Trusts hope investors are ready to be thrilled

Simon Hildrey reports on the revival of venture capital funds

Although many people will view Chancellor Gordon Brown as an unlikely saviour for investors, he might just have rescued venture capital trusts (VCTs) from terminal decline.

Because, on 5 April this year, just as VCTs had become the forgotten asset class of investments, the Government changed the tax benefits.

Under the new rules, if you invest in a VCT before 5 April 2006, you will receive a rebate of up to 40 per cent. For example, put in £10,000 and you get £4,000 back from the taxman. You don't have to be a higher-rate taxpayer to reclaim this 40 per cent.

However, the sum is restricted to the amount of income tax you pay: if you invest £200,000 each tax year but have paid only £5,000 to the Inland Revenue, you will receive only a £5,000 rebate.

All gains and dividends in the trusts are tax-free but you must hold your investment for at least three years to enjoy these benefits.

VCT managers hope the tax changes will herald a return of the good old days and encourage a significant increase in investment. More than 15 launches of new VCTs have already been announced on the back of this expectation. The managers are hoping that at least £250m will be raised, and possibly as much as £500m.

The peak demand for VCTs came in the 2000-01 tax year, when £440m was invested in them. In 2001-02 this fell sharply to £140m, following the decline in the stock market, and then there was a still steeper drop to £50m in 2002-03. There was a slight recovery to £59m in 2003-04 but that is still just 13 per cent of the amount attracted three years ago.

VCTs are marketed for their tax benefits but shouldn't be chosen solely for this reason. They are closed-ended vehicles listed on the London Stock Exchange and invest in start-up ventures, unquoted companies and shares listed on the Alternative Investment Market (AIM), with capitalisations of less than £15m. This makes them higher-risk investments than blue-chip FTSE 100 stocks, and there is less liquidity.

When investing in a VCT, you need to select from one of three categories: generalist, AIM or specialist. All can offer attractive long-term returns, but performance varies widely. For example, the online publication Tax Efficient Review says that of the generalist and specialist VCTs launched during 1997-98 and 1998-99, Foresight Technology has delivered a return of 18.47 per cent. The next best performer is Enterprise, with 4.98 per cent, while Advent 2 has dipped 8.74 per cent over the same period and British Smaller Technology Companies has fallen by 16.12 per cent.

Both the performance and charges of VCTs have been criticised but John Spiers, managing director of independent financial adviser (IFA) Bestinvest, believes the average returns compare well with equities.

"Of the £1.6bn put in VCTs since 1995, investors have lost an average of 5 per cent of their money," he says. "The average investor across equity funds has lost 16 per cent."

These returns for VCTs are after charges, which can be as high as 5 per cent initially, with the total expense ratio typically 3.5 per cent a year.

Liquidity is expected to improve. It is now common for new VCTs to include a buyback policy that typically allows investors to sell their shares at a 10 per cent discount to the net asset value (NAV).

Bernard Fairman, managing partner of VCF Partners, which manages the Foresight VCTs, says legislation is being drafted which will allow trusts to be merged. This should create greater economies of scale and greater liquidity. Mr Fairman expects more corporate activity along the lines of the acquisition in July by Foresight of Advent's two VCTs.

But David Knight, director of tax-shelter research at the London-based IFA Allenbridge, says one problem that could arise with share buybacks is if all investors in a VCT decided to sell their shares after three years, because there would not be sufficient liquidity to allow them to do this.

He says it is difficult to compare the performance of VCTs with that of equity funds because of their different nature. "VCTs have three years to invest the money they raise and can keep 30 per cent in cash," he says. "Around 50 per cent of money in VCTs is invested in unquoted companies. These are difficult to value."

The other problem is that it can take years before VCTs start seeing a return from the firms they invest in. Furthermore, a trade sale or stock market listing of the underlying companies is unlikely for at least five or six years. This is why advisers recommend investors stay in the trusts for several years at least.