VCTs were first introduced in 1996, to replace business expansion schemes (BESs) as retail, off-the-shelf venture capital investments. BESs also enjoyed tax breaks but these were widely abused. Since June of last year, VCTs cannot be "asset-backed", invested into property, or carry any guarantees of minimum returns. This means any VCT investment carries risk to your capital.
In return, you can invest up to pounds 100,000 in each tax year, qualifying for four generous tax breaks, two on income, and two on capital gains. All dividend income from VCT shares is tax free. If subscribing in a new issue you can claim back lower rate income tax, or 20 per cent of the amount you invest.
All capital gains on VCTs are also tax free. Again, if subscribing to a new issue, you can roll over any liability for capital gains tax made from the sale of shares or other assets, by re-investing the gain into a VCT.
The snag is that to qualify for two of these tax breaks - the 20 per cent rebate and CGT roll-over, you must hold the VCT shares for at least five years.
The risk comes from the size of VCT investments; no more than pounds 1m per tax year into any one company which itself must not have net assets worth over pounds 10m. Also, companies are not to have share quoted on any stockmarket, except the Alternative Investment Market (AIM), itself set up to trade only in small company shares.
The VCT sector is small by comparison to others, with an estimated pounds 400m total funds under management, and around 12,000 investors. Compare this with the 1,075 separate PEPs held in the UK, with funds under management worth over pounds 47bn.
"This is tiddly stuff by comparison to the unit and investment trusts most people are aquainted with," concedes Nick Lewis, managing director of Downing Corporate Finance. "For instance, we're launching a new VCT at the end of October, hoping to raise pounds 10m."
Downing's VCT will be "generalist", looking for deals across a range of sectors. "Some came from disposals by big groups which decide a subsidiary is no longer compatible with their core businesses," says Mr Lewis. "The existing managers organise a management buy-out (MBC), and come to us for capital."
"What we do is hands-on, often taking a seat on the board, plumbing in management skills which may be lacking among the managers."
Meanwhile, Singer and Friedlander is launching an AIM VCT on 6 October. Aiming to raise pounds 5-15m, this will invest solely into shares already traded on the AIM.
Andrew Banks, Assistant Director at Singer's, reckons, "This is a good time to buy shares in small companies, precisely because they are being hit by high interest rates. Only the fit survive."
The average deal size for these VCTs is pounds 733,000, and with such small investments the success or failure of a fund depends on its "deal flow". Managers must have ability to sniff out new deals, and Martin Churchill, of Allenbridge Securities, believes: "The personal track record of managers - whether they have a history of being successful at finding small companies set to grow - is vitally important when deciding whether to invest."
Because VCTs are set up to run over five years, it's difficult to know whether you have made or lost money in this term, usually because the owners have died or are desperate for money. Examples include shares in Questors VCT. "These have a current net asset value of 103 pence per share, but have recently changed hands at just 82 pence. This makes them a good speculative buy," thinks Mr Churchill.
Gareth Marr, an independent financial adviser with Moores Marr Bradley, concedes that secondhand VCTs may be good investments. But he argues: "Their primary use is a means of deferring and avoiding capital gains tax. Only a minority of investors can take advantage of all these tax breaks."