Pack away your money before he opens the box

Venture capital trusts can offer good returns and attractive tax breaks, writes Andrew Geldard

With a Budget looming next month, investors with capital gains they want to shelter are being urged to invest in venture capital trusts (VCTs). Yorkshire Fund Managers is keeping its British Smaller Companies VCT until 30 May in the hope of a last-minute rush of investors worried that on 10 June the tax advantages will be reduced or ended for new investors.

This may or may not be good advice. But venture capital funds have performed better over 10 years than the FT-SE All-Share index, according to a recent survey commissioned by the British Venture Capital Association (BVCA) and calculated by WM Company, the pension and performance measurer. It shows independent UK venture capital funds have produced a net return of 15.7 per cent a year over the past 10 years and outperformed all asset classes held by pension funds. By December 1996 the overall net return to venture capital fund investors increased to 14.2 per cent per year on funds raised between 1980 and 1992.

On average, venture capital funds enjoyed a particularly prolific 1996, with successful management buy-outs helping to create a net return of 42.9 per cent, while over five years the average performance was a very commendable 25.7 per cent.

Venture capital investment has always had the reputation for being a much riskier option than unit or investment trusts. Indeed, the survey's long-term average does conceal a wide variation in the performance of individual fund managers ranging from a profit of 40 per cent to a loss of 20 per cent. However, investors should not let this potential volatility deter them from taking a look at the serious benefits that investment in venture capital can offer in terms of capital growth and tax planning.

Venture capital investment became more accessible to the public when the Conservative government introduced VCTs in 1995. They were designed to encourage investors to plough money into small businesses by offering generous tax breaks and the potential for spectacular growth. VCTs enjoy the same immunity from income and capital gains tax as PEPs, plus an annual investment limit of pounds 100,000.

Another advantage of VCTs is income tax relief of 20 per cent, meaning that an investor can put in pounds 100,000 at a net cost of pounds 80,000, the only proviso being that the investment must be for a minimum of five years.

After five years gains may be withdrawn without incurring capital gains tax. A VCT can also defer a capital gains liability that has been incurred from another source such as the sale of property or shares. By putting this capital sum into a VCT, investors only become liable for the capital gains when they sell the VCT shares in the future or the VCT is wound up. And this can be avoided entirely if, after the initial five-year period, they only withdraw amounts that are within their annual capital gains tax exemption limit.

Combine these tax advantages and you are well on the way to offsetting the possible risks that investors face throughout a VCT. So what are these risks? Regulations stipulate that all qualifying VCTs must only invest in those companies that have less than pounds 10m of gross assets and, if listed on a stock market, are only on the Alternative Investment Market (AIM). Which means, in theory, that they have to target exactly the sort of companies that will find it hard to survive any sudden downturn, especially during times when the cost of borrowing is high. Certain companies do not qualify, including those in retailing, law and accountancy.

However, as VCTs are similar in structure to unit or investment trusts in that they spread investments across a number of companies, the possibility of losing your capital if one company runs into difficulties is reduced. The risk factor is being further eroded by the growth of the guaranteed VCTs offered by fund managers such as Close Brothers and Noble & Co, which give 50 per cent of the money raised to banks to invest in VCT-qualifying companies as loans. The bank in turn guarantees these loans and interest. A further 25 per cent is invested in gilts, while only the remaining 25 per cent goes directly into shares.

Guinness Mahon, Johnson Fry and Murray Johnson offer VCTs with a more aggressive approach by investing more of the raised capital directly into small companies. They have an established record in small and unquoted company investment and will reject many requests for capital before choosing the companies with the best potential.

Michael Royde, an independent financial adviser, says: "Over the long term, a VCT would have to perform extremely badly for the investor, particularly one who has put in a sizeable sum, to lose the advantages they have gained from the tax concessions."