practice, according to Churchill. "The average carried interest or performance fee is around 15% of everything over a 7% compound per annum return, after the 5-6% initial charge and 3%-3.5% running cost," he said.
Most fund managers decide upon a hurdle rate, typically 6%-8%, which must be achieved before performance fees can be paid. This may also be only after a certain period of time, usually around five years, said Churchill.
David Thorp, managing director of Friends Ivory & Sime Private Equity and chairman of the BVCA, said: "There is less of a standard with VCTs than with institutional investing as there are a variety of fund managers with differing legal constitutions. A company such as Friends Ivory & Sime is a public company and it would be in our interest to be paid extra fees. If the fund manager is a small partnership then to take a share holding in the VCT is more suitable."
Churchill said: "It would be desirable to have a performance fee standard but there is not a desperate need as long as investors and manager are adults that can agree on appropriate remuneration."
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