David Stevenson: How to work capital that’s waiting for a venture

I’ve tended to ignore most “conventional” venture capital trusts (VCTs) until recently. I’ve invested in generalist funds in the past and bitterly regretted the adventure.

The tax treatment for VCTs might, indeed, be generous: 30 per cent tax relief on initial investments plus all returns, including income, free of tax. But that preferential treatment can’t hide the fact that average returns from the underlying investments in unlisted companies have been pretty dreadful – especially after the high management costs.

However, there are some notable exceptions. I’ve always liked the Ventus VCTs that focus on wind power and I think there is some value to be had in the second-hand VCT market (if you know what you’re doing). Also, some specialist VCT managers, such as Downing, are now trying to control inherent risk by offering asset-backed vehicles. These invest in businesses, such as kindergartens, hotels and leisure clubs, where, in the worst case, the property assets could be sold off to give around 70p in the £1 back to investors (the equivalent of their net contribution after tax relief).

Downing has also tried to address another risk: the discrepancy that can open up between a VCT’s stated net asset value (NAV) and its share price. It’s come up with two solutions: a buy-back discount control policy on some of its open-ended funds, and “limited life” funds.

But its biggest innovation has been in the structuring of returns. Take, for example, the Downing Absolute Income VCT 2, which aims for an income of 5p in the £1 – giving a net return of 7.8 per cent, if you include the initial 30 per cent tax relief on every £1 invested. For top rate taxpayers, that is comparable to a bond return of more than 10 per cent a year.

Some analysts have even suggested this as an alternative to equity income funds for pensioners. Personally,
I find this a little bizarre
as the underlying assets are still risky early-stage businesses that could fail (as the many empty pubs, nursery schools and hotels in my area attest). Also, VCTs can take three years to find these businesses, so guess where the 5p dividend comes from while the cash is still on deposit? Yes, the capital.

Downing has another fund that takes a different approach, though. Its Structured Opportunities VCT 1 also aims to pay a 5p annual dividend – but much of this will come from a portfolio of listed structured products, managed by Brewin Dolphin.

Now, these are very different from the dreadful structured products peddled by some high street banks and building societies (the ones from Barclays and Blue Sky being honourable exceptions). They are stock market listed vehicles sold by the big investment banks – Merrill Lynch, Barclays and Citi – to institutions and wealth managers.

In my view (and I hold a fair wad of this stuff), these look like good value. They were bought in 2009 after their prices collapsed. As a result, some now offer returns of around 10 per cent a year but the credit risk is much lower.

Of the 17 portfolio holdings, I like what I see. For most of the products that are linked to the FTSE 100, the downside barrier – the index level below which you lose money – is between 2,000 and 3,000. But the trigger point for the payment of the coupon – the 10 per cent return, based on the 2009 purchase prices – is between 4,000 and 4,700. There are also some synthetic zeros from Barclays and Merrill Lynch yielding between 13 and 17 per cent to maturity with fairly strong barriers. Crucially, no single issuing bank accounts for more than 20 per cent of the portfolio. The pay-out timescales for these products also varies between six months and three years.

So, based on the £5.9m book cost of the holdings,
I think it’s possible for the fund to receive back just under £7.8m by the end of 2012 – a return of about 30 per cent. These returns should help pay for that 5p a year promised by the Downing VCT in dividends, until the portfolio is wound down and the proceeds invested in those asset-backed businesses.
adventurous@ft.com