Why should you consider VCTs for your clients?

David Prosser explains venture capital trusts.

At this time of year, the minds of investors and their financial advisers automatically turn towards tax matters. First, there’s the end-January deadline for filing self-assessment tax returns and paying any tax still due from last year. Then there’s the run-in to the end of the current tax year on 5 April – this is traditionally a period when fund managers and other financial services companies do their utmost to persuade people to use their annual tax-free investment allowances before it’s too late.

Most of the attention is focused on individual savings accounts, but while ISAs are a mass-market product, it’s important to remember that they’re not the only option. In particular, at least consider venture capital trusts, a specialist sector of the closed-ended fund industry that attracts its own range of generous tax breaks.

First launched in 1995, VCTs aim to encourage investors to put their money into small businesses – typically unquoted companies, though some funds invest in businesses listed on the Alternative Investment Market (AIM).

There are strict rules on exactly what a VCT can invest in – certain sectors of the economy are excluded and companies can’t be worth more than £15m or have more than 250 employees. Also, the VCT can’t put any more than £5m into any one company. “Both the nature of VCTs, by investing in small and often less mature UK companies, and their structure mean they have higher risk characteristics than more traditional investments,” explains Mick Gilligan, head of fund research at stockbroker Killik & Co.

However, investors are entitled to a number of tax breaks as a reward for taking on this risk, though they must hold on to their shares for five years to retain all the advantages. These include 30 per cent income tax relief for purchases of new VCT shares (you don’t get this perk if you buy shares on the secondary market), dividends that are tax-free where the fund is able to pay them, and the right to sell the shares with no capital gains tax to pay.

The income tax relief alone means that an investor who puts £10,000 into a VCT is effectively doing so at a cost of just £7,000, which leaves scope for losses without pushing the investment into the red.

Moreover, VCTs are far more generous than ISAs on contributions. While annual ISA investments are limited to £15,000, you can invest up to £200,000 in VCTs each tax year and still benefit from the tax relief. The only caveat is that an investor can’t claim a tax rebate worth more than the income tax they are due to pay.

Venture capital trusts won’t suit everyone, but they do offer exposure to small companies with the potential – at least theoretically – of growing fast and becoming the big businesses of tomorrow. Many VCT investments will fail, but a few spectacular wins may be enough to deliver strong performance – and the collective fund approach gives investors some protection, by providing a diversified portfolio.

Don’t get too hung up on the tax breaks, warns Gilligan. “The tax incentives can be significant for investors, but they should not be the primary reason for investment,” he argues. But for advisers who believe in the potential of growing businesses – and whose clients have already used up their Isa allowances with less high-risk investments – professionally-managed VCTs may offer some interesting opportunities.

What the analysts say this week

Matthew Dodds, Numis Securities

“Schroder AsiaPacific aims to take advantage of the domestic growth story in Asia through a bottom-up, stock-picking approach. It benefits from an experienced manager, Matthew Dobbs, and has an impressive long term track record, with net asset value returns of 265 per cent (13.8 per cent a year) over the past decade compared with 227 per cent (12.6 per cent a year) from the MSCI AC Asia ex Japan. The fund has consistently achieved top quartile performance versus both open and closed ended funds, and is our core recommendation in the Asia Pacific ex Japan sector.

“A lower oil price is a net benefit to Asia, and price to earnings valuations of 12 times are attractive compared to their long term average of 15.3 times. However, Dobbs remains highly selective, particularly in China and Korea where seemingly attractive multiples can reflect poor corporate governance standards. We believe the manager’s experience and impressive record of stock selection suggest that the fund remains well placed to benefit from domestic growth opportunities in the region.”

Anthony Stern, Oriel Securities

“Over the year to 30 September 2014, Polar Capital Global Healthcare delivered a solid set of results with a net asset value total return of 20 per cent as large cap pharmaceuticals moved back to trade at their long-term average valuations. Management now believe the catalysts exist to push these companies onto a premium to their long-term multiple levels. Since the end of September the net asset value has continued to advance, increasing by a further 12 per cent.

“After a number of years of low volatility, markets are starting to become more unpredictable. The biotech sector has been surging over the last four years and some investors may want to consider locking in some profits. For those looking to keep some exposure to the healthcare sector, Polar Capital Global Healthcare is an attractive option. The fund has no leverage, only a small amount of exposure to the surging biotech, and a low beta portfolio. The fund’s original thesis of playing the re-rating of the large-cap pharma stocks has largely played out, allowing the fund to achieve its objectives of doubling investors’ money two years ahead of schedule. The shares are trading at a 9 per cent discount. As the original multiple expansion this has largely played out and the fund’s wind up date remains three years off, we maintain our neutral rating.”