VCTs

The Financial Services Authority recently sent out its second warning in eight months to brokers and advisers who sell venture capital trusts, complaining that too many of them were still failing to make the risks clear to investors. It criticised some companies selling VCTs for giving too much prominence to the benefits and not enough to the potential pitfalls.

So what are VCTs?

VCTs are funds that invest in small and start-up companies which are either unquoted or listed on the Alternative Investment Market, the junior stock exchange. They were launched 10 years ago to encourage investment in fledgling businesses. However, after a sharp fall in sales during 2003 and 2004, the government last year improved the tax breaks, offering investors in the funds a 40 per cent income tax kickback on their investments.

Is that why VCTs have become popular again?

In short, yes. The change in tax breaks triggered a rush of providers launching new funds. In the 2004/05 tax year, some 40 trusts collectively sought £1bn of investor money. In the end, just over £500m of funds were sold, a huge increase on the £60m worth sold in 2003/04 tax year.

So how do VCTs work?

In order to maintain their tax breaks, VCTs must invest 70 per cent of their assets in “qualifying investments” within three years of launch. “Qualifying investments” are companies that have gross assets such as machinery, stocks or property of less than £15m. In addition their shares must not be listed on the London Stock Exchange. Certain businesses such as nursing homes, hotels and property development are excluded from VCTs.

Are there different types of VCT?

There are many different types, but most VCTs fall into three main categories. First, there are Aim VCTs which invest in companies that are quoted on the Alternative Investment Market. VCTs can only invest in Aim companies that are raising new finance, for example companies that are seeking their first stock list on the exchange. VCTs that invest in Aim shares are likely to be fully invested more quickly than other VCTs and so may show higher early returns if the shares of the companies in the portfolio perform well.

Second, there are specialist VCTs which invest mainly in unquoted technology companies. Often, a portion of the money raised is also invested in some Aim-quoted technology companies in a bid to reduce the risks. Technology VCTs are perceived to be more risky than Aim VCTs but can offer higher returns.

Finally, there are general VCTs which may spread investments between Aim-listed companies and unlisted companies. They often have a policy of investing in companies that are already or very nearly profitable in an attempt to reduce risks.

Any other differences?

There are three types of VCT launch. A new launch is when a brand new VCT is launched. A new share class launch is when an existing VCT looks to raise additional funds for a new portfolio. A top-up offer is an additional issue of shares by a VCT which may involve buying into an existing portfolio.

How many VCTs are open to investors?

There are currently about 15 VCTs open to new investors by companies such as Baronsmead, Close, Eclipse, Electra, Foresight, Framlington, Keydata, Matrix, Noble and Pennine. More are likely to be launched as the tax year draws to a close as this is the key period for VCT sales.

Who can invest in them?

Anyone over 18 can buy a VCT. To receive the tax reliefs, an investor must not invest more than £200,000 in any tax year and the upfront income tax relief is only available if the shares are held for a minimum of three years.

Why would investors buy one?

VCTs are the most generous tax incentives available on any UK investment. All income and capital gains are paid free of tax and new shares in VCTs acquired after April 6, 2004 entitle investors to 40 per cent income tax relief.

What are the typical charges?

Initial charges are typically around 5 per cent and the ongoing annual costs 2.5-3.5 per cent.

How have VCTs performed so far?

According to website www.taxefficientreview.com which tracks the market, most VCTs have performed well, although this is partly due to the generous tax breaks. It says Aim-based funds, which can revalue daily, have performed strongly. But it points out that as the VCT has three years in which to invest in qualifying companies, many of them have quite immature portfolios. In addition, valuation rules prohibit upward revaluation in the first year of holding an unquoted investment.

What are the risks?

Most of the assets of VCTs will be invested in small UK trading companies and investors can expect that at least one in 10 start-ups will not survive.

Are they easy to sell?

The volume of shares traded tends to be low because, although there are still tax benefits in buying existing VCT shares, the main attraction is buying them at launch and holding on to them for the qualifying period to gain tax breaks. Because there are few buyers and sellers, anyone looking to sell VCT shares before the fund is wound up risks selling them at a substantial discount to their underlying value.