Venturing out for a trusty return on your cash

If you like risk and diversification, venture capital trusts fit the bill

Venture capital trusts are back in the business of raising money, despite the Government's decision to trim their generous tax breaks in last year's Budget.

VCTs are collective investment funds that back small, often start-up, companies and therefore tend to be high-risk investments. First launched 12 years ago, they have always offered a range of tax breaks to encourage private investors.

Originally, investors were given a 40 per cent income tax relief on their investment, and could use the funds to defer paying tax on capital gains earned on other investments.

Today, the CGT relief is no more and investors enjoy an income tax rebate of only 30 per cent. Even so, for investors with an appetite for risk and a diversified portfolio, VCTs can be lucrative - small businesses sometimes turn into spectacular growth stories.

The 30 per cent rebate means that individuals are in effect paying only 70p for every £1 they invest, giving considerable downside protection should the fund fail to perform. And if their investment grows, or the fund pays out dividends, these are also all tax-free.

There are four main types of VCT. Generalist funds tend to invest across a wide range of unquoted companies, regardless of sector. Like all VCTs, however, they can only invest in companies with net assets of less than £8m at the time the investment is made.

The second, most common, breed of VCT is AIM funds, which invest solely in companies quoted on that market.

Then there are specialist VCTs, which invest in unquoted companies from specific sectors. Of the funds open this year, for example, Ibis has a VCT investing solely in media companies, while Sitka offers a fund focused on healthcare.

The final variety of VCTs - a relatively new kind - are the limited-life VCTs, which aim to provide investors with a degree of capital protection and to return their cash at the earliest possible opportunity. A condition of the VCT tax relief is that investors must hold on to their investment for a minimum of five years, and limited-life funds tend to work towards this deadline.

Investors are limited to putting £200,000 each tax year into VCTs, so most money goes into the funds in either March or April, at the end of the tax year or at the start of the new one. This year, however, has so far proved one of the slowest on record, owing to the reduction in the tax breaks.

Martin Churchill, a VCT analyst who runs the www.taxefficientreview.com website, says only about £90m of the £460m capacity put on sale has been filled so far this year.

Alastair Conn, the managing director of NVM Private Equity, which manages the Northern range of VCTs, says his company decided against launching a new fund this year. "Our research indicated that as a result of the 2006 Budget changes, investor demand would be well down from the peak reached last year," Conn says. "We think the market is unlikely to exceed £200m this time."

Churchill worries that the tax breaks could be pared back further in future, pointing out that about half this year's new VCTs are so-called limited life funds, whose main aim is simply to preserve investors' tax relief. Most do this by loaning a large proportion of money to companies for a fixed period rather than directly investing in them. "I question - if these funds are successful - whether the Treasury will retain its very supportive attitude towards these products," Churchill says. "The idea behind these funds is not really what the Chancellor had in mind for VCTs."

The Government has committed to keep the current tax breaks in place until the next election, it is possible that regulations will be tightened to ensure that VCTs continue to invest across the entire universe of smaller companies.

If you're interested in investing in a VCT this year, there are about 20 funds to choose from. Churchill says investors should pay close attention to managers' track records and how long team have worked together, as well as fees and charges. VCTs will typically levy an initial charge of about 5 or 6 per cent, taking a further 3.5 per cent or so each year, as well as additional fees if the fund performs well.

Funds to back

* Fund management groups such as F&C, which runs the Baronsworth range of VCTs, have a strong and proven track record at picking good unquoted companies. Similarly, Close Brothers has a very good track record on the AIM sector.

* Although past performance provides no guarantee of future returns, finding a strong management team is particularly crucial when it comes to VCTs. Over the 12 years since they were launched, less than half have managed to deliver investors a positive total return. The very worst performers have lost shareholders more than 60 per cent of their money.

* Ben Yearsley, an investment manager at Hargreaves Lansdown, the independent financial adviser, recommends Electra Kingsway, a generalist fund, and Foresight 2, a specialist technology VCT, as two of the best funds this year.

* Foresight's first fund remains the best-ever performing VCT, while Electra has built a solid reputation as a small company investor over the past few years - making money for investors in both its funds.

* Unless you're an experienced investor, seek financial advice before you commit to buying a VCT. To find an adviser in your area, visit www.unbiased.co.uk or call 0800 085 3250. For more information on VCTs in general, visit www.taxefficientreview.com.