As VCT portfolios reach maturity (normally after three to five years), VCTs have the potential to be...
As VCT portfolios reach maturity (normally after three to five years), VCTs have the potential to become tax effective high yield vehicles as their realised capital gains and income can be distributed as tax-free dividends to qualifying shareholders.
The early VCTs are now heading towards the fifth anniversary of their launch which is an important date. After this date shareholders can sell shares without withdrawal of the 20% income tax relief claimed at the time of investment. To do so does mean that any capital gains tax, which an investor has deferred, will be crystallised which is a clear disadvantage.
If shareholders are happy with the tax-free dividend flow from the funds it may be a better idea to hold the investment indefinitely and enjoy the tax-free cash flow. Indeed some VCTs are now starting to pay significant dividends resulting from capital gains realised from investee companies. Alternatively, the unhappy shareholder could sell the shares and either pay the capital gains tax or roll the capital gain into a new VCT.
Another approach available to the investor who likes VCTs is to buy shares in the secondary market, which may develop after the fifth anniversary of each VCT, from exiting shareholders. This would give the new shareholder access to tax-free dividends and tax-free capital gains but would not give him or her any income tax relief or the opportunity to defer a capital gain. These benefits are only available for subscriptions for newly issued shares in VCTs. The secondary purchase of VCT shares may be particularly attractive as part of an investment portfolio designed to maximise (tax-free) income. This is the case with pensioners who are subject to income tax on dividends received from investment trusts.
VCTs were first announced by Ken Clarke in his 1993 November Budget and the VCTs legislation was subsequently enacted in the 1995 Finance Act. Since then, over £900 million has been raised and the highlights of VCT investments to date are highlighted in table 1 below.
Most early VCTs were generalist. For instance they invested across most industrial sectors and concentrated on existing companies in traditional industries rather than high risk start-ups. To date this approach has generally not produced large returns though most such funds have delivered a steady, if unexciting, dividend stream and have asset values at a modest premium to the launch value.
As the VCT market has developed, specialist funds have started to emerge. The first specialist category to develop was the AIM fund which invested mostly in AIM quoted companies (which qualify for VCT investment if other criteria such as size are met). These do have the advantage that the asset value is always linked to a market price. Their principal disadvantage is that investments are made at higher prices than would be the case for an unquoted investment. Thus, the long-term performance may be lower as the VCT investing in unquoteds hopes to make much of its return from the premium when the investment goes public. More recently, another area of specialist VCT has emerged which focuses on technology.
This group carries the greatest risk but the possibility of the highest reward. As an example the first VCT to return all of investors capital by way of dividend was a technology fund.
Such funds are not ideal for investors wanting the lowest risks in the VCT sector but they have real appeal for the investor who has made large capital gains and can understand and accept the risks of such an approach.
Part of that risk comes from the nature of technology investment. For instance it may not work and, if it does, it may not be accepted by the market.
Typically these companies will also be at a very early stage of their lives and failure is an ever-present risk. On the other hand the rewards from one or two good investments can easily repay several failures and show an overall return. There is ample evidence that venture capital investment can produce good returns. The latest British Venture Capital Association (BVCA) Performance Measurement Survey (1998) produced in conjunction with Crossroads Management and the WM Company shows the results over five years in table 2 below.
Venture capital investment in the UK has grown rapidly since the early 1980s, with the amount invested in UK unquoted companies by BWA members increasing from £20m in 1979 to over £6bn in 1999. Latest figures available show that in 1998, the UK venture capital industry represented approximately half of the total venture capital activity in Europe.
Venture capital is used to finance the development of an unquoted company. In return for providing risk capital, the venture capital investor acquires an agreed share of the equity capital and/or other securities of the company, such as preference shares and/or loan-stock (which currently may have a running yield of around 8%). Venture capital funds are created so that their investors can benefit from a spread of venture capital investments under the supervision of professional managers, who can in many cases contribute valuable experience, contacts and strategic advice to the businesses in which they invest.
Medium, long-term view
Investment in the venture capital market involves a medium to long-term commitment (three to seven years) and requires considerable time and effort on the part of the investment management team. The objective of such investment is to participate in the development of smaller companies into the major businesses of the future, thereby providing investors with above-average returns on their investment.
In conclusion, venture capital as an asset class represents a higher risk/higher reward investment opportunity. It can form up to 5% of an individual's investment portfolio, subject to their particular risk profile.
The tax reliefs available to VCT investors help to reduce the risks
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress