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What are the prospects for Aim after two bumper years for VCTs?

The first few months of this year saw stocks on the Alternative Investment Market overheat somewhat. Prices were boosted by two bumper years of fund-raising for venture capital trusts. The weight of this money has distorted the market and will continue to provide support for the next 12 months.

This inevitably has had an impact on unquoted opportunities but the sector continues to offer attractive returns for those prepared to do their due diligence.

Private company valuations did not rise in tandem with Aim prices so the value gap has widened considerably and deal flow has increased now the Aim door has closed.

The growing UK economy will continue to provide support to Aim and unquoted stocks but we are close to the peak of the economic cycle, which will probably occur some time in 2007. Some negative earnings’ growth will follow as higher taxes and interest rates start to choke off growth. Interest rates are bound to go up towards the end of the year as the inflation spectre returns. Higher rates can make life harder for smaller companies that have to service debts but equities have an in-built defence against inflation because their cashflows and assets tend to rise as well.

There will be negative factors emerging from the US economy, which is set for a slowdown as the Fed raises interest rates to cool inflation, but the effects will be mitigated by a resilient European economy, which will provide the UK with trading partners this side of the Atlantic.

Returns on Aim equities are bound to fall from 10 per cent last year, probably to around 8 per cent this year, but merger and acquisition activity will continue to give support. What is unusual for this stage in the economic cycle is that companies have healthy balance sheets and will continue to seek sales growth via takeovers.

Commodity markets remain high and will continue to spur the issue of the new resources stocks that Aim has been so successful in attracting. Primary issues will go quiet during the summer but we can expect a deluge of new issues in the commodities sector in the autumn and they will have good underlying fundamentals and prospects.

We can expect a recovery in companies upgrading their IT, which bodes well for the sector. Telecoms will also continue to attract interest. Investors are becoming more risk-averse and there will be less of the concept stocks seen in the TMT boom. Companies will have to demonstrate revenues and profits, so stable businesses with visible earnings will be coming to the market. Support services are also showing potential as they account for an ever bigger part of UK GDP.

On the downside, I am sure retailers will be weak. The strength of the housing market is a worry for the monetary policy committee but while house price growth will be positive this year, it will not match recent levels. Consumers have over-borrowed so we can expect high-street sales to continue to fall. Consumers are also looking to the internet as they become more concerned over prices in the high street.

Leisure and travel may encounter difficulties as people rein in spending. Even the more traditionally defensive food producers are being squeezed by high energy and commodity prices, which they find hard to pass on to customers, who are sensitive to price rises in this sector.

Rising interest rates will only make the situation worse, so we will be cautious towards this sector.

Expectations of adverse changes to the VCT tax regime spurred investors in get in quick at the end of the last tax year. Now that the Chancellor has reduced income tax relief from 40 to 30 per cent and reduced the gross assets test from 15m to 7m, inflows will be reduced, perhaps by as much as 60 per cent. Investors need to ensure that their manager is able to minimise the risk while investing in companies which pass the gross assets test.

Charlie McMicking is head of private equity at Noble Fund Managers

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