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OPINION

Patience matters with VCTs

Patience matters with VCTs
October 29, 2021
Patience matters with VCTs

Since a relatively high proportion of early-stage businesses fail, the selection of the right investments is critical. As with other investment trusts, you’re paying VCT fund managers for expertise that you don’t have. The difficulty in selling struggling businesses means that wrong choices at this small end of the market will probably become stranded in the trust or written off. VCT companies suffer similar pressures to the wider market – when demand suddenly dried up with the lockdowns in early 2020, many plunged in value. So, both the selection and the monitoring of the businesses are labour-intensive processes. Considering that a typical VCT also tends to be much smaller than many investment trusts, it’s hardly surprising that ongoing annual fees are typically higher, at about 2 per cent, with possibly performance fees on top.

Aim VCTs are similar to generalist ones, except that they prefer to invest in early-stage companies just before, or just after, they list on the Aim market. They tend not to place directors on boards and are not so close to their investee companies, but since most of their investments are listed, Aim VCTs have greater flexibility in choosing when to sell.

Yet, despite the risks, VCTs are popular, no doubt helped by the income tax rebate of 30 per cent of the amount subscribed. Successive governments have recognised that VCT investments in successful entrepreneurial companies create wealth and jobs, and without this concession, VCTs would struggle to raise so much capital. They enhance productivity, and the resultant economic growth, is worth far more than the refunded income tax.

Because of the risks involved, they’re not for everyone. You have to earn sufficient income tax to offset the rebate against it, and ostensibly they’re for higher earners – although all that’s required is a self-declaration designed to demonstrate that you understand the risks and could afford to lose your investment. You’re also tied in for at least five years – sell before then and you lose the rebate. Another thing to be aware of is that the value of the bundle of companies within a VCT can never be measured precisely. That’s because, in contrast to companies listed on stock exchanges, where the share price defines the market value, the valuation of unquoted companies relies on a degree of judgement. Valuations are normally audited only with the annual results, but in fairness this also applies to any type of private equity.

 

My experience

Over the last couple of years, I’ve sold six VCTs. On average, the proceeds paid back the net cost (ie, the initial cost less the tax rebate), and tax-free dividends added another 50 per cent or so. That’s not a bad return – it works out at a compound average rate of just over 10 per cent, but there is a caveat: these were mostly purchased before 2015, when a tightening of the rules increased the intrinsic VCT risk.

A couple have caused concern. Downing Three VCT (DDVI) was marketed as investing in renewable energy, but despite having managers experienced in this field, my H shares went badly wrong. A planned wood pelleting plant cost far more to build than expected; a standby electricity generating plant had faulty equipment; and the development of solar farms in India (plenty of sun there, you might think) had to be written off. About half of my original net investment has been paid back as dividends, but they’ve stopped now. Many of the assets have been written off, and the remainder are in the process of being sold. Gresham House Renewable Energy VCT 1 (GV10) has had some performance issues, too, but here there’s a different issue: the shareholders of its sister VCT2 (GV20) voted against their trust continuing. The VCT1 directors then concluded that it wouldn’t be viable to manage just one renewable energy VCT on its own, so it too is now being wound up. If this is completed within five years of my purchase, the tax rebate will have to be refunded.

Ironically, both of these were the very ones that I thought would be the safest. My conclusion? That within VCTs, while every small business has a story to tell, and hearing about them can be fascinating, some losses are inevitable. And that goes for VCTs as well: you can never be certain of how well they will fare, so it’s prudent to keep your investments diversified.