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Venture scouts

March is a key time for last-minute tax planning and venture capital trusts offer investors significant tax advantages in the form of capital gains tax deferral and income tax relief.

However, only a tiny percentage of the CGT raised by the Government this year is likely to be mitigated by the use of a VCT. Is this because of a poor understanding of VCTs or a general mistrust of the products on offer?

There are number of good reasons why people should think twice before investing in VCTs. Unquoted companies are by definition at the higher end of the risk spectrum. Less regulation in this area tends to mean that levels of fraud are much higher and the quality of management as a whole tends to be poorer.

Company managers often have less experience and appreciation of the commercial realities confronting them, making them more likely to make common mistakes such as overexpansion.

VCT rules also tend to discourage majority ownership of a company, making it even harder to influence or change an underperforming management team. Furthermore, even with a successful company, the investment is very illiquid and can take many years to crystallise, therefore bringing down returns.

Second, the structure and investment restrictions of VCTs, as devised by the Government, have encouraged but not coerced investment managers into risky investment strategies.

All too often, investments have been made into early stage companies which had not yet proved their worth as viable businesses. Many had complicated business plans within the technology and biotechnology sectors, where the ability of managers to conduct due diligence prior to investment was limited.

Failure rates were predictably high and this shepherded managers into banking on a couple of star investments, which they hoped would outshine the rest.

In addition, during the boom years of 1997-2000, many managers made the classic mistake of overpaying for assets. This was exacerbated by their having to invest 70 per cent of their funds into qualifying companies within three years. This may help to explain why performance from existing VCTs has been pedestrian.

The very best of the 60 or so VCTs that have been launched have very rarely posted annual returns of better than 10 per cent, with many materially less good than this.

There is no doubt that these pitfalls have contributed to a much quieter VCT fund raising season this year. But VCTs are still extremely useful for people who want to preserve the gains they have been lucky enough to enjoy, perhaps through selling a business or a second home. Rather than dismiss VCTs as too risky a proposition, investors need to be made aware that it is possible to invest in a VCT that provides decent returns but without a high level of risk.

How does one find a relatively low-risk investment opportunity that should deliver a decent return? The real trick for choosing a successful VCT is to pick a manager with a sensible investment focus. Narrowing the search criteria to a particular sector such as technology or market such as Aim will only narrow the chan-ces of success so the first rule of thumb is to pick a manager with a generalist focus.

Second, investors need a manager who is as experienced as possible. It does not matter if a manager is new to the VCT market – it is their investment experience in the smaller and unquoted sector that counts.

This is important because it means that the manager will have learnt key lessons such as the fact that extensive due diligence is the key to counter-fraud, just as vetoes on key management decisions prevents management overext-ending themselves.

On the upside, the longer a fund manager has been operating successfully, the greater the network of contacts it enjoys. This means that it will have all the greater chance of finding promising opportunities from pre-qualified sources.

Third, investors should pick a manager who has their feet on the ground. If they really want a lower-risk proposition, they should go for an investment focus which favours simple business plans over the latest blue-sky technology and where more established companies have good cashflow characteristics. The advantage is that the investor stands a far greater chance of seeing their original investment back within, say, five years rather than 10 years or more.

The truth is that smart money goes on development capital, not adventure capital. It may seem less exciting but the returns will be better and the risk less. Furthermore, the paradox is that, at a time when the VCT industry looks set to raise the least amount since 1996, investors stand to reap the best returns as managers are able to negotiate cheap entry levels into companies.

In an environment where quoted stockmarket returns are struggling as valuations remain high yet earnings growth is scarce, the ability to buy genuine growth stories cheaply is attractive. In addition, when such a facility is put into a tax wrapper far more generous than an Isa, VCTs start to look very compelling.

In the final analysis, as markets remain depressed and absolute returns become increasingly important, VCTs should form a part but not the whole of any balanced portfolio. The choice of investment manager is important and investors trudging through this year&#39s tax forms should find this asset class a worthwhile instrument in decreasing their contribution to the Treasury and increasing their net worth.


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