As traditional lines of corporate funding evaporate, the tax-advantaged venture capital trust sector in the UK can afford to be choosy about their investments.

Long a favourite of high net worth investors, there is evidence that the popularity of venture capital trusts has been dented by the flight to investments offering more security and liquidity.

However, some wealth managers argue that the drying up of traditional lines of credit, combined with buying opportunities presented by the credit crunch, mean that these tax-advantaged, listed vehicles will be able to be extremely selective about what they choose to invest in during the next 12 months, while others are turning their back on these risky investments in the current environment.

VCTs were set up in 1995 to encourage

UK investors to invest in smaller, unlisted companies in need of start-up, early stage or expansion capital by offering considerable tax benefits. Investors are able to claim 30 per cent income tax relief on an investment into a VCT up to an annual limit of £200,000 ($281,000).  In addition, any dividends paid by the fund are tax-free, and if held for five years, any uplift in the value of the shares is also tax-free.

The industry is extremely bullish about the potential opportunities for VCTs in 2009, predicting what it is calling “a vintage year” as the tightening of liquidity by banks to smaller companies in 2009 is expected to create potentially exciting opportunities for these investments.

Despite the onset of recession, members of the Association of Investment Companies say they are seeing strong deal flow and anticipate a busy year as entry valuations fall. “Banks’ reluctance to lend is creating opportunities for the

UK’s Venture Capital Trust industry,” AIC communications director, Annabel Brodie-Smith, told WealthBriefing.

“We expect much more realistic pricing to emerge during 2009,” said Mark Wignall, chief executive of Matrix Private Equity Partners. Richard Power, manager at Octopus Investments VCTs, describes the current environment as “a perfect storm for smaller companies” and sees banks pulling back on lines of credit creating a major impact on funding for them. 

Opportunities

“AIM is awash with investment opportunities,” Mr Power said, referring to

London’s Alternative Investment Market. Stuart Veale, managing director of investment house Beringea observes that companies raising equity finance now have lower valuation aspirations “allowing VCTs to negotiate more attractive investment terms than have been possible over the last two to three years.”

Some wealth managers agree. “Despite the money and liquidity being injected into banks by the government, it is going to be difficult for small businesses looking to grow.  So on that basis VCTs could do very well because there will still be good investments out there looking for money,” said Ben Yearsley, investment manager at independent advisory firm Hargreaves Lansdown.

“There are fewer funding opportunities available for smaller companies and the funding that is available is expensive,” said Jamie Perkins from Westminster Wealth Management. “This means that there will be excellent opportunities for VCT investments in certain types of smaller companies in 6-12 months time as we start to move out of recession and we are talking to clients about these.”

David Cartwright from financial advice firm Blue Fin Group points out that many traditionally uncorrelated assets have all been impacted by the credit crunch, meaning that advisers are looking for truly alternative assets to spread risk for clients.

“All four major asset classes have nosedived at the same time, so I can see how a VCT might be used as a proportion of the alternative play in a client’s portfolio,” he said. “Advisors are looking to spread risk on behalf of clients. Conventional wisdom is that the larger companies in the FTSE 100 are less volatile than the smaller end, but in a situation where the world’s largest insurers and some of the largest clearing banks have gone bust, that’s been proved to be not necessarily the case.”

Others, however, are less convinced. “I’d be wary of giving money to companies that need it when we are on the verge of a long and deep recession, particularly when there are big listed companies with such low p/es and you can potentially gain considerable upside without the risk and with far more transparency,” said Gary Reynolds, director and chief investment officer for wealth management firm Courtiers, who told WealthBriefing that VCTs are “best left well alone” at the moment.

Thomas Becket, head of global investment strategy at PSigma, the

UK investment firm, said the investment thesis around VCTs may well be sensible and there may be some “once in a lifetime” deals available on smaller companies’ shares, but says at the moment, investors are cautious.

“We’re not investing in anything at the moment that we can’t get out of the next day. The liquidity risk is too great and in the current environment, we could lose a client if we cannot liquidate problematic positions for them on a daily basis,” he said. “When the economic recovery comes, the opportunities in smaller companies will look a lot more interesting,” he said.

At the end of November 2008 there were 129 VCTs in existence with some £2.26 billion ($3.21 billion) of assets held. Funds raised by VCTs reached £505 million in 2004/5 and £779 million in 2005/6, when the up-front tax relief was at 40 per cent, but fell back to £237 million in 2006/7 and £219 million in 2007/8.

Westminster Wealth’s Mr Perkins notes that contributions to VCT funds is expected to be lower this tax year, particularly at the lower end of the spectrum such as £5000 and £10,000 contributions.

“Understandably, client demand has fallen,” said Mr Perkins. “We are still seeing demand amongst those clients that are independently wealthy and for whom fluctuations in annual income is not make or break”. He estimates the total market in 2009 will be around £100 to £120 million.

Performance

Average performance across VCTs is not particularly meaningful as sector and individual VCTs have provided vastly differing performance over the last five years. According to AIC data, £100 invested in the best performing VCT over the last five years would now be worth £281.93 whereas an investment in the worst performing fund over the last five years would have left an investor with less than £20 for every £100 invested.

Independent VCT commentator and editor of the Tax Efficient Review, Martin Churchill, said some AIM VCTs have performed terribly and that there have been problems with others that focused on special situations such as technology. However, Mr Churchill is adamant that the only sensible way to look at VCTs performance is to consider the internal rate of return, which combines the effect of the tax break they offer with the return on investment. “On this basis, many VCTs have provided excellent returns,” he said.

Mr Cartwright makes the point that these days, Enterprise Investment Schemes provide a better CGT shelter, but the income tax benefits of VCTs are still valuable and have the effect of reducing the risk involved in real terms. “The real risk is the net contribution, so £70 for every £100 invested in a VCT,” he said. On this basis he believes that VCTs are probably of interest to a “significant minority” of wealthy individuals.

TER’s Mr Churchill divides the industry into two groups. The first is generalist VCTs which exist to provide venture capital to growing and start up companies such as ProVen, Baronsmead and Matrix. The second group is limited life VCTs such as Downing, Edge and Ingenious, which exist primarily to enable investors to avail themselves of the tax breaks offered by VCTs and work within the rules to provide investors with as much capital protection as possible.

“I subscribe to the view that cash will be king over the next 18 months. For those individuals that can invest their money for 7-10 years with one of the generalist VCTs that knows what it is doing, in combination with the tax breaks, I don’t think that they’ll be disappointed. These are not three or five year investments and are highly illiquid, so if there is a chance you will need your money in the next five years then don’t do it," he said.

Using limited life VCTs, which according to Mr Churchill attracted 60 per cent of VCT investment last year, investors can expect a return which encompasses the tax break and a modicum of money.

“However, investors should be confident with what is providing the capital protection on these,” said Mr Churchill, making the point that since the demise of Lehman Brothers, counterparties are not what they were.

Tax considerations

Even taking into account the tax breaks, some wealth managers remain unconvinced. Courtiers has used VCTs in clients’ portfolios in the past for those individuals retiring and wishing to roll over CGT relief, but since taper relief dropped to an effective 10 per cent on gains, Courtier's Mr Reynolds believes this became unnecessary.

In his experience, tax considerations have been put to the back of clients’ minds in favour of a focus on risk and Courtiers is diversifying risk out of clients’ portfolios as much as possible to ensure that they come out the other side of the current market turmoil.

“I wouldn’t put any clients in VCTs in the current environment, even if they are cash rich with free capital. As one client said recently, “I’d rather pay the tax on the business gain rather than roll over the CGT into a load of basket cases,” said Mr Reynolds.

“The market is very cheap, there is so much opportunity in the mainstream and some of the biggest ever rises in equity markets have come on the back of the biggest bear markets ever. However, VCTs can still be wiped out even when the market is improving because an investment doesn’t come through,” he said.

Liquidity is also required in order to walk away from an investment and as VCTs are not valued ‘mark to market’ everyday, their true underlying value only becomes clear when an investor comes to withdraw. “I would ask investors “Do you really need the risk?” ” concluded Mr Reynolds.

Despite the potential opportunities and the tax breaks available, VCTs must be considered a high-risk and long-term investment. “It is also an area where wealth managers can really add value to their clients as there are a lot of VCTS with different investment objectives and risk profiles,” said Ms Brodie-Smith from the AIC. Reflecting the risky nature of VCTs and the specialist knowledge required to advise on the diverse range available, Bluefin risk manages this area of advice and provides a specific licence to a small number of its advisers to advise on them, which must be renewed every year.

Whether 2009 will be a vintage year for VCTs remains to be seen. While opportunities clearly exist, the key will be identifying them and then holding on tight for the economic recovery to take hold.