3Mar 2016

Venture Capital Trusts for Income Seekers

venture

Venture capital trusts, or VCTs, are a niche play. While being quoted and, therefore, benefiting from the regulatory environment, they generally have relatively poor liquidity (a lot of activity takes place through new issuance) and trade at discounts to their net asset values (NAVs).  Worse than that, their NAVs appear to go nowhere over time and, indeed, may even demonstrate a gentle downward trend, implying some form of deterioration.  For many investors, these are good enough reasons to avoid the sector.

Venture Capital Trusts for Income Seekers

Gross investment (new issue) £10,000
Income tax relief2  -£3,000
Cost of investment £7,000
Gross issue costs at 5%  -£500
Initial discount at 2%3 £200
Value invested at NAV £9,700
   
Income yield at 5% of NAV4 £485
Yield as %age of cost of investment  6.9%
Notes:

1.Based on general stylised assumptions; individual circumstances and VCTs will vary

2.There will be a timing difference between investing and receiving the tax refund

3.This assumes that a discount broker is used.  There may also be a partial trail commission refund

4.A typical target, although often exceeded

Venture capital trusts, or VCTs, are a niche play. While being quoted and, therefore, benefiting from the regulatory environment, they generally have relatively poor liquidity (a lot of activity takes place through new issuance) and trade at discounts to their net asset values (NAVs).  Worse than that, their NAVs appear to go nowhere over time and, indeed, may even demonstrate a gentle downward trend, implying some form of deterioration.  For many investors, these are good enough reasons to avoid the sector.

But that would be to ignore their advantages.  The first and foremost benefit is the tax relief, which is 30% of the gross investment at the time of investment in new issues.  That is not quite as attractive as it sounds, because new investments are normally priced at NAV, so there is an immediate loss compared to buying in the secondary market at the discount.   It is rare, however, for that loss to exceed the gain from the 30% tax rebate.  At the time of writing, for instance, the 25[1] VCTs had mid-price discounts ranging from 4.2% to 18.7%, with a simple average of 7%.  I would add a word of caution about market pricing of VCTs: many VCTs are active in buy-backs and that could well distort the quotes.

With this tax relief comes restrictions; you lose it if you sell the shares within five years, although after that sales are free of CGT.  Logically, therefore, an investor should sell and reinvest every five years.  Here again, regulation intervenes, so that you cannot sell and buy back into the same fund within a period of six months.  In practice, this may be more of an inconvenience than an obstacle, as investors in VCTs are likely to be diversified to the extent of holding a number of VCTs and can just switch their purchases to another VCT.  There are also some other restrictions, with which investors would be wise to acquaint themselves.

The other main tax concession is that dividends are tax-free.  This is obviously a very significant advantage to, in particular, higher rate tax payers but is – with the new tax regime in April – also of benefit to some basic-rate payers.  This benefit has actually shaped the performance of VCTs over the years.  If you go back some ten or 15 years, the performance of VCTs was much more erratic and one of the problems for management was that they were not sure of what their objectives should be.  Over those years, I would describe them as having generally matured, with a much lower manager risk.

That is now obvious when you attend an investor session or an AGM of a VCT.  These are generally older (average age certainly over 50) sophisticated individual investors who have bought in for the income.  It would seem that, in most cases, these investors understand the risks – they know that they are not as secure as gilts, but are attracted by the high yields.  Income is the main objective.

The income return can be high.  Most VCTs target a yield of 5% on NAV, and often exceed it.  Typically, that works out at about 7% on the net investment (post tax relief).  Most of the larger older funds have a good track record in consistently producing such income, which is why they are particularly attractive to the older income-seeking investor.  In addition, funds will often return capital to shareholders through special dividends when profits are realised on sales of their underlying investments.  This element is obviously volatile and largely unpredictable in terms of timing, as most of the sales will be made at opportune times in the market rather than being driven by any requirement to supplement the dividend flow.

Such a practice is different to that of most quoted companies, who main objective is to expand the company, organically or through acquisitions, making themselves more competitive and, incidentally, bring rewards to the management.  It makes sense to the VCT shareholders, who receive that part of the NAV returned to them without a discount and without any tax.  If the VCT then wants to raise new capital, it can do so either with an open offer or, sometimes with an offer only limited to existing shareholders.  The difference may well indicate the amount of capital required at the time and the perceived appetite by investors.  Of course, this is not the most financially efficient way of managing a capital base but it is net beneficial to shareholders.

A few years ago, I wanted to invest in Baronsmead VCTs, but I was aware that they had limited their capital raising to existing investors, so I bought some shares on the secondary market through my broker – which qualified me for the subsequent offer.  Although the secondary market shares were not quite as attractively priced as the new shares net of tax relief, the discount to NAV at the time was much greater than that prevailing recently and they were not a bad investment in absolute terms.  With current discounts, that is now really only a means of acquiring a nominal holding.

There are some VCTs with a limited life or defined exit, that intend to realise all of their investments in a fixed time period some five years plus from their formation, and return all capital to the shareholders.  This is going to be trickier than it seems, as it is dependent on the state of both the underlying assets and the market at that time in the future.

That brings me on to what these underlying investments are.  The VCT regulations restrict what a VCT can invest in, but these are generally small businesses.  Although VCTs can invest in start-ups, the more consistent ones prefer to use their capital to finance companies after the initial one or two rounds of financing.  Company failures can still happen, of course, and that is why it helps, for an objective of steady dividends, to invest in one of the large and, therefore, more diversified VCTs.

Unfortunately, due to EU intervention on the basis of limiting state-aid (another plank for Brexit!), the regulations on the investible universe have recently been tightened so that management buy-outs – often seen as safer than other forms of early-stage investment – are excluded.  In addition, the amount that a VCT can invest in any single company has been restricted and VCTs can only invest in companies that have made their first sales within the last seven years (or ten for ‘knowledge intensive businesses’).  VCTs responded that these changes will not affect their investment pipeline to any great extent but, of course, they do not scare away any new investment capital.

This reduction in the investible universe means that the underlying investments will be riskier, although whether they will also produce better returns (on the basis of higher risk should produce higher returns) remains to be seen.  Ultimately, however, the performance is determined by the selection capabilities of the VCT managers.  Unlike the managers of, say, investment trusts and unit trusts that deal in quoted equities, the VCT managers do not have the advantages of news flows, sell-side analysts, analytical software, track records, or mountains of recommendations from many sources.  Instead, they need to rely on their experience of selecting companies on the basis of the quality of the managers, an understanding of the market in which they are operating and the products or services that they are producing.

For that reason, I prefer managers who have been around for a good few years and have learnt from their mistakes as much as from their successes, who should be able to guide their investment businesses on how to be successful and understand the need is to make money rather than be carried away with the latest idea.

The role of VCTs in my portfolios is to produce a reasonably steady income.  They are long-term investments, not least because of their relatively low liquidity and the regulations.  But they enable me to be more flexible with the rest of my portfolios, knowing that I can target total returns rather than just a reasonable level of dividend income.

A good starting point for selection is the list in the FT.  You cannot buy primary market stocks through your broker, but you can directly from the VCT or its agents.  It makes sense to purchase through a discount broker that will refund (in additional shares) the initial fee and part of the trail commission.  Not all VCTs have the ability to buy back shares to limit the discount to NAV, so it is worth checking on that before making acquisitions, as well as to be aware of the management fees.

[1] Admittedly only a proportion of the 82 funds in existence at December 2015

Credit to Diana Patterson

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