Why the VCTs love the credit crunch

Small firms are turning to venture capitalist trusts, says Rob Griffin. Should you?

Volatile stock markets and the damaging effects of the credit crunch may be worrying investors around the world, but the economic conditions are good news for one particular group of people: venture capitalist trust (VCT) managers.

As the tightening of lending criteria makes it more difficult for businesses to attract funding, VCTs have been provided with a golden opportunity to take advantage, says Ben Yearsley, an investment manager at Hargreaves Lansdown. "The banks have shut up shop so small businesses looking to expand or acquire now have to approach VCT managers," he says. "In the absence of other sources of funding, VCTs have all the bargaining chips and can drive better deals."

Considering that the global economic outlook remains uncertain, the future appears very bright for VCTs, which were introduced by the Government in 1995 as a way to encourage investment in smaller, unquoted companies by providing generous tax breaks.

VCTs are listed on the London Stock Exchange and have to be approved by HM Revenue & Customs, which lays down strict limits governing the amounts being invested and the assets that can be purchased.

Although the regulations have changed over the past 13 years, VCT investors still benefit from a 30 per cent income-tax rebate on new issues, which must be held for five years. If sold before this date, then the rebate is lost. In addition, there is no capital gains tax liability – even if the VCT shares are subsequently sold for a handsome profit.

There are downsides, however. The charges levied for these products are higher than most other types of investment. Initial charges, for example, are typically 5 per cent, with ongoing costs weighing in between 2.5 and 3.5 per cent.

They also tend to be higher risk – by virtue of the fact that they invest in small, younger companies in fast-growing sectors – and the lack of a vibrant secondary market for these shares can make them harder to sell.

As well as investing in companies not quoted on a stock market, VCTs can invest in those on the Alternative Investment Market, which caters for growing firms. Since its launch in 1995, AIM has seen more than 2,500 companies join, and £34bn raised.

Rival VCTs have differed enormously in their performances, according to statistics compiled by Martin Churchill of the Tax Efficient Review website (taxefficientreview.com). "The star performers are turning in high single-digit, low double-digit annual rates of return, 8-11 per cent," he says. "Unfortunately, there are some that have suffered, usually from falls in the AIM market, which are heavily underwater."

For example, one of the best performing VCTs of the past decade is the Baronsmead fund, which has delivered an annual return of more than 6 per cent. One of its big hits was investing in the Fat Face clothing chain. The Foresight 3 VCT (previously known as Advent), however, has lost an average of 7.58 per cent a year since lanch.

"VCTs have generally performed very well for people," says Churchill. "If you're making 8 per cent per annum without the tax break, you are probably looking at doubling that rate of return when you bring it into the equation."

There have also been mitigating circumstances that could help explain why some VCTs have plunged into negative territory. "The poor performers have been those involved in technology stocks purchased in the run-up to the crash of 2000/01," he says. "People that came into this late and went into technology have been very badly mauled."

However, choosing the right VCT can be fraught with difficulties, as the performance figures illustrate. So how can you improve your chances of picking a manager capable of delivering consistently high returns?

"You are looking for a decent fund-management team that you can trust with your money," says Yearsley at Hargreaves Lansdown. "They will need to be well resourced, with the experience and contacts to make profitable investments."

So are VCTs a worthwhile investment, or should people steer clear? Andy Gadd, head of research at Lighthouse Group, is an advocate of VCTs, but warns that they won't be right for everyone – only for those willing to accept a fair degree of risk and to invest over the long term.

"It is sensible for investors, as part of a balanced investment portfolio, to consider putting money into small-cap stocks," he says. "This is provided that it represents no more than 10 per cent of their equity holdings and that they are willing and able to lock this money away for a minimum of five years."

As the usual minimum amount needed to invest is £5,000, this would mean you would need a fairly substantial equity portfolio of between £50,000 and £70,000 before considering putting your money into a VCT. But people attracted to the sector will find the management teams at the helm of the current crop of VCTs far more amenable to their needs than previously, says Yearsley.

"There is much more awareness of shareholders than was the case seven or eight years ago. VCT boards are paying much more attention to issues such as linking performance fees and paying regular dividends, which is good news."

There was further good news for VCTs in this week's Budget: from the beginning of October this year, they will be exempt from VAT on management fees. Daniel Godfrey, director general of the Association of Investment Companies, was delighted by the news. "This is a very welcome boost to the industry and to VCT investors, who will benefit from this cost saving over the long term," he said.

Most VCT managers are upbeat about the prospects for 2008, and are not fazed by the prospect of a further market slowdown over the coming months. Mark Wignall, the chief executive of Matrix Private Equity, insists it is a great time to be involved in the industry. "The slowdown in economic growth and highly volatile markets will feed through to ideal conditions for buying into companies at much lower prices later this year," he says. "VCTs are well-placed to meet strong demand at much more attractive prices."

However, warns Andy Gadd at Lighthouse Group, investors still need to approach the field with their eyes wide open – and to be careful not to allow themselves to be seduced by the superficial benefits of investing in VCTs.

"Investors need to understand the risks associated with VCTs," he says. "The attractive tax breaks are in place to create demand for investments that otherwise might be considered too high-risk for many investors."

Four of this year's best new funds

We asked Ben Yearsley, head of VCT research at Hargreaves Lansdown, to recommend some trusts that might be worth a look.

Edge Performance

It invests in live events, which is a fast-growing sector and has proven to be extremely cash generative. It is also completely unrelated to stock markets and equities, so is a great diversifier. In addition, Harvey Goldsmith is involved in the VCT. He was behind Live Aid and Live 8, so the team is very well connected.

Noble Aim

This is managed by Paul Jourdan, who is a top-quality AIM fund manager. It is a bit riskier, as it invests in small companies, but is an exciting option.

Matrix Income & Growth

This is a traditional venture capital trust, investing in opportunities such as management buyouts and profitable small companies, with a very well resourced and dedicated management team at the helm.

Northern 2

This is very similar to Income & Growth in as much as it is very well resourced with a good management team, and invests in a lot of management buyouts. It began in 1999 and has net assets of £43m.