Tax-efficient investments: Venture into a different world

Venture capital trusts may be volatile, but the investor is compensated by attractive tax breaks. By Iain Morse
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THE GENEROUS tax breaks available if you buy shares in small and growing companies through a venture capital trust (VCT) are good news for anyone who has used up their PEP allowance and still has spare cash to invest. But VCTs are not directly comparable to PEPs. While PEP funds can only buy and sell shares listed on our main Stock Exchanges, VCTs are not allowed to do so.

Instead, they can only buy shares in unlisted companies, or those with shares traded on the Alternative Investment Market (AIM). By definition, these types of share are "illiquid"; they have no ready, predictable market value. Hence they are also riskier than shares traded on the Stock Exchange.

This means that VCTs are inherently volatile. They give a greater chance of gain or loss than more mainstream retail investments. On the other hand, they carry more generous tax breaks than PEPs. You can invest up to pounds 100,000 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 buying a new issue, you can claim back income tax relief of 20 per cent on the amount you invest. All capital gains on VCTs are also tax free. Again, if subscribing to a new issue, you can roll over and defer any liability for capital gains tax made from the sale of shares or other assets by re-investing the gain into a VCT. This applies to any gains arising within 12-month periods on either side of your VCT investment.

The only problem is that in order to qualify for two of these tax breaks - the 20 per cent rebate and CGT roll-over - you must own the VCT for at least five years. This can be a problem because of the inherent risk in this type of investment.

VCT fund managers are bound by tight rules and regulations; no more than pounds 1m per tax year can be invested into the shares of any one company, which itself must not have net assets worth in excess of pounds 10m. These investments cannot be "asset backed". This rules out the purchase of shares in property-owning companies, or other "guaranteed return" investments.

But if a company becomes insolvent, or unable to pay its trade creditors, then shareholders rank last in priority on any wind-up. So, after any bank loans have been repaid, a VCT fund may receive nothing for the value of its shares.

The VCT sector is small by comparison to others, with an estimated pounds 500m total funds under management, split among only 12,000 investors. By comparison, total funds under management in PEPs are worth over pounds 47bn. This makes the world of VCT investment small scale, and closely focused compared to that of most retail fund management.

Expect VCTs to be "themed" or "generalist". Themed trusts - such as Oxford Technology - are often built around very specific expertise and contacts in their management team. Oxford deals exclusively with information technology and hi-tech start-ups in and around Oxford itself.

Generalist trusts - such as Downing's Classic - tend to be larger, with management teams coming from a background in making venture capital deals. Look out for managers who have worked with 3i, or the mainstream small company unit and investment trust sector. Look out also for VCT managers like Murray, Close and Downing who manage several VCTs and have access to wider management resources. Often the same managers will manage several VCT funds.

But more so than with other retail fund, VCTs each have a unique flavour. Take the generalist VCT on current offer from Close Bros.

Fund manager Ole Bettum explains: "We are looking to invest into established and fast-growing firms across very broad business sectors. Average investment size will be around pounds 750,000, some of them in equity and some of them in secured debt. This means that we can provide development capital with reduced risk - although, of course, if a company becomes insolvent, we rank behind any bank which may have lent them money."

Because VCTs are set up to run over a five-year minimum term, none have yet matured. It's also very difficult to know whether you have lost or gained within this term. VCT shares can be traded like any other, but few have come on the market. Those that do often trade at a big discount, but now most of the larger VCT providers have started to buy back any such shares, pushing their value up.

Martin Churchill of Allenbridge Securities has some clear advice for anyone tempted to invest into a VCT. "The track record of the managers - whether they have a history of finding small companies and investing to help them grow - is vitally important when deciding where to invest."

Venture Capital Trusts on offer

Yorkshire Fund Managers; target: pounds 15m; closing date: 31/5/99 (0800 854057). Close Bros Development VCT; pounds 15m 31/3/99 (0171-426 4000). Downing Classic VCT; pounds 10m; 29/1/99 (0171-411 4700). Murray VCT; pounds 10m; 31/3/99; (0141-226 3131)