Rewards of thinking small

Venture capital trusts will channel finance to growing companies. Iain Tulloch explains what's in it for private investors

THE FIRST three of a new breed of specialised investments, designed to channel money into growing businesses with the help of tax incentives, are making their appearance in the next few weeks. Venture capital trusts, generally known by their acronym VCT, were first proposed by the Chancellor in his November 1993 Budget.

VCTs are sorely needed to address the equity gap, also known as the Macmillan gap, because it was first identified by Harold Macmillan before the Second World War. He realised there was a shortage of smaller amounts of finance. Governments of different hues have tried to address this problem in a number of ways ever since, but with a singular lack of success. A company which has a viable project and business plan has little difficulty in raising pounds lm and more. Those seeking half this amount face a long, difficult, and often unfruitful exercise.

In the 1980s, Business Expansion Schemes tried to address the problem by channelling cash to individual projects, but lost their way and were eventually axed. VCTs are the latest attempt to fill this gap.

A VCT is a company similar to an investment trust, shares of which will be listed on the London Stock Exchange. The principal requirement is that within three years after launch, it must have at least 70 per cent, by value, of its funds invested in new subscriptions in "qualifying holdings" of smaller companies which are unquoted, or whose shares are traded on the Alternative Investment Market.

The qualifying investment by the VCT in any company in any year may not exceed pounds lm and, to qualify, the gross assets of a company immediately prior to investment must not exceed pounds 10m. Certain activities, such as dealing in property, banking, leasing, and licensing, are excluded.

VCTs are exempt from corporation tax on capital gains arising within the venture capital trust. Unlike an investment trust, a VCT is permitted to make distributions of all its profits, including realised capital gains.

VCTs offer substantial tax advantages to the private investor, aged 18 or over, on investments up to pounds 100,000 in each tax year.

Investors will be exempt from all income tax on dividends received from a venture capital trust and from all capital gains tax on disposal of venture capital trust shares, in a similar way to holdings in a personal equity plan. These reliefs apply to shares bought in the secondary market, as well as new subscriptions.

In the year of subscription, investors in new ordinary shares in a VCT will also receive income tax relief, at 20 per cent of the amount subscribed, provided such shares are held for at least five years.

Investors can, in addition, defer the payment of capital gains tax on any other realised chargeable gain, by reinvesting that gain in new ordinary shares in a VCT. The deferred capital gains tax becomes payable on disposal of the VCT shares. This is attractive to an individual who has an investment which has been particularly successful, but who may be reluctant to sell it, since a disposal will crystallise a capital gains tax liability. The investor can now free up funds by realising the holding and reinvesting just the chargeable gain in a VCT.

No one should invest for tax reasons alone, however attractive they may appear. The vital question is whether VCTs can make an acceptable return in their own right; in particular, can the managers invest in and manage a portfolio of expanding qualifying companies?

Successful managers must have a strong quality-deal flow from different parts of the UK; the human resources to exploit that deal flow; the ability to monitor and add value to qualifying holdings; and the expertise to manage the portion of the portfolio not invested in qualifying holdings.

There is another important point; the manager must not raise too much finance. Undue pressure to invest can only result in underperformance.

There should be a large number of qualifying holdings in the portfolio, thereby spreading the risk. For example, a pounds 30m VCT might have up to 40 holdings, with the result that the occasional receivership would not affect performance severely.

Most VCTS will invest in a large number of industrial sectors. There might be a few specialist trusts, concentrating, for example, on technology; these will have a higher risk profile, although potential rewards will also be greater.

Risk can be controlled by investing only a small percentage in start- ups and early-stage financings, the high risk/ reward sector of the industry. Investment in profitable companies, whether by way of buy-outs or expansion finance, can still provide excellent returns with a lower level of risk.

The three VCTs currently raising finance are all taking the lower-risk route. Murray Johnstone's VCT will raise up to pounds 30m to invest in up to 40 companies at various stages of evolution, including buy-ins and buy- outs. The offer closes on 8 September. Northern Venture Capital Managers, based in Newcastle, is raising pounds 15m to invest in about 20 businesses, mainly in the North of England and Scotland. Baronsmead, another specialist venture fund manager, will be raising pounds 30m next month to invest UK-wide.

VCTs have a key advantage, the capability of distributing, within reason, realised capital gains. This has long term implications for VCTs; there is a strong case that the successful ones could, once the portfolio of qualifying holdings has matured in four or five years, trade at a premium.

It is arguable there should be few sellers of shares, even after the five-year holding period, because this would crystallise the rolled-over capital gain. VCTs will not produce the winners which will fuel performance in the short term. The investor must take at least a five-year view, which also allows the new issue subscriber to maximise the generous tax advantages.

q Iain Tulloch is a director of Murray Johnstone Ltd.