Ben Yearsley: When banks can't help you grow, try the VCTs

The Analyst

I am departing from the norm this week to write about a higher risk investment with some excellent tax benefits, and one that is playing an increasingly important role in the UK economy.

Over the next decade the balance between public and private sectors will change. Public-sector employment will fall and the private sector will be called upon to take up the slack, so it was encouraging to note GlaxoSmithKline's recent announcement of 1,000 new jobs at its new R&D facility. Yet it is the smaller companies where many new jobs will have to come from and because they lack the resources of larger firms they often need help to expand. Unfortunately smaller companies tend to rely on banks for borrowing and they are reluctant to lend at present. So who can lend to small businesses if banks can't?

One source of funds is venture capital. Venture capital trusts (or VCTs) aren't suitable for everyone as they are higher risk, long-term investments, but they do come with some very generous tax advantages for investors subscribing for new shares (see below). VCTs invest in small and growing businesses with no more than 50 employees, providing finance for these companies to develop, or for management teams to buy a business from its present owner. This could be a halcyon period for VCTs as they have the pick of the opportunities, but it won't last forever as the banks will gradually return at some stage.

There will probably be in excess of 30 VCTs seeking funds in the coming months and, as with any investment, there are both good and bad. Their strategies vary significantly, so if you are contemplating VCTs please make sure you know what you are getting into. One that I will invest in is Elderstreet VCT, a fund with a bias to software companies. It is a traditional VCT, genuinely investing in small, developing companies, aiming to grow them over time. Elderstreet's founder, Michael Jackson, was chairman of the accountancy software firm Sage for many years, taking it from a small company to the FTSE 100. Clearly this doesn't happen with every investment, and some businesses inevitably fail along the way, but the winners should more than make up for the failures over the long term.

One common misconception about VCTs is the level of risk. Admittedly they are higher risk and should be held for 7-10 years or more, yet most VCT managers avoid "blue sky" start-up companies. Instead they look for established firms with proven business models that are looking to expand. Once an investment is made, nurtured, and helped to grow, the manager will look to sell it, probably after 3-5 years. Any profit is then generally repaid to investors as a tax-free dividend – another one of the tax breaks available. Over the last four or five years many VCTs have been consistent with dividend payments, and tax-free yields of 5-6 per cent are commonplace.

The Elderstreet VCT is small in size at only £18m, though it has investments in over 20 companies. As an investor in this year's fundraising, you can benefit from a 30 per cent upfront income tax relief (provided you have paid sufficient income tax), and because it is an existing fund you gain access to a mature portfolio, which should mean an earlier dividend stream from businesses that are sold plus income from loans to the underlying businesses. The fund features a number of software businesses but it also has a wide range of other companies including engineering firms, a vending machine operator and a packaging business. Common to all is Elderstreet's hands-on approach. The investment team typically take positions on the boards of the companies.

I have been saying for the past 18 months that it is a good time to invest in VCTs due to the absence of bank financing. The situation persists, so this year could again be a particularly good vintage for those prepared to invest for the long term, and Elderstreet VCT is certainly one to consider.

Ben Yearsley is investment manager at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent