The current venture capital trust season got off to an excellent, if early, start and VCT managers a...
The current venture capital trust season got off to an excellent, if early, start and VCT managers are set to raise more money than ever for investment in small companies. Now is the time to consider whether VCTs are coming of age, not just as good tax efficient investment vehicles, but as attractive investment vehicles in their own right, even for cautious investors.
From January to the end of March, there will be at least 14 VCTs looking to raise about £500m to invest in unquoted (or Aim-listed) companies. This is in addition to the £1.1bn already raised, roughly 600m of which has been invested in 600 qualifying companies.
Although it is impossible to predict accurately the number of investors, the number of individual VCT subscriptions in the five years to date is in excess of 45,000, with average commitments of 20,000. Many IFAs say their clients invest in VCTs to defer a capital gains tax (CGT) liability, but just as many say their clients also expect high returns.
Surveys suggest that one in 10 households has more than £55,000 to invest, not taking their home and pension into account.
These people are likely to be sophisticated investors. The more conservative among them in their forties and early fifties have built up a portfolio of investments over a number of years. In addition, there is also a new group of investors who are less risk averse than average but keen on making money. They may be professionals in well-paid jobs who have a good understanding of business and finance. Both groups appreciate that it is effective money management to have a part of their portfolio in higher risk investments.
But are VCTs really as high risk as many people think? Like many other things in life, risk is relative. One IFA I spoke to recently said the term venture capital in itself can sometimes put investors off. There is a vast potential of clients out there who have a CGT liability, but who are too afraid to invest in VCTs.
Although the venture capital industry has made a big leap into the limelight over the last couple of years and there is greater understanding of the term venture capital, it still conjures up images of risky investment. In addition, coverage of VCTs in the vast array of personal finance publications always underlines the fact that they are not aimed at the faint-hearted. Of course, just as with any stock market investment, investors should be warned that they may not get back the money they invested. Nobody should ever invest in VCTs unless the money is genuine spare cash.
But compared with other investment vehicles, VCTs are arguably no more risky than technology ISA funds and similarly specialist unit trusts that many individuals hold. And from a practical point of view, investing in a VCT is a lot less risky than investing in the stock market yourself.
There is also not enough made of the in-built risk control mechanisms of VCTs. New VCTs have a maximum of three years from launch to have at least 70% of their funds invested in qualifying companies.
Obviously, they have the advantage of allowing you to spread your investment, and therefore your risk, across a number of companies, rather than putting all your money into just one.
Clearly, the bigger the VCT fund, the more companies it can invest in, and the record amounts raised in this season will help fund managers invest in more companies than ever before.
This is effectively a risk spreader counterbalancing the fact VCTs are restricted to investing in companies at the smaller end of the small company market. As big companies grow, small companies are also getting bigger and companies with a market cap of 500 million are these days considered small. As VCTs have been designed to help Britain's entrepreneurs, they only invest in genuinely small companies.
In addition to spreading the risk by investing in more companies, the valuable tax benefits further help reduce the risk. Although you need to invest for at least three years to keep all the tax reliefs, these are very attractive and include 20% up front income tax relief, up to 40% capital gains tax deferral on gains that are reinvested, tax free dividends on income and capital profits, and no CGT on disposal profits.
The only other comparable investment vehicle that has similar and even better tax perks is the Enterprise Investment Scheme. With an annual investment limit of 150,000 (compared to 100,000 for VCTs), EIS investors can claim unlimited capital gains tax deferral relief and income tax relief at 20% on the first 150,000 invested.
Future gains on disposal are tax free and, unlike the VCT, no inheritance tax is payable on money invested in EIS, provided shares have been held for two years. But these tax perks come with a much higher risk compared with VCTs.
As the successor to Business Expansion Schemes (BES), the EIS was introduced in 1993/94 to encourage investment in small unquoted companies. The investment criteria for EIS are the same as for VCTs so they can only invest in companies with maximum gross assets of 16m. Importantly though, they are much higher risk because investment is usually into just one company which means there is no spreading of the risk within the EIS unless a portfolio service is used.
Going for diversification
Taking all these points into account, though, the key argument to put to investors interested in VCTs is that they should be seen as part of a diversified portfolio. Investing in fledgling companies can act as a useful counter-balance to FTSE 100 investments. For instance, our analysis suggests that the optimum split for a UK equity investor seeking the portfolio with the highest return and the lowest risk might be 80% FTSE 100 and 20% AIM companies.
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