With appropriate risk controls, VCTs could accelerate the revitalisation of smaller growth companies in the UK
When Ken Clarke finally gave the nod to the launch of venture capital trusts (VCT) in December 1994, he heralded a £2.5bn investment into fast growth entrepreneurial companies. His number was plucked from the 'assured' BES schemes of the previous decade ' erroneously so as this prior scheme had little to do with equity investment let alone backing entrepreneurs.
Despite this error of judgement, we can now look back and see that he was at least half right as some £1.4bn has been raised and all 61 VCTs successfully launched since legislation was enacted in summer 1995 are still in existence.
A number of VCTs have outperformed the comparable FTSE All-Share Index, handsomely so if the tax reliefs are taken into account. The private investors and their advisers have also learnt that VCTs do provide an excellent longer-term financial and tax planning tool. The five tax reliefs can really leverage the returns when compared to alternative types of investment and other tax-efficient investment products:
• On subscription ' 20% cash back via income tax relief and capital gains tax deferral, up to 40%.
• For all qualifying shareholders ' tax-free dividends and no capital gains tax on sale of VCT shares. As no tax is payable on investment gains, these capital profits can be paid out as dividends.
The success of VCTs stems from their being fully listed companies, quoted on the London Stock Exchange. This status affords shareholders a high level of investor protection, most notably in the:
• launch and the prospectus
• role of the independent directors in representing the ongoing interests of shareholders
• diverse nature of the investment portfolio
• ability to buy and sell shares
• transparency of statutory reporting to shareholders
The investment managers of the VCT also have a very full part to play. They too have to be vetted during the prospectus preparation as having the relevant investment skills. Both as individual fund managers and also via their firms, the investment managers will have to be accredited, normally IMRO but soon to be unified under the overarching Financial Services Authority regulations being introduced this November.
The directors, managers and advisors treat the completion of a prospectus with the utmost seriousness. If found to be incorrect, corporate and personal reputations are at risk as well as the personal liabilities that attach to this process. When completed, this document can give the answers to several key questions in choosing a VCT.
The first is the nature of the investment policy. This will be the cornerstone on which the VCT and its investment managers need to remain focused. Private investors and their advisers can decide on whether to invest into the three main types ' generalist, AIM or technology VCTs. The first will normally have greater diversity across different stages of growth and sector plus a mixture of unquoted and AiM shareholdings.
AiM VCTs will typically be into more liquid shareholdings as shares can be traded actively on this junior stock market while technology VCTs will go into higher risk/higher reward companies. The prospects for this last group may seem difficult at present but a number of professional investors believe the current fall is an excellent time to invest.
Also important is the track record of the investment managers. The UK Listing Authority has to ensure there is relevant experience but beyond that it will be their historical track record in venture capital and other VCTs in particular that will be important. The expertise comes from the breadth and depth of the team of investment professionals.
VCTs are proving to be relatively long-term ' less than 5% of shareholders of Baronsmead VCT launched in 1995 have sold whereas the existing shareholders have subscribed in top ups for some 20% of the total raised since inception, for example. Key policies include buy-back, dividend reinvestment and distribution, coupled with the level of disclosure and transparency of communication to shareholders and their advisors.
As for the role of the independent VCT directors, their prime responsibility is to represent the best interests of shareholders, together with appointing, managing and replacing the investment manager. They have to be endorsed by the UKLA and their relevant experience is also set out in the prospectus.
Their decision-making does not normally cover the actual investment and divestment decisions but more the valuation of unquoted equities and the pricing of anything to do with issuing and buying back share capital. They sustain an active dialogue with the managers about strategy and responding to changes in the venture capital marketplace. They handle any conflict of interest issues on which they can arbitrate if necessary.
VCT legislation was originally designed to introduce high levels of diversity. A minimum requirement, borrowed from investment trusts, is that no one shareholding may be more than 15%. In practice, this means more than just seven investments, particularly as the managers have to manage the 70% VCT ratio in qualifying investments after the first three years of raising new capital.
Few managers would want any holding on first investment to be more than 5% of the portfolio and so 20 to 40 shareholdings are commonplace, sometimes more if AiM-focused, where acquiring largish shareholdings is not easy.
The volatile markets now show the wisdom of such diversity at a time when IT and telecommunications are in the downswing while healthcare and consumer spending have stayed more robust. The share capital waiting investment can also be invested in non-qualifying fixed interest securities or equities, depending on the original prospectus mandate.
Although individual investments are likely to be more risky than larger quoted companies, a number of commentators believe that a diversified portfolio of unquoted and AiM equities shows much lower volatility and can be comparable to a similarly sized portfolio of quoted equities.
The nature of the long-term investment benefits and tax reliefs within a VCT give shareholders a strong degree of choice whether selling, holding or acquiring more VCT shares. Each VCT has two market makers and so there is the normal quoted company mechanism for buying and selling shares. This secondary market is still in its infancy but over £5m of shares were sold between 1 April and 30 September 2001.
The level of discount between net asset value per share and the mid-market is key to maximising the financial planning opportunities, hence the need for an active buyback policy being adopted by the VCT's board of directors.
A number of VCTs paid out capital distributions in 2000/2001. For individual investors not requiring the income, VCTs can also offer a dividend reinvestment scheme. The new shares all have the VCT tax reliefs.
Full communication is the last check and balance that can give confidence to VCT shareholders and their advisors about how their capital is being invested. Full disclosure in statutory accounts is essential, plus informative newsletters. Annual general meetings can be dry but a number of VCTs arrange for their entrepreneurial investees to illustrate their activities and prospects. This helps investors to understand how they can participate in creating some of the fast growth businesses of tomorrow.
VCTs need to maintain performance in the light of the current downturn in equities but are holding their own. VCT managers generally believe that they are managing 95 pence per share on subscription (net of typical launch costs) while this figure is 40 pence per share in the eyes of the private investors who can use all the tax reliefs.
The importance of VCTs can be seen from the high number of transactions in the overall UK venture capital industry (perhaps as high as 1:6). Once the economic story of the next year or two has been weathered, it could be the VCTs that can prime the fresh shoots of growth and accelerate the revitalisation/innovation of smaller growth companies in the UK.
With some relaxation in present VCT rules, the volume of VCT funds could be much larger in five years time.
Taking account of the tax breaks, many VCTs have significantly outperformed the FTSE All-Share.
VCTs are proving to be a relatively long-term investment.
VCT legislation was originally designed to introduce high levels of diversity.
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