It is sometimes easy to lose sight of the point of investing, getting caught up in issues such as tax, risk and timing. This is especially true of venture capital trusts.
Many people focus either on tax breaks offered by VCTs or the excitement of investing in risky, high-growth, entrepreneurial companies. What often gets forgotten is that the purpose of investing in a VCT is to make a profit – and that profit is generally distributed over the longer term via tax-free dividends.
As VCTs have evolved over the last decade, the industry has consolidated. There are now fewer management groups but they are bigger and better resourced. Managers have become more conscious of the importance of delivering consistent dividends to attract investors. Having been a proponent of VCTs for years, I love the tax-free dividend cheques.
With interest rates close to zero, investors are searching for alternative sources of income. VCTs historically had erratic dividend payments primarily based on profitable sales of companies but greater emphasis is now being placed on deal structures that provide regular income for the VCT, which can then be distributed to shareholders.
The method is to provide the majority of the investment as a loan to the underlying business, with a smaller amount in shares.
As well as providing income, loans rank ahead of equity in the event that a business fails, making the deal less risky if the company has assets that can be sold.
There is £2.5bn invested in VCTs, ranging from high-risk, early-stage start-ups to limited-life VCTs that seek to control risk and are mainly for the tax breaks. In between sit traditional, generalist VCTs.
Last year, £123m in dividends were paid out by the VCT sector as a whole. From the present capital base, this equates to an average dividend yield of just under 5 per cent – tax-free.
In times of very low interest rates, this is an attractive yield and worth considering for sophisticated clients.
When choosing VCTs, it is a good sign of a successful manager if they have consistently paid a high level of income without depleting capital.
After last year’s solar VCT bandwagon, this year provides a return to normality. The majority of offers are either top-ups to existing VCTs or limited-life offers with established records.
I have always been sceptical of limited-life VCTs designed to offer the tax break with little investment into proper, growing businesses. It is clear that HM Revenue & Customs wants VCTs to focus on long-term, growth-orientated companies, so my suggestions are unashamedly all traditional, generalist VCTs – Maven Income & Growth, British Smaller Companies 2 and Edge Performance H Share.
I would strongly urge reading the prospectus to gain a full understanding of each offer but, as a brief summary, Maven looks to back profitable companies in a broad range of areas. It has particular expertise in the oil & gas sector, which is not normally found in VCTs.
British Smaller Companies 2 historically had a technology bias but in recent years has broadened its approach. It tends to invest in earlier-stage businesses than most VCTs and is higher-risk as a consequence but offers the potential for higher reward.
Finally, Edge Performance H Share aims to profit from the exciting growth available in the media and entertainment sectors.
Each of these funds invests the majority of their portfolios in the areas that VCT legislation always intended. I believe today’s absence of bank lending is presenting plenty of opportunities for just such funds.
Venture capitalists are in a strong position and small, successful companies starved of investment are accepting capital on favourable terms to investors. The investment case stacks up and is enhanced by the tax reliefs available.
Ben Yearsley is an investment manager at Hargreaves Lansdown