Keiron Root and Oliver Haill review the current state of the venture capital trust sector.

Venture capital trusts (VCTs) are closed-ended investment vehicles that are designed to encourage investors to back the UK’s small and medium-sized enterprises (SMEs). They
do this by offering a range of tax reliefs to investors.

The intention is that the bulk of the money raised by VCT managers should be invested
in suitably qualifying companies, but there is some leeway. VCTs have to invest at least 70 per cent of their cash within three years of launching so, while they hunt for suitable targets, they keep much of their funds sitting in non-qualifying assets, such as other investment funds or money market instruments.

A route to private equity
Tim Levett, executive chairman of NVM Private Equity, which currently manages four VCT portfolios, argues that ‘VCTs provide one of the few opportunities for private individuals to invest in unquoted companies via a collective investment vehicle. So, effectively, it’s a key route into the private equity field. As a result, there are more than 120 VCTs, with combined funds under management of well over £2 billion.’

He adds, ‘But private investors get other crucial benefits with VCTs. If they invest in a new fund issue, for example, they’re entitled to 30 per cent income tax relief on the capital invested. Profits on the sale of shares are exempt from capital gains tax after five years. And dividends generated by VCTs are tax-free. For higher-rate taxpayers, particularly those facing Alistair Darling’s 50 per cent tax rate from April 2010, that makes them a valuable part of any rounded portfolio.’

Levett insists, ‘The tax advantages are a real plus. As an example, assume the dividend on a given VCT ordinary share is 5.5p per annum. If the investor came in during the initial fundraising and bought shares at 100p, then received the 30 per cent income tax relief, the annual tax-free yield on the net cash invested is 7.9 per cent.’

Bridging the gap
Of course, these tax breaks are there for a reason. Such government-inspired generosity is intended to bridge the ‘equity gap’ between banks, government grants and business angels, and full-scale corporate private equity.

As Kevin Lee, managing director of Calastone, a two-year-old company set up to provide services that deliver cost savings to boutique fund management houses, explains, ‘We’re too big for angel venture capital but too small for corporate so VCTs are a perfect fit in between. We looked at investment banks but, because the amount we required was lower than their general minimum, VCTs became the obvious choice.’

It must be said, however, that changes to the rules governing VCTs in successive Budgets have severely restricted their fundraising ability. In 2005-06, when the level of tax relief for investors was 40 per cent, VCTs collectively raised some £790 million. In the subsequent three tax years, as the legislative squeeze tightened, this has fallen to £269 million, £290 million and, in the 2008-09 period, just £135 million.

However, this figure was better than some in the market feared. Mark Wignall of Matrix Private Equity Partners observes that ‘The leading VCT managers had fruitful fundraisings, garnering sums of between £5 million and £30 million. Several managers hit 70 per cent or more of their fundraising target, proving investor appetite for tried and tested VCTs, even in challenging fundraising conditions.’

Narrower focus
Wignall believes that this fall is largely due to the reduction in the 40 per cent upfront tax break to 30 per cent, while Alex Macpherson, chief executive of another multiple VCT manager, Octopus Ventures, observes that ‘There has been a dramatic contraction in the amount of money available for UK SMEs, and legislative changes have forced investment into areas where businesses are smaller. So we tend to have only backed the very best companies with the best teams and really good growth opportunities rather than established businesses looking to do MBOs and then grow their business.’

Certainly, global economic turbulence has made institutional investors much more risk averse. This has, in turn, seen the cash in the venture capital pot dry up significantly, with money raised by venture capital funds plunging 70 per cent last year compared with 2007.

Chilton Taylor, head of capital markets at Baker Tilly, feels that ‘There is very little venture capital in this country at the moment. Most private equity houses are not active. What’s happening is that, because private equity houses are not investing, as they cannot get the debt, VCTs have been one of the few sources, if not the only source, of early-stage finance in the country. And because they are one of the few players in the area, they have been able to adjust their risk profile to look at only later-stage investments.’

No shortage of opportunities
For those VCT managers with cash to invest, however, opportunities abound. The most recent research into the sector conducted by What Investment’s sister magazine Business XL – the VCT Report 2009 – has uncovered more than £600 million currently waiting within the coffers of established VCTs to be invested in suitably qualifying companies. Drilling further down, the research indicates that, collectively, these funds have more than £230 million of actual liquid cash in the bank, with this pot soon to be further filled by £131 million of new funds attracted in the most recent round of VCT fundraising.

Alex Macpherson comments, ‘I think the irony is that, these times, which are most difficult for businesses, are the best time for making investments. We are in that fortuitous position where we can invest at the bottom of the market.’

And Chilton Taylor points out that ‘Over half the investment has been for companies with contracted revenues, that is to say safer investments. AIM companies, in particular, have been hit as the dedicated AIM VCTs are quite restricted by the gross asset limits, which are not really appropriate for AIM companies.’

The secondary market
The VCT market also displays a degree of maturity. For much of their history, the emphasis has been on investing in VCTs at launch or via subsequent new fundraisings. Yet VCT shares can be freely bought and sold like more conventional investment companies, and investors are increasingly discovering the attractions of the secondary market.

NVM’s Tim Levett points out that ‘Buying into a new VCT at launch can be a step in the dark because the fund is unproven. Existing funds offer more peace of mind. Although the illiquidity of most VCTs means they trade on the stock market at a hefty discount to net asset value, that also means they offer good yields. For example, the ordinary shares in a VCT managed by NVM, Northern Venture Trust, are currently trading at a mid-market price of 53p, a 30 per cent discount to the latest NAV. With a 6p dividend in prospect, that’s a tax-free yield of just over 11 per cent.’

He adds, ‘VCTs are considered quite high risk. The shares are relatively illiquid, making it harder to cash in the investment, and to qualify for that initial income tax relief investors must hold the shares for five years. VCTs also commit capital to smaller, private businesses that offer fewer certainties than quoted companies, and there’s less disclosure.’

A pension supplement
Levett continues, ‘VCT shares bought in the secondary market can be sold at any time without losing the tax breaks on dividends, whereas new shares have to be held for five years to retain the benefit of the initial income tax relief. And you should remember that, if an existing VCT is trading at a discount to NAV of more than 30 per cent, it is actually better value pound-for-pound than a new issue, even with the tax break.’

And he concludes, ‘Put together strong yields and exemption from income tax, and you have
an ideal vehicle for investment as a secondary pension plan. So, for example, once the investor’s SIPP has reached, or is nearing, the maximum level of investment, VCTs offer a chance to build up another portfolio. Remember, from April 2010 that 11 per cent tax-free yield will be equivalent to a 22 per cent gross return on a taxable stream of income to a top-rate taxpayer. And given the chancellor’s plans to restrict tax relief for pension savers earning over £150,000 by tapering it to 20 per cent, VCTs are becoming even more attractive.’

Copies of the VCT Report 2009 can be pre-ordered for £295 + VAT, by calling Halid Delkic on
020 7250 7039 or emailing Halid.Delkic@vitessemedia.co.uk.

For a full list of current research reports visit www.vitessemedia.co.uk/store/research