Last year was a bad year for the venture capital world after a stellar 2000, but there are signs that the market may be offering upside prospects once again
If a week is a long time in politics, then the past year has been a lifetime in the world of venture capital trusts.
In January 2001, the prospects for the sector looked good, with fund performance generally on an upward trend and the climate for raising new funds verging on the tropical.
Almost £200m of new money flowed into the industry from private investors over the nine months from April to December 2000, and during the same period the FTSE Small Cap Index reached its all-time high. The 2000/2001 tax year was to see a record total of well over £400m raised by VCTs.
Twelve months on, the picture is not so bright. Most funds have seen their performance figures knocked back by the heavy falls in the stock market, while the raft of new VCTs launched in September and October 2001 have found that investors are, at least for the moment, sitting firmly on their chequebooks. The total of funds raised in the 2001/2002 tax year so far is struggling to get past the £50m mark, while forecasts for the full year fall anywhere in the range from £100m to £300m ' well short of the mark reached a year earlier.
Most VCT managers spend a lot of their time talking to financial advisers about the investments their clients have made, or are considering making, in VCTs. The feedback we have been getting recently is that investors are taking a cautious approach right across the board, not just in relation to VCTs but also with regard to the financial markets as a whole. The general feeling of wariness has been reinforced by other events such as the Equitable Life debacle.
So far, so gloomy. Inevitably in such circumstances, VCT managers have had to take a hard look at their investment strategy in order to decide whether their approach is still appropriate to the conditions.
Stock market apathy and economic recession do not represent the ideal background against which to run a successful portfolio of small unquoted companies, especially when some of the clearing banks are intent on cleaning up their lending books by reducing their exposure to those industry sectors perceived as particularly vulnerable.
It is worth restating the basics of the venture capital investment approach. First and foremost, venture capital is a long-term business and we are investing for long-term returns. In order to make those returns, we have to get two things right: first, we have to pick the right companies in which to invest and second, we have (if possible) to buy into them when prices are relatively low and sell when prices are relatively high.
At risk of stating the obvious, the task of picking the right companies is a difficult one. There is naturally a temptation to put money into sectors that are currently strong performers ' as was seen two years ago when several VCTs adopted a strategy based on investing primarily in e commerce and IT-related businesses. With the wonderful benefit of hindsight, going overboard for technology has usually turned out to be as disadvantageous as not going into technology at all.
A compelling solution is to stick to a well-balanced generalist approach to portfolio management, with a broad mix of industry sectors represented so as to avoid over-exposure to any potential danger areas.
This does not remove the need for careful stock selection ' in a time of recession we have to be particularly careful to avoid the pitfall of investing money in businesses that are about to go over a cliff ' but it does mitigate the risk inherent in betting too heavily on individual sectors.
Having established that a broad spread of holdings makes sense, the focus switches to the question of investment timing. In the middle of the pervading economic pessimism ' there has to be more to life than retail sales figures ' it is important to remember that some of the best opportunities come along when the gloom is at its greatest.
These include the so-called old economy businesses, many of which still make things that people actually need and generate cash which to pay rent and wages.
Contrast this with the high technology sector, where investors can find that businesses still seek to value themselves on a multiple of sales even when order books may have reached a state of suspended animation.
In the current climate, the attractions of such businesses are enhanced by the fact that valuations, after a long period of unrealistically high expectations, have reduced to the point where it is once again possible to buy into good businesses relatively cheaply. As a result of this, a number of commentators have observed that the 2001/2002 crop of VCTs could well be one of the best vintages in the longer term.
It is ironic, but perhaps typical of past cycles in the wider stock markets, that investors should be slow to commit funds to the market at a time when the upside prospects are starting to look attractive once again.
Happily, there have been some signs in the past couple of weeks that investors are beginning to return to the VCT market ' a movement that can be expected to gather speed as annual tax planning comes to the top of the agenda in February and March. Although this article has concentrated on the investment merits of VCTs, the tax breaks available are simply too good to be ignored.
With cash back income tax relief at 20% and all future dividends tax-free, the super-Isa aspects of VCTs are a strong selling point ' even for investors who in the current markets may be temporarily unable to take advantage of the capital gains tax deferral provisions. And of course those selling private businesses or investment properties, or making changes to a mature equity portfolio, may still have substantial gains.
An investment in a VCT can also be used to shelter gains which arose up to 12 months earlier, so VCT investors in the first quarter of 2001 will be able to defer tax that would otherwise be payable on gains dating back to the corresponding period in 2000.
So the argument for continuing to invest in VCTs is a strong one. The recent uncertainty as to the economic and market outlook will not disappear overnight. Someone who invests in a generalist VCT now is not placing a bet on what will happen to the markets over the next three months.
Think of it rather in terms of putting money into a cash fund (with the benefit of tax reliefs) that will then be invested over a two to three-year period in a portfolio of young growth companies, at a time when we should start to see a climb out of recession in the UK economy and corresponding improvement in stock market values.
Almost £200m of new money flowed into VCT industry from April to December 2000.
A broad spread of holdings can mitigate risk inherent in over-exposure to certain sectors.
Ironic that investors slow to commit money to market when upside prospects are finally looking good again.
Two global vehicles
'Further plug advice gap'
Must appoint separate CEOs and boards
Advisers do come out well
Will report to Mark Till