When venture capital trusts (VCTs) were introduced in 1995, I am embarrassed to say I was sceptical. In my defence, my appraisal was coloured by their predecessor, business expansion schemes, which were, in the main, very poor products. They were launched not for good business reasons but purely to capture the tax incentives, which invariably led to poor investment outcomes.
I had a eureka moment a few years ago when the dividends from VCTs were brought to my attention. To understand the dividends, one needs to understand how venture capitalists structure their deals. Although they obtain a good equity stake in the business, most of the capital is injected by way of loans with fixed rates of interest. The venture capitalists then passes this income to VCT investors as dividends. Many VCTs offer dividend yields in excess of 5 per cent with the potential for dividends to grow. In the current environment 5 per cent in itself is a great return, but when you consider that it is tax free, no matter what your rate of tax, VCTs become even more attractive.
You then have to take into account the tax relief available. For those investing at launch, the taxman reduces the initial cost by 30 per cent (providing the amount claimed is no greater than the amount of tax you pay). The tax benefits are generous, and this should be seen as icing on the cake rather than the reason for investing. Remember, too, that while you won't get the initial tax relief, you can sometimes also buy in the secondary market, where discounts to NAV of up to 20 per cent can be available.
There are various types of VCTs, but the ones I will focus on today are the Aim VCTs from Hargreave Hale. Aim has been in the press recently because its shares have become eligible for inclusion in Isas for the first time, in order to support the market. So far this seems to have generated a lot of interest among investors.
Yet Aim VCTs have long allowed private investors to invest tax-free into this market. While Hargreave Hale is probably better known for running the Marlborough Special Situations, Marlborough UK Micro-Cap Growth and Marlborough Multi-cap Income funds, it is quietly carving out a respectable track record on its VCTs. This should not be a surprise. Its unit trusts have superlative track records and include Aim shares within them. So this is a team with some pedigree. It is looking to raise more money into its two Aim VCTs with the current offer closing at the end of October.
The two VCTs have identical investment policies, seeking to maximise distributions to shareholders from capital gains and income generated from the investment portfolio. Each aims to pay a 5 per cent distribution yield, although this is not guaranteed. Clearly the Aim market can be volatile, but Hargreave Hale's approach, through fund managers Oliver Bedford and Giles Hargreave, is to be pragmatic and flexible. They recognise there are times when you want to invest more money in stocks and there are times when you want to be more defensive.
The qualifying part of the portfolio is biased towards established and profitable businesses. Aim is an under-researched market and accurate information can be scarce, so the team places great emphasis on getting to know companies and management well. They see 30 to 40 companies a week, both in the office and on site, and they also review the competitors, customers and suppliers of potential holdings.
While they are looking for profitable businesses they are allowed to invest in non-qualifying equities. Here, intelligently, they use the Marlborough Special Situations Fund, enabling them to get exposure to their favoured companies quickly rather than having large amounts sat in cash. If they are cautious on stock market prospects they can switch to cash and fixed interest products.
If you are already using your annual Isa limit or perhaps you have maxed out on your pension contributions, then it strikes me that VCTs are a natural place for some of your money. You do need to take at least a ten-year view and to qualify for the tax relief you must stay invested for at least five years. Personally, I have thoroughly enjoyed the tax-free dividends coming in. They are building up for my own retirement in due course.
Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit hl.co.uk/independent