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Considering the merits of VCTs

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27 February 2015

David Prosser explores venture capital trusts.

As the countdown to ‘pension freedom day’ continues, financial advisers must ponder some difficult questions. What should they advise clients about the pros and cons of annuity purchase? What kind of investments might be suitable for people still managing their money after retirement? What do the reforms mean for the relative merits of private pensions and individual savings accounts (Isas)? There is, however, a danger that the focus on pensions will mean other extremely tax-efficient savings vehicles are ignored this year – and that would be a missed opportunity for many clients.

In particular, venture capital trusts continue to offer investors exposure to exciting growth companies while featuring some of the most generous tax reliefs available from savings vehicles. These funds are not without risk, but with more than 20 existing and new VCTs raising money in the final few weeks of the year, they should not be ignored.

The basic premise of a VCT is simple. Introduced more than 20 years ago to encourage investors to back small businesses, there are strict rules about how they must use money raised. At least 70 per cent of the portfolio must be invested in qualifying companies – broadly companies that are worth no more than £15m.

In return for supporting these businesses, investors get upfront tax relief of 30 per cent and tax-free dividends, plus there is no capital gains tax to pay on any profits earned. Investors have to hold on to their VCT shares for five years and only new shares get the tax breaks, but these are nonetheless generous incentives.

All the more so given the nature of the underlying investment, for while VCTs are more risky than other types of collective fund, they may not be quite the brave punt that many advisers and investors assume. For one thing, the funds hold portfolios of businesses, so get diversification benefits, and in any case, 30 per cent of their assets can be held in less-risky investments. Not all the businesses in VCTs’ portfolios are unquoted and unknown – many Alternative Investment Market-listed shares qualify. Plus the upfront tax relief gives you a sizeable buffer – you’ll still be in the black on a fund that loses 25 per cent of its value, say.

“I think you should get in context what VCTs are,” Ben Yearsley, head of investment research at Charles Stanley, told Morningstar in an interview this week. “Lots of people think they are investing in these really, really micro companies but that’s actually quite rare. That might have been the intention in the first place back when they were set up in 1995. But actually most of these businesses might have 50 employees or 100 employees. Most tend to be profitable and so the risk is probably different to what you actually perceive it to be.”

Does that mean VCTs are suitable for all investors? Not at all. Clearly, the risk profile of these funds is higher than on other investment companies – the small businesses in which they are invested are more likely to struggle, or even to go bust, than larger, more established companies. Equally, the five-year investment requirement may put some people off. However, for those investors looking for new tax efficient opportunities in addition to Isas and pensions, VCTs may be very attractive – and much less niche than many advisers assume.

To end where we began, it’s worth noting that the abolition of compulsory annuity purchase is not the only pension reform with which savers are currently grappling. We have also seen a sharp reduction in the contribution limits to private pensions over the past year, with the lifetime allowance cut from £1.5m to £1.25m and the annual allowance reduced from £50,000 to £40,000. For long-term savers butting up against these new lower limits, VCTs may be an interesting option.

What the analysts say this week

Ewan Lovett-Turner, Numis Securities

“Shareholders have approved a change of investment policy to adopt a multi-asset mandate as part of a move of management from F&C to BlackRock. The name of the fund has also been changed to BlackRock Income Strategies and it now trades under the ticker ‘BIST’.

“It comes as no surprise that the proposals were approved as there was little in the way of defence from F&C. In addition, the board had indicated it would move management to BlackRock regardless of the outcome of the vote. We believe the new mandate is interesting, and that there is a role for a low cost, income oriented multi-asset closed-end fund, with a progressive dividend policy and a focus on capital preservation.”

Iain Scouller, Oriel Securities

“Sherborne has renewed proposals to appoint directors to the Electra board and announced a £100m plus equity issue. The Electra/Sherborne situation continues to move deeper into unchartered territory for the listed private equity sector. The Sherborne Investors B Fund is proposing to raise at least £100m in new equity to pay down leverage that has been used to purchase shares in Electra in recent months. We calculate that at current prices this could be used to purchase a further 3.3 million shares or 9.3 per cent of shares in issue, before paying down any debt. Sherborne has also announced that recent purchases of shares in the market have taken its holding to 25.2 per cent.

“It appears that Sherborne’s game plan is to continue purchasing further Electra shares in the market following the raising of cash in the equity issue. If Sherborne owns in excess of 29.9 per cent of shares in issue this is likely to trigger a mandatory bid for the company at the highest price paid for the shares in the last 12 months – which is likely to be around 3100p, which is close to the current share price.

“In such a scenario we would be surprised if at least the 20 per cent of other shareholders that Sherborne would need to win over would accept a bid at the level – we think many shareholders are likely to demand a significant premium above the current price before ceding control of the company to Sherborne. A key question is that if Sherborne were to trigger a mandatory bid, how would this be financed, given Sherborne’s relatively small size in comparison to Electra? Clearly this situation has a lot further to run and we advise shareholders to continue to hold.”