Investing in Venture Capital Trusts (VCTs) is not for the faint-hearted. A number of factors conspire to present an off-putting proposition for anyone who sees the looming negatives outweighing any possible upside.
Not least of these is the illiquid nature of VCTs, which stems from the fact that the trusts' underlying holdings tend not to be listed on a major stock exchange, and so managers cannot trade in those holdings at fair value.
Further, since the tax breaks are only available on new subscriptions, there is also effectively no secondary market for VCT shares. Taken with investors' obligation to hold their shares for at least 5 years to avoid a tax claw-back, it seems that once you're in, you're stuck with it.
This needn't be a hardship in itself for investors taking the longer view. The trouble arises when the investor is effectively locked in to a VCT investment that was ill-chosen to suit the buyer's objectives, or otherwise turns sour. And since last year's Budget changes, these eventualities have become more likely. VCTs, in order to claim tax break status, must place 70% of their assets in qualifying investments. Among other conditions, the qualifying equities must be UK trading companies with gross assets of less than £7m. The Treasury has reduced this threshold from its previous £15m ceiling, and the VCT managers are not happy about it.
This move is helpful for small companies that have no access to capital market: with VCTs competing for good opportunities, companies will be able to negotiate better terms. But it is not so good for the VCTs themselves, who will be entering an area where failure rates increase, and where this combines with reduced premiums on their deals to affect returns. And competition there will be. Although the number of launches is projected to be reduced in 2007, they are expected to be bigger offerings, and the funds raised from them will create a pool of market liquidity which is looking for a home.
So where does this leave potential investors, and how should the VCT market be developing?
The first point is that size does matter. A trust needs to be managing assets of more than £10m if it is to achieve the degree of diversification that mitigates risk. It will also need to have an experienced manager in place, with access to a competent, well-resourced investment team. As private equity investors pull out of sub-£5m deals, there will be many small enterprises looking for funds. And opportunities are also plentiful in non-mainstream sectors like environmental services, healthcare and technology. So size, and the right investment management are essential for picking a way through the marketplace in the first place, then taking a close, hands-on approach to managing investments thereafter.
The VCT industry needs to take responsibility for its investor-facing issues as well. First of these is a degree of re-education in the wake of last year's Budget changes. While tax breaks have been cut by a quarter, the message must be that this was never a good enough reason on its own to invest in VCTs. There are arguments for looking at VCTs for their investment properties, ways of putting their risk characteristics into perspective, and a need to make the whole area more transparent to investors.
The development of a secondary market in VCT shares would also represent considerable progress. Although it is not easy to see how this could be achieved, the VCT providers should be talking to each other and to bodies outside their immediate circle about how to create this. While they're talking, it would help in the push for transparency to doorstep the Association of Investment Companies. There is room in the AIC's sector classification system for more precisely defined sub-categories, so giving investors clearer headline information on where VCTs are targeting their assets.
In all, this is a marketplace where successful investments can be expected to double in value every 3-4 years, well within the minimum holding period. The rewards are there and, yes, tax breaks too. All investors need is a better understanding of the products, a means of putting the risk factors into context, and the information to select a VCT that matches their investment objectives. It's time for the VCT industry to act.
2 February 2007