The choice between generalist and specialist trusts is a key point as investors look at using venture capital trusts as a tax-efficient route for their cash before the end of the 2006/07 tax year.
Chancellor Gordon Brown reduced the up-front income tax relief on VCT investment from 40 per cent to 30 per cent in the 2006 Budget, inflicting a blow to the vehicle’s unique selling point. But at the same time he reduced the ceiling of the value of companies in which VCTs invest. VCTs can now invest in companies with assets totalling just £7m before investment – less than half of the former £15m requirement.
For investors, this means a greater exposure to smaller and therefore potentially higher-risk companies and this fuels the argument that VCTs have become specialist vehicles in themselves without any further classification.
When you add to this, Brown’s decision to increase the period needed for investors to qualify for the tax relief, from three to five years and the expectation is that the VCT market is expected to attract between just £200m and £300m by the end of this tax year – a fraction of the £750m bonanza enjoyed in 2005/06.
Research conducted by Tax Efficient Review suggests that VCT investment is expected to dip to the lower end of expectations, that is, closer to the £200m mark.
But with fewer VCTs currently open, there will be less competition for the reduced cash pool.
Tax Efficient Review editor Martin Churchill says: “There are a lot of VCTs not in the market because they have enough money from the last two years.
“A lot of people invested more than they would have because, while they did not know what the Chancellor intended in last year’s Budget, they knew it was not going to get any better.”
In simple terms, generalist funds are accepted by IFAs as the most appropriate choice for investors looking for a diversification to their investment portfolio.
As Churchill says: “VCTs are for clients with big portfolios wanting the tax benefits. People should not make an investment just because of the tax breaks.”
The incentive extends to tax relief on VCT dividends, with no capital gains tax liable on VCT share sales.
Specialist VCTs are typically suited to more seasoned investors who fully understand the risks of VCTs as well as the specialist markets and fund managers.
Generalist VCTs are largely more risk-averse than specialist trusts because of their diversity, with companies usually being established and profitable UK unquoted companies seeking to raise capital for capital.
Generalist VCT returns have been consistently strong, particularly for F&C’s Baronsmead VCTs.
According to the Tax Shelter report, Baronsmead VCT 3 raised a top-up fund of £24m for the 2005/06 tax year and reported a total return (net asset value plus dividends) of 99.40p per share.
Generalist VCTs are often criticised for their potential for cross-investment and this is where specialist VCTs come into their own as there is no chance of duplication of investments. This, together with the fact that specialist VCTs can make high returns during an upturn in their specialist markets, allows them to give generalist trusts a run for their money.
Foresight Technology VCT is a case in point. The VCT, which was started in tax years 1997/98 and 1998/99 when the creation of the dot.com bubble was well under way, returned 221.30p per share, with an internal rate of return totalling 18.8 per cent – the best-performing VCT to date. This compares with Baronsmead 2, which returned just 166.30p, achieving an IRR of 6.9 per cent, in the same year.
The fact that specialist VCTs know their markets well should mean they can spot start-ups with potential.
Special health VCT the Sitka Health fund is concentrating on the long-term health market which could be boosted by the UK’s ageing population. Fund manager Louis Nisbet says he is planning to invest mainly in new ventures.
Specialist media VCT Ibis Capital’s investment director David Stephens says he will invest in existing and new ventures.
What is notable about the specialist camp is the manager expertise. Stephens, for example, is no stranger to the media sector, having previously worked at media giant WPP while Nisbet holds a PhD in biochemistry and has worked for a number of pharmaceutical giants such as the Glaxo Group.
However, specialist funds have a long way to go before establishing the track records in manager and investment performance that their generalist competitors have achieved.
It is very difficult to compare the likes of Baronsmead and Close, which, as John Davey of Bestinvest says, already enjoy a strong deal flow, with the relatively newer players such as Sitka and Ibis.
Whether looking at generalist or specialist, investors should remember to look beyond the initial tax advantages.
As Worldwide Financial Planning managing director Peter McGahan says: “Individuals can claim income tax relief on the capital invested in a VCT in this tax year. Great! The income tax relief is fine but what happens if you lose all your capital beneath?
“Remember that you are investing in a company that can either cash-burn for a long time as it develops or go out of business. The fact that it is high risk – on a scale of 1-10 it is a fat 10 – will also mean that the potential returns are very high but you need to know what you are buying.”