Vcts step into the spotlight

The sector’s turnaround is remarkable. After reaching a peak in 2000/01, when VCTs collectively took more than £450m, the entire sector then struggled to raise even £50m in the 2003/04 tax year as the combination of a savage bear market and an increasingly redundant set of tax breaks took their toll.

When VCTs were first launched nine years ago, one of their main attractions was that they provided a tax shelter for up to £100,000 worth of capital gains each year. With capital gains tax threatening to eat up 40% of any windfall, VCTs were a good way for investors to manage a large tax liability, or at best, see their investment grow by enough to pay off the tax bill. Furthermore, the trusts offered a 20% income tax relief.

But as the bull market came to an end, and fewer people were left with stockmarket gains to shelter, VCTs lost their main source of investors.

As a result, the industry went running back to the Treasury, asking for a change in the tax breaks to provide a much-needed jump-start. After much debate, the Government finally relented, agreeing to ditch the capital gains tax sheltering facility in favour of an extended income tax break of 40%.

The industry’s request for new tax incentives to re-stimulate demand was cloaked in irony. Just four years ago, as VCTs fought off investors at the market’s peak, providers had expressed their frustration that too many people were being drawn in by the tax breaks, and not enough were taking account of the potential investment story. Providers hoped to turn VCTs into an investment in their own right – not just a tax break with an investment tagged on, as many investors had perceived them.

Three years later, and having felt just how quickly sentiment can turn against a market, the sector’s architects were singing an entirely different tune: help us, or VCTs are on their way out.

Undoubtedly the industry’s original plan – to stimulate demand by promoting the investment story – was a victim of bad timing. As the bear market got into full swing in 2001 and 2002, it became increasingly difficult to persuade investors to continue putting their money into equities at all, let alone the higher-risk private equity market.

However, the VCT industry had not done itself any favours. The performance of most trusts was dire by the start of 2001 – even after several years of plenty in equity markets and the small business world as a whole.

When the first VCTs were launched in 1995/96, their managers advised investors to have a time horizon of at least five years. But before long it became apparent that this would be too conservative for most trusts. By 2000, managers were advising investors to take a five to seven-year view. And by 2002, it became seven to 10 years.

This last approximation is probably the fairest – especially in the case of new issues. New VCTs have up to three years from launch to invest their funds – and in many cases it takes trusts as long as this to find a portfolio of suitable investments. This means that most investors’ money has barely even started working for them before year four.

By the very nature of VCTs, there will always be exceptions, however. Foresight, for example -which remains by far the best-performing trust, largely down to the performance of one internet company in its portfolio, E-district – had doubled its investors’ money after just two years. But even Foresight would probably admit that the story of its investment in E-district was a lucky one. Just months after the trust sold its holding, at the top of the market, the company was embroiled in a scandal that saw the Serious Fraud Office brought in. The value of the shares was decimated.

At the opposite end of the scale, there are funds such as Foresight 3 (formerly known as Advent), which has lost investors two-thirds of their money over nine years. Not many funds in any asset class can boast those sort of numbers.

But while the investment story of VCTs has been patchy, a handful of investment houses have provided a degree of consistency and skilful management. In fairness, it was many of these houses that were calling for investors to focus on performance and not on the tax breaks. However, the VCT market has suffered from being swamped by many trusts that simply did not have the management expertise to deliver in the notoriously tricky start-up and smaller companies arena. It is these trusts that have given the sector a bad name in terms of performance, many of them having wiped out a substantial proportion of their investors’ money. The most successful houses, such as Isis (which runs the Baronsmead trusts) and Close Brothers, have so far provided positive total returns for all their investors, and in some cases, quite healthy returns. Nevertheless, it is only when the tax breaks are taken into account that the performance in even these funds begins to look remotely impressive.

So should you be putting your clients into VCTs at all this autumn? Certainly not if the only reason is because of the tax breaks.

The smaller end of the private equity market is entirely different from other markets, and tends to bear little correlation to the performance of the FTSE 100. For this reason, it is a useful diversification tool in a portfolio, but only portfolios of sufficient size. Even with a 40% tax kickback, VCTs have the capacity to lose investors 60% of their money – in a relatively short space of time.

Ben Yearsley, an investment manager at Hargreaves Lansdown, says VCTs should make up no more than 5-10% of any portfolio, and that ideally a client should have about £100,000 of investments before VCTs are looked at as a serious option. He adds that holding a handful of trusts rather than just one is also a sensible strategy. “If you’re looking at VCTs that invest in the Alternative Investment Market, it’s not so important to diversify, because you get a lot of companies that are held within all of them,” he says. “But if you’re looking at unquoteds, it’s definitely worth diversifying. If you had £200,000 to invest in VCTs this year, I would recommend holding four or five different trusts, of which one might be an Aim VCT. That would give you a nice spread.”

For the fund strategist who is investing in VCTs this year, the biggest challenge will be working out which trusts to use. With about 25 already launched or about to launch, and many more expected to follow, there is set to be more supply than ever before.

There are three main stages at which you can invest in VCTs – at launch, during a top-up, or in the secondary market. The opportunities for buying VCTs in the secondary market are relatively limited. Furthermore, investors will not be granted the tax breaks, and owing to the small supply, liquidity is poor and spreads are wide.

This is an area the industry desperately needs to address – not least because the illiquidity of the secondary market could soon become a serious turn-off for potential investors. Not only is it difficult to get into VCTs through the secondary market, but more importantly, it is difficult to get out of your VCTs through it too -at least at a fair price.

New legislation coming in that will allow VCTs to merge, promises to help liquidity at least to a certain extent. Most trusts also offer share buyback schemes, but if the industry is to be sustainable in the long term, it will need to make the secondary market work efficiently.

For most investors, however, the point of entry into VCTs is through a new launch or top-up.

As a result of the time it takes to get an unquoted VCT portfolio up and running, investors looking at new launches need to have a healthy time horizon for their investment. All VCT investors need to hold on to their investment for at least three years to qualify for the tax relief, but for those getting in at a new launch, it is sensible to count on being invested for at least 10 years.

The exception is perhaps with Aim VCTs, which invest in companies that are quoted on the Alternative Investment Market. VCTs that invest in Aim will be able to allocate investors’ funds immediately, and can invest in much more developed companies.

However, the two other types of VCT – generalist and specialist – invest in unquoted start-up and early-stage companies, which take time to find, and time to invest in.

For this reason, top-ups tend to be a much more attractive – and slightly less risky – way of getting involved with generalist and specialist trusts. In the case of top-ups, investors are getting involved with an existing portfolio, which has a proven track record. And in many cases, the money that investors put down will be used as the next round of investment in the trust’s existing holdings.

The other safety factor provided by top-ups is that the amount of money raised during the offer period is usually not so relevant. In the case of a new trust, a failure to raise sufficient funds will either mean that the launch has to be pulled, or that your investment will be part of a very small portfolio. A fund that raises only £2m, for example, will not be able to make a meaningful investment in many companies, and could leave you part of a much more risky operation.

In the case of top-ups, the portfolio is already established. However, it is worth checking to see how much money is in the original fund. If it is only a small amount, it may be worth avoiding the top-up unless you know that the offer has already been successful.

One final option is getting involved through a C-share issue, which is the halfway house between a new issue and a top-up. C-share issues are effectively separate portfolios run in parallel with an existing trust, enabling it to save on costs. These tend to come with the proviso that they will be merged into the main trust at some stage down the line.

Picking the right VCT should be much easier this year than it has been in previous years. With the sector now nine years old, it has become clear who has the ability to manage successfully in this complex market and who does not.

However, Martin Churchill, editor of www.taxefficientreview.com – a specialist website that publishes VCT performance data as well as details of new issues – says there is no real rush.

“I’ve been saying to fund strategists recently that if you’ve got clients who want to invest in VCTs, why put them in now?” he says. “Why would you want to put them in before January, February or March – when you will have the whole market to choose from?” Churchill expects there will be as many as 40 VCTs launched by the end of the tax year, most of which are yet to open their doors to business. He points out that the timing of launches used to be more significant in the days when investors had capital gains to shelter in VCTs, as they only had one year from the realisation of the gain to invest it. However, with the capital gains shelter gone, the timing is less relevant.

With so much supply, the biggest worry for VCT investors in 2004/05 is going to be whether there are enough quality companies to invest in. The Aim and private equity markets have had a good run over the past year, with plenty of Aim floats getting away very successfully in 2004. But will there be enough good investment opportunities to sate the rather large demand that the VCT market will bring this year?

Bill Nixon, the lead manager of Aberdeen’s VCT range, says he believes that the flurry of new Aim VCTs may struggle, as they are limited to a relatively small universe of stocks. However, he says the generalist and specialist funds like his own, which invest in unquoted companies, have a huge number of opportunities.

“Although the VCT market might grow by 10 times from what it was last year, what you’ve got to look at is the size of the private equity market as a whole,” he says. “VCTs would still only account for a very small part of the overall market.”

Nixon says he has seven offices around the country that work on finding the right deals for his funds – something which he believes gives him a distinct advantage over the many VCTs that work out of one office.

While the generalist managers may not struggle to find places to invest their money this year, some of them are certain to struggle to get enough money through the door. With so much capacity, many VCTs are going to be left disappointed, perhaps even failing to raise the minimum amount of money required.

Churchill says that there will be supply of about £800m this year – of which he predicts as much as half will go unfilled.

Whatever happens over the next six months, it seems certain that Venture Capital Trusts are in for one of their best seasons so far. The challenge for the industry now is once again working out how to maintain the momentum. Gordon Brown has offered the new 40% income tax kickback for just two years, leaving the industry once again to try to market VCTs as an the essential diversification tool for every investor’s portfolio, rather than just a great tax break.

In the eyes of the investor, there will surely be nothing that makes that point better than some great VCT performance during what looks set to be a rather flat time in the world’s quoted equity markets.

Venture Capital Trusts are back in the shop window for two more years. If they miss this chance to secure their future, they are unlikely to get another chance.

What’s on offer?
Picking a VCT right now is a bit like navigating through a minefield. Few of the established funds have come back to the market for a top-up this year, forcing most investors who are looking to buy into the market, to take their chances with one of the many new launches (see table on page 23).

Among these, however, are some solid names that stand out. The C-share offer of Baronsmead’s second VCT is a chance to put money with one of the best-established teams, with the prospect of becoming part of a bigger fund later down the line. Of the brand new funds, Close Brothers Income & Growth is an exciting prospect. Close’s other VCTs are all among the top performers in their sector.

New entrants to the market this year are two of the big-name fund managers – Invesco and Framlington. While these have both proved their worth in the smaller companies arena, Aim can prove to be fundamentally different. Historically, the larger fund management houses have not fared too well in the VCT market. Will Invesco and Framlington be able to shake the trend?

Excuse for poor performance?
The poor performance of VCTs has disillusioned many shareholders. Unfortunately, however, the rather lax corporate governance procedures that surround most of the trusts do not leave investors many options. For those who are unhappy with their trust’s performance, the choice tends to be either to vote against the management by selling their holding – more than likely at a significant discount because of the illiquid markets – or hanging in there and hoping for things to get better.

Enter the UK Shareholder Association, which over the past few months has taken it upon itself to put pressure on trusts to up their game. Starting with the likes of Quester 3, which has provided a negative total return of 45% since its launch four years ago, the UKSA has begun pressurising the boards of the worst-performing VCTs to sack their managers and to put better corporate governance procedures in place.

Given the high fees that managers of VCTs command, it is only right that they are answerable to their investors. Most trusts, for example, take a 20% performance fee for all returns over 5-8%.

These are modest targets for high-octane private equity funds – and if such high payments are to be made, it is only fair that at the other end of the scale, when managers are massively underperforming, shareholders have the right to have them ejected.

Many managers to date, however, have got away with consistently bad performance without being questioned. Admittedly, they have not met their performance fee targets, but their base salaries are fairly hefty as well in most cases.

The Murray Johnstone range of VCTs, for example, owned by Aberdeen Asset Management since 2000, is one of the worst-performing sets of funds on the market.

But the wave of change may have begun here too. After nine years in charge, the lead manager of the Murray funds, John Simpson, stepped down last month – perhaps in a bid to pre-empt the arrival of the UKSA, which had already stated that the Murray range was next on its list.

Downing, a VCT promoter, also sacked Classic Fund Management as the manager of its funds earlier this year.

While getting hold of up-to-date performance figures for VCTs remains a challenge, there are a few websites that do their best to provide as accurate information as possible: www.taxefficientreview.com, www.taxshelterreport.co.uk.