Mark Dampier: You take a chance but VCTs have sorted the wheat from the chaff

Fields of dreams: venture capital trusts help young companies to grow, potentially delivering big returns for investors

Fields of dreams: venture capital trusts help young companies to grow, potentially delivering big returns for investors (AFP/Getty)

At the niche end of the investment spectrum, venture capital trusts (VCTs) don’t tend to receive wide media coverage.

Introduced in 1995, they trade on the London Stock Exchange alongside other publicly listed companies. Each issue of new shares has a limited capacity and is generally aimed at sophisticated investors who have fully utilised their Isa and pension allowances.

I admit they rather passed me by at first – perhaps because their predecessor, the Business Expansion Scheme, turned out to be fairly disastrous, even after the tax relief. It serves as a reminder to investors to ensure the tax tail isn’t permitted to wag the investment dog.

VCTs primarily invest in very small companies that are looking for further investment to help develop their business. The VCT managers use their experience to help the business grow, taking a hands-on approach, generally appointing a chairman to the investee company and taking a seat on the board.

A common misconception is that VCTs are primarily for capital growth. But VCTs are far more about dividends, which are completely tax free. Many VCTs offer yields in excess of 5 per cent, which, for a higher-rate taxpayer, is equivalent to a taxable yield of more than 8 per cent.

Alongside taking an equity stake, a VCT will often inject capital into a business by way of fixed-rate loans.

The equity stake provides exposure to the company’s growth potential, while the interest payments on the loan provide a more immediate income stream and can be used to pay tax-free dividends to VCT shareholders. An investment in a mature and established VCT portfolio can result in dividend payments within the first year.

In nearly two decades, the wheat seems to have been sorted from the chaff. A small selection of skilled VCT teams, with strong track records of developing and nurturing young companies, remains. These include British Smaller Companies, Pro-Ven, Maven, Mobeus and Albion.

The best VCT managers are adept at timing their exit from a company and getting the best value from trade buyers or private equity firms. Over the years, as successful investments are sold, the managers are able to supplement the flow of regular dividends with special dividend payments.

It can take a number of years for a company to reach a stage where the managers wish to sell, so special dividend payments often don’t occur in the early years of a VCT investment. It therefore makes sense, in my view, to invest in a number of VCTs over the years, to smooth any future income stream.

Investors in new VCTs and top-ups receive a tax rebate of up to 30 per cent of their initial investment, in essence restricting the amount of income tax they pay (this only applies if the relevant amount of tax has already been paid). As a simple example, an investment of £100,000 will in effect cost £70,000. A total of £200,000 can be invested each tax year, and there is no capital gains tax to pay on disposal.

Although an investment needs to be held for five years to retain the tax relief, I would suggest holding a VCT for 10 years or more.

Obviously investing in small, generally early-stage companies can be high risk. However, gaining exposure through a VCT provides diversification, with the added benefit of an expert managing the companies day to day. In my experience, the successes usually outweigh the failures over the long term.

On the downside, the costs involved with a VCT are often higher than for other investments. Many have performance fees in addition to high annual management charges. This is one area in which I would like to see reform, with reduced performance fees and a more transparent charging structure.

I invest in a range of VCTs to spread my risk, and I reinvest dividends into new VCT offers to boost my holding and eventual income. Investors fortunate enough to have already utilised their full Isa and pension allowance, or indeed who have applied for pension protection, could look to VCTs as a new string to their retirement bow.

Equally, investors who have previously dismissed VCTs as a growth investment might wish to take another look.