Full steam ahead for VCTs

Promoters of tax-efficient venture capital trusts (VCTs) are hoping for a much better fund-raising season than in the 2008-09 tax year. Subscriptions to new VCT shares slumped to £156 million compared with more than £200 million in each of the two previous years.

On 1 December, there were 18 VCTs open to subscription, seeking £156 million in new money, according to the Association of Investment Companies.

Two reasons for their renewed optimism are that tighter restrictions on pension contributions and the new 50% income tax from 6 April will encourage wealthier investors to take a renewed interest in VCTs.

VCTs offer not only 30% upfront income tax relief, but also the prospect of tax-free income and capital distributions over the long term.

In contrast, pension contributions of more than £30,000 a year are already limited to basic-rate tax relief if HM Revenue & Customs deems it to be above an investor's norm, and tax relief is scheduled to be restricted to the basic rate for all pension contributions for those with annual incomes exceeding £150,000 from April 2011.

In addition, the rates available on annuities into which most pension savings are converted have resumed a downward trajectory after a brief upturn in 2008, and any annuity income is fully taxable.

As the cherry on the cake, VCT investors and their heirs retain the ability to realise their holdings in due course, whereas people who have converted their pension pots into annuities have given up their capital forever.

Improving climate

Another reason for the VCT industry's optimism is the improved investment climate. This has helped restore the historic returns of the better VCTs to levels that are more likely to encourage support.

It is also making it easier for the managers to find new investments and realise old ones after a period when it has been hard to do either. VCTs managed by Baronsmead, for instance, have made no new investments over the past year, despite having plenty of cash.

When deciding which of the new offerings to support, it is essential to consider how well the managers have performed in the past. It is usually at least five years before a private equity/generalist VCT starts to show its paces.

It is, therefore, difficult to judge whether newer VCT managers, such as Octopus Partners, are worthy of support.

However, six of the 13 generalist VCTs that have a 10-year record have substantially outperformed the FTSE All-Share index over that period, as has one of the three eligible technology-oriented VCTs.

Unfortunately, a number of the others have fallen very far short, as have all the VCTs focused on Aim. Even the most resilient Aim VCT has lost 57% of investors' original outlay.

In descending order, the VCTs that have outperformed the All-Share in terms of 10-year total returns, even before their tax advantages are taken into account, are: Northern Venture Trust (but not Northern 2 VCT), Albion VCT (but not Albion Development or Albion Protected VCT), Baronsmead VCT, British Smaller Companies VCT, Foresight 4 VCT (but not Foresight 3 VCT), Downing Protected VCT, and Baronsmead VCT 2.

More focused approach

Investors might not be familiar with the Albion title. The former Close VCTs have taken this name to reflect their manager's buyout of the Close Ventures business in early 2009.

This is part of a general move towards more focused investment businesses, which has also seen the formation of Maven Capital Partners by the buyout of Aberdeen Asset Management's private equity division. VCTs represent a major part of these businesses - 99% in the case of Albion Ventures.

That means the ongoing success of the VCTs is high` on the managers' agendas, with their rewards often highly dependent on performance fees.

Another encouraging trend is successful VCT managers taking over mandates from weaker players. One recent example was Foresight Group taking over Keydata's VCTs.

The merger of smaller VCTs, such as Ortus and Gateway in September 2009, should help to keep down total expense ratios, which are often up to 3.5% in the VCT sector.

It is not, however, a safeguard against unfairly structured performance fees, which investors need to watch out for carefully.

As an illustration, there was outrage in spring 2009 when the two Artemis (AIM-oriented) VCTs were merged into one, and it was proposed that not only that their performance fee should be rebased to the exceptionally low net asset value pertaining in March, but also that it should be 25% of any gain achieved in successive six monthly periods, with no hurdle rates.

This is not an isolated incident. Two of the Maven VCTs, for instance, have similar 'performance' fees, claiming 27.5% and 20% of any gains regardless of any index comparisons, and Aberdeen Growth VCT's performance fee is uncapped.

Nearly all the new VCT offerings are in the generalist sector, which is not surprising given the poor results of most AIM VCTs and the dire shortage of qualifying investments listed on the exchange over the past few years.

Unless VCT managers succeed in lobbying for a relaxation of the increasingly onerous restrictions that have been placed on AIM-qualifying investments, it is hard to be bullish about any of the recently launched VCTs in the AIM subsector.

Secondary advantage

However, older VCTs in both the Aim and generalist sectors can continue to invest their funds under the regime that pertained at the time the capital was raised.

In theory, any new funds have to be invested subject to the current regulations, but in practice they can be used to cover management costs and fund distributions.

So the Baronsmead VCTs, for instance, are careful not to raise more than can be utilised in this manner and thereby maintain maximum flexibility.

When considering a new VCT purchase, investors should bear in mind that purchasing existing VCT shares will not secure an income tax rebate, but a good discount and the lack of issue expense can make up for much of that.

Also, there is no minimum five-year holding period to avoid repaying the income tax relief.

Another advantage of buying in the secondary market is that the portfolio should be at least partially invested and therefore nearer to achieving worthwhile capital and income distributions.

Those distributions will enjoy the same tax relief as if the VCT shares had been bought at issue, in just the same way that any eventual gains on any VCT holding will be tax-free.

VCTs - the tax breaks

Investment in small UK start-ups and consequently they include a number of attractive tax breaks to help boost performance. These include:

  • Income tax relief equal to 30% of the sum invested in newly issued VCT shares, which can be set against any income tax liability. The maximum investment for which deferral relief can be claimed is £200,000 per tax year. Relief is repayable if the shares are sold within five years, but not if the investor dies.
  • Exemption from income tax on dividends and distributed capital gains, regardless of whether the VCT shares are bought at issue or in the secondary market.
  • Exemption from capital gains tax when VCT shares are sold, regardless of how they were bought.

There is no maximum investment if VCT shares are bought second-hand, and no need to hold them for a minimum of five years.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010

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Just to say thank you for your very informative and short ! article on the VCT in the Full steam ahead for the VCTs.