01 February 2018
Is it time to be a dragon?
Venture Capital Trusts may be worth a look.
by Frank O’Nomics
Those of us who enjoy watching the BBC’s Dragon’s Den probably do so in part because we quite fancy having a wad of cash in front of us to spend on the next big thing. Clearly the logistics for most are impracticable – we don’t have enough money and it would be foolhardy to invest a chunk of it on one risky new venture. However, when such investments are looked at collectively and are selected by a group of fund managers who have decades of experience in identifying value, then there is scope for a great many investors to become dragons. These collective investments, which invest in many companies that you will have heard of (such as Virgin Wines and Monica Vinader), are called Venture Capital Trusts (VCTs). Apart from offering new avenues to get a return on our capital when conventional investments seems to be fully valued and helping us to feel that we are promoting economic growth, the government wants you to get involved, offering significant tax breaks. Before we get on to the attractions, however, we should point out that these investments are not for everyone. They are still inherently risky and have a number of drawbacks that I will try to outline later.
The VCT industry held its breath going into the last Budget, worried that the Government’s Patient Capital Review would recommend cutting tax incentives, thereby undermining the business model. To a large extent there proved little to worry about. The government has made an effort to undermine investments that endeavor to just preserve capital while reaping the benefits of the tax breaks, and there is a push to ensure that more money goes towards early stage small and medium-sized entities (SMEs) which will, over time, make VCTs still more risky. However, the tax breaks have been maintained, so that investors can claim tax back at the rate of 30%, on investments in a VCT up to £200,000 per year (assuming that they have paid tax) as long as the investment is held for 5 years. Once that 5 years is up, if you decide to sell your VCT, the capital gains are tax-free. Further, many VCTs, once established, try to pay a regular dividend of around 5%, which again is tax-free. When one looks at the performance of VCTs, recent history shows that many of them stack up very well against more conventional investments. If you take, for example, one of the Mobeus VCTs, the total return in net asset value since 2005 has been over 70% when capital and dividends are added together, and these numbers do not take account of the initial tax incentive. There are of course good and bad VCTs (and past performance never guarantees future returns) but Mobeus is by no means alone in generating such returns. The recent wave of successful management buyouts has proved a great source of profitable opportunities for VCTs and a number have done very well from investing in AIM listed companies.
So what’s not to like? The first issue is liquidity. Because you are investing in the early stage of a company’s life cycle, you may have to wait a long time to see the benefits and, if you want your money back in the interim, you are likely to be shown a price which is a significant discount to net asset value. Those who cannot take advantage of the 30% tax rebate on an initial investment might want to buy in the secondary market at a discount to net asset value given that they will still benefit from tax free dividends. Further, there is a strong case for looking at the more established VCTs which have a broad range of investments, some of which they have held for a long time and are close to realising.
The other major issue is risk. A rising tide floats all ships and VCTs, like most assets, have had a very strong run. One VCT manager has only suffered one loss in the last 9 years and even then got 97% of the investment back. However, opportunities to buy assets cheaply have become much harder to identify and there is a risk that the competition for such opportunities will lead to managers paying too much for them. Most of the major VCT managers have been raising new funds this year (in total targeting over £500mn) so there is a lot of money that needs to be put to work.
This wave of fund raising has other difficult dimensions. First, the new investors instantly gain some ownership of the current assets and the dividend flows, which dilutes the holdings of existing investors. Second, it takes some time to source further investments, during which time investors are paying high fees for money that is held in cash. Finding a manager with a history of sourcing successful investments should help, but the current environment may mean that the process takes longer than it did. The issue of fees is tricky. Initial fees can be as much as 5.5% (although some offer significant discounts in the form of additional shares to early investors) and there are ongoing annual management fees that are also high and somewhat variable. This is not all bad given that some of it is performance related and many managers have invested significant amounts in the trusts themselves.
Finally, one should remember that the tax incentives attached to VCTs may not last forever. The industry escaped significant damage in the Patient Capital Review, but the door will never be closed. The more money that is raised, the less tax that will flow through to the Exchequer and there is a real danger that, at some stage, the tax-free dividend element could be taken away.
Once again there is no free lunch and it would be foolhardy to get involved in VCTs if you only have a modest amount of savings or do so without any advice. As a rule of thumb many argue that VCTs should not be considered by anyone earning less than £100,000, or having investable assets of less than £250,000 – and even then VCTs should not constitute more than 10% of a diversified portfolio. However, the minimum investment can be as low as £3,000 and those of us who are dragons at heart find it hard not to relish the prospect of saying “I’m in”.
