Perhaps unsurprisingly, the total amount raised through new Venture Capital Trusts (VCT) issues in the 2008-09 tax year was severely down, at just £135m versus the £209m raised in 2007-08. During the falling markets of 2008 and the first quarter of 2009, investors sought liquidity and were reluctant to lock capital away in a VCT, where the minimum holding period to qualify for upfront income tax relief is five years.
Why VCTs?
We believe that VCTs will now become a more attractive investment than they have been in recent years, primarily due to the removal of higher rate income tax relief for larger pension contributions and the 50% rate of income tax for earners over £150,000. Paltry interest rates on cash deposits may mean that the tax-free dividend available from VCTs will become increasingly attractive for those able to withstand the additional risks such as limited liquidity, smaller higher risk companies and a generally more concentrated portfolio than regular collective investments.
How do I access VCTs?
One of the first decisions an investor will face will be whether to invest in a new issue, C-share or a top-up.
New Issue
A new VCT seeking a listing on the London Stock Exchange(LSE). New issues will have fresh capital and no legacy investments, but will be subject to cash drag which could be a concern in current conditions.
C-Share
A VCT that is already listed on the LSE can raise money to be invested in a separate share class. This money may or may not immediately merge with the Ordinary share pool. A C-share will benefit from economies of scale, and will share the cost of administrative services/director fees with the ordinary share portfolio. Like new issues, C-shares will have fresh capital and no legacy investments, but will also be subject to cash drag which could be a concern in current conditions.
Top-Up
A VCT that is already listed on the LSE, seeking to raise money to be invested alongside the existing pool of Ordinary shares. Top-ups will dilute the existing shareholders, meaning that investors may be able to access a more mature, dividend producing portfolio of investments. However, investors may be subject to a fall in Net Asset Value (NAV) if the current portfolio is re-valued downwards in the future. VCT rules have changed much over the years, and money raised in earlier tax years is subject to less onerous restrictions regarding the investee companies. Often managers raising money through top-ups are using this money solely for the provision of buy-backs, payment of dividends and for non-qualifying/liquidity investments. By keeping the new money separate in this way allows money raised under previous regimes to be invested under less restrictive conditions. Specifically, the reduction in the net assets test in 2007 and the introduction of a maximum of 50 employees test has meant that certain service businesses are now excluded for new money raised.
When to invest?
It is unlikely that all VCTs will raise enough funds to meet their capacity. The amount raised to total capacity ratio has come down steadily over recent years, with only 39% being filled last year. It is possible that the better VCTs will fill their capacity and it may be advisable to secure your place early.
VCT strategy
The VCT market is split into the following strategies:
- Asset Backed
- Generalist
- Private Equity
- AiM
- Limited Life
Each strategy behaves quite differently with Generalist and Private Equity investing in more traditional, small dynamic companies seeking absolute growth. It is likely that some of the portfolio companies will go bankrupt over the five year minimum hold period, however, one successful company achieving supernormal growth could offset poorer returns from the remainder. It is worth pointing out that the current credit crunch is playing into the hands of some strategies and hampering others. Some Asset Backed managers will generally seek a lower overall risk/return do not include external debt within their transactions. With smaller companies still finding it difficult to obtain bank debt, these managers are now able to negotiate far better terms, often including a share of the potential upside. Strategies that are heavily dependent on external bank debt such as those focussing on Management Buyouts (MBO), may find the immediate environment more difficult to navigate. Over recent years, Limited Life VCTs have captured an increasing share of the VCT market. We expect this to continue, but investors should focus on the downside risks and protection of the net contribution, and record of actually returning cash to investors as investment returns will be minimal. We do not expect any AiM VCTs to launch this year, as the initial public offering markets have shown little activity.
The manager
For Generalist and Private Equity VCTs, the manager’s deal-flow network is crucial. Generally, well established managers with larger pools of money to invest will have a greater range of opportunities from which to choose from. Several VCTs have a strong and long track record of investing whilst others have raised significant assets in a relatively short space of time, and are now beginning to prove that they have also worked equally as hard at developing their deal-flow network. When assessing a manager’s track record, the stability and continuity of the team should be checked; often the managers who have been responsible for the historic track record have moved on to another company.
Cash
With deposit rates at all time lows it is important to consider the strategy for the non-qualifying element of the VCT. VCTs have up to three years to achieve a minimum of 70% in qualifying investments. Traditionally the remaining 30% is left in cash on deposit. The combination of fees often in excess of 3% per annum and paltry deposit rates means that capital will become eroded. We have witnessed VCTs that will seek to invest in structured products through the non-qualifying element. This has an additional advantage in that the VCT wrapper can pay out dividends free of tax from capital gains achieved through the structured product. Others may use the non-qualifying element to invest in hedge funds.
Dividend
The tax-free dividend may become increasingly attractive as investors struggle to find income. Investors entering a top-up should seek clarification of the amount of distributable dividend reserve the vehicle has, several for example have over two years. Other VCTs are launching with significant clarity over their underlying investee companies’ earnings which should produce a healthy yield for the VCT.
Fees
Fees are one of the main issues of VCT investing. We prefer vehicles that align themselves with investors and believe performance fees over an initial hurdle rate (excluding the initial tax relief) are an efficient way of achieving this. Limited life VCTs, that are able to return capital quickly to investors, can also make an argument for collecting a fee for achieving this. In general, we do not believe that sweet equity/co-investment schemes, are entirely fair. The manager is not investing on the same terms as the VCT.
Annual management charges are generally above 2%, significantly higher than a traditional managed fund and are often quoted exclusive of adviser commissions, director remunerations and administrative costs. We question fees when the manager is not involved with the day to day management of the VCT and welcome developments such as other managers who have rolled up management charges interest free and only take their fees at the time of wind up, subject to a priority investor return.
Our website details those VCTs that are open, in the pipeline and crucially how much they have raised to date. In some cases managers offer attractive early-bird incentives and these are also noted.
If there is anything you wish to discuss regarding this article please call one of our Advisers on 020 7189 9999.