Investors urged to play with fire and back VCTs

As demand slumps for venture capital trusts, Simon Hildrey asks if now is the time to buy

The dramatic decline in the popularity of venture capital trusts (VCTs) was graphically illustrated last month when the Cornerstone trust was withdrawn after raising only £1.7m of the £20m sought by Matrix Securities.

In just two years, the money flowing into VCTs has dropped by almost 90 per cent, from a record high of £450m in the 2000-01 tax year to £50m in 2002-03.

Of the 12 VCTs now open to investors, only four have attracted more than 50 per cent of the capital they are seeking, says Martin Churchill, editor of Tax Efficient Review, a website that offers information on the trusts. The Baronsmead VCT C share issue has fared the best, raising 63 per cent of the £14m targeted. The offer closes on 23 May.

The Teather & Greenwood AIM VCT C share issue, due to close on 30 April, has raised only 12 per cent of the money it is after. Electra Kingsway's second issue has fared little better, attracting 18 per cent of the required capital; it too closes on Wednesday.

However, just as the logic goes that you should invest in stock markets when others are despondently selling shares, so proponents of VCTs say the decline in their popularity means now is a good time to get on board.

But VCTs are not low-risk or short-term punts. To claim the benefits of 20 per cent income tax relief and exemption from income tax on dividends, as well as from capital gains tax (CGT) on selling VCT shares, investors need to hold them for at least three years.

And it is commonly accepted that VCTs, which are investment trusts listed on the London Stock Exchange, are five- to seven-year holdings. Because their capital is invested in start-up, unquoted or Alternative Investment Market (AIM) listed businesses, it takes a number of years before the trusts can realise profits from a company's initial public offering.

Mr Churchill believes there are three reasons for the drop in demand for VCTs. First, one of their main attractions is that they allow investors to defer CGT on up to £100,000 of their profits each year. After three years of declining stock markets, however, investors do not need to defer CGT.

Second, the market falls have made investors more risk averse, so they are shying away from small and unquoted firms. Small companies tend to be higher risk because they usually have only one product and are more vulnerable to a client going bankrupt or a supplier closing. Furthermore, it is easier to sell a stake in a larger company.

Third, the performance of the trusts has been "mixed". Of 68 VCTs, 14 have delivered a positive return since their launch. The two best performers have been Foresight Technology, with a return of 22.68 per cent since November 1997, and Oxford Tech 2 VCT, with 15.51 per cent since April 2000. Not surprisingly, five of the positive performers were launched in 1995 and 1996 – well before the onset of the bear market.

David Thorp, investment manager of the Baronsmead VCT, argues that while they are perceived as being higher risk than funds investing in the FTSE, a number of VCTs have done well. The Baronsmead VCT, for example, has returned 3.22 per cent since November 1995. "Disregarding the capital gains, it has paid out an average 8 per cent a year in dividends," says Mr Thorp. "Income is an important attraction for investors. The capital gains are boosted when the tax advantages of VCTs are taken into account."

Mr Thorp says he focuses on investing in companies in niche markets where their "profit margins will not be trampled on by the big boys". He adds: "We invested in a company four years ago that distributes central heating systems. We sold it recently for four times the amount we had paid."

The key to reducing risk, says Richard Harris, chief executive of Enterprise Private Capital, is investing across a number of companies and sectors. "Diversification helps balance the winners with the failures," he says.

Another way of trying to cut risk is through the use of loan stocks, suggests Hugh Rogers, VCT analyst at Bestinvest, the independent financial adviser. He says the Close Brothers VCT, which has returned 7.13 per cent since April 1996, invests only in companies that own freehold property. "This ensures it receives some money at least from its investments."

There are other investment opportunities among VCTs, depending on your attitude to risk. "It can take VCTs three years to be 70 per cent invested as they cannot put more than £1m in a single company in one year," says Mr Rogers. "This means they drip-feed money into companies. If you believe that stock markets will rise over the next three years, some VCTs should be good investments."

As well as Close Brothers, Mr Rogers likes Northern Venture Trust, Baronsmead VCT and Quester VCT – "which is slightly higher risk".