Uncharted territory

Venture capital trusts are the latest tax-free investment vehicles and offer some of the biggest breaks. But they are also high risk and should be bought only by richer and more adventurous investors, particularly those with capital gains to roll over.

Dreamt up by the Chancellor, Kenneth Clarke, in his 1993 Budget, the first three VCTs to get off the ground raised pounds 42m last autumn. Despite the lukewarm response - Friends Provident pulled its proposed issue and the three that made it had hoped to raise nearer pounds 80m - 11 more hopefuls are presently raising money.

Managers believe the timing of the current issues, which close just before the end of the financial year, will help them to fare better than the pioneers. Capital gains tax rules stipulate that gains rolled into a VCT must be created within a year either side of the investment date. But the starting point is 6 April 1995.

VCTs were designed to encourage investment in private British companies too small to interest mainstream venture capital firms. Investors are allowed to subscribe up to pounds 100,000 a year. They gain income tax relief at 20 per cent on the money put in, dividends are free of income tax and the final disposal of shares is free of CGT. Tax on realised capital gains, up to a maximum pounds 100,000 a year, can be deferred by reinvesting in a VCT. The upfront reliefs are only available on new VCTs, not on those bought in the secondary market, and depend upon shares being held for five years.

The tax breaks mean that a higher-rate taxpayer with a pounds 100,000 CGT liability can invest in a VCT and gain an immediate pounds 20,000 income tax credit rather than pay pounds 40,000 in tax. The CGT must still be paid when the VCT is realised whether it has doubled the initial investment or halved it. Therein lies the rub. VCTs are new and untested vehicles and nobody knows what returns they will produce.

Advent, one of the 11 presently raising a VCT, has made an average annual compound return of 33 per cent on investments it made between 1990 and 1995 in VCT qualifying companies. To qualify, companies must have assets of no more than pounds 10m and no more than pounds 1m can be invested by the VCT manager. Advent also claims to be unusual in that it will distribute tax free all capital gains realised from successful investments during the life of the fund. A decision on winding up the fund is left to shareholders. VCTs have the advantage over investment trusts of being allowed to distribute realised capital profits.

Most VCT managers have stated their intention of avoiding start-up companies, which are more likely to go bust than established businesses.

Noble & Co is avoiding risk by another method. Only a quarter of the money it raises will be invested in unquoted equities and half will go into guaranteed bank loans to small companies. The remaining quarter will go into five year gilts. While the downside is limited by such an approach, so too is the upside if the companies prosper.

Allan Hodgson, managing director of Hodgson Martin, which is also raising a VCT, points out that unquoted companies have produced average returns of 12 per cent a year, according to the British Venture Capital Association.

Mr Hodgson says the economic climate is favourable based on Treasury forecasts of a recovery in economic growth and an expected pick-up in consumer expenditure after tax cuts this April.

Although investment performance is the most crucial determinant of success, investors should also be aware of charges that are generally higher than those on other pooled vehicles like unit and investment trusts. VCTs require more work on the part of the manager, both in due diligence before making investments and in monitoring investments once made.

Initial charges are usually 5 per cent and annual management fees range from 1.5 per cent to 2.5 per cent by the third year. Some VCTs have a rising structure of fees to reflect the fact that initial investments will be in gilts and fixed-interest stock as the manager searches for suitable unquoted companies.

Minimum subscriptions start at pounds 2,000. VCTs are stock market quoted companies but are not expected to be actively traded due to the five-year requirement to hold shares to qualify for upfront tax relief.

Companies presently raising VCTs: Advent 0171-630 9811; British Smaller Companies 0171-488 4040; Capital for Companies 0113-243 8043; Close Brothers 0171-426 4000; Gartmore 0171-782 2000; Guinness Flight 0171-522 2127; Hodgson Martin 0131-226 7644; Johnson Fry 0171-451 1000; Noble & Co 0131- 225 4044; Pennine 0151-236 6666; Quester 0171-222 5472.