VCTs ready for secondary market

Venture capital trusts (VCTs) have had a long and bumpy ride over the years. Many profited from the fund raising boom after tax reliefs were introduced for investors, but then failed to deliver returns. Consequently there was a consolidation of the industry with some merging, some changing management contracts, others dissolving and those with the successful brands names becoming bigger and better. For example, the four generalist Baronsmead VCTs managed by David Thorp, partner in ISIS Equity Partners have, over the last five years to June 30 2007, generated average total returns ranging between 9.7% to 12.5% per annum.

More transparency in the market and revised legislation means that managers are looking at more creative ways to entice investors to their products. VCTs now have more media prominence than ever, such as a separate daily table in the Financial Times and also the publication of standard total return figures by the Association of Investment Companies (AIC). So those players with significant funds under their belt now have to make sure they continue to give investors good value for their money and for this reason many of the core players in the market and also experienced investors in VCTs are citing a secondary market as a natural evolution for these funds.

Many private investors will be wondering what the merits of buying on the secondary market are, if buying into a VCT at launch an investor is offered 30% tax relief. According to a survey by the AIC of VCT providers representing 93% of the VCT sector, the main attractions of buying on the secondary market are tax-free dividends, which can be higher in an established VCT and being able to invest in more mature portfolios to generate quicker returns.

Patrick Reeve, managing director of Close Ventures explains the current issues surrounding the VCT market: “A successful and healthy market needs to provide liquidity for buyers and sellers alike. Currently the market is largely limited to one source of supply (new issues) and one source of demand (VCT buy-backs). This sadly ignores the considerable investment potential attractions for shareholders buying in the secondary market.”

He cites several barriers to establishing a secondary market. Firstly, the actual size of the funds is small. While there are some £27bn assets in the market, this is split among 119 VCTs making an average size of £23m per fund. Secondly, there is a difficulty in assessing the underlying risk of a fund’s investments and thirdly, one of the main barriers is the general perception that historical returns from VCTs have been poor.

So there are challenges to overcome before a secondary market is able to flourish, but the appetite is there, as well as the maturity of investments and with 74% of managers considering it very important and over 150 market professionals wanting it to happen, it is an inevitable development.

Reeve cites dividends as a major attraction of VCTs for private investors. These vehicles can pay dividends out of realised capital profits, as well as from net revenue. Regular, predictable dividends provide the following: tax free income; proof that the underlying unquoted portfolio is still alive; the ability to value shares and therefore the confidence to buy in a secondary market.

Close VCTs have a policy, once the portfolio matures, of paying out stable and substantial dividends from revenue and from net realised capital profits. Reeve says four out of seven Close VCTs have reached this stage with stated pay-out policies of 10 pence, five pence, eight pence and five pence per annum, yielding a tax-free yield of between 5.5% and 8.5% on share price. And between them £1.4m of Close VCT shares have already been bought in the secondary market since the start of this year.

Reeve stresses the importance of a mature portfolio to entice investors to the secondary market. “Close’s first VCTs are 11 to 12 years old – you can see what they’re doing. Much younger than that, you can’t really see how they’re going to perform.”

He adds that if anyone is going to make the secondary market for VCTs work, it’s going to be the private client fund managers.

Robert Corden of private client stockbroker Charles Stanley, says: “The key attractions of second-hand VCT shares are the potential for substantial, and consistent tax-free income from an asset class to which private clients would otherwise have difficulty in gaining exposure.”

But until an efficient secondary market develops, private client fund managers stress that VCTs need to support their shares with strong buy-back policies.

Tony McGing of Downing Protected VCT I, says: “It has become the VCT market norm for investors (and was the firm expectation of many investors when they invested) to be able to exit at a 10% discount to NAV. It would be a retrograde step for VCTs to allow their discounts to widen. Investors will shy away from VCTs if they do not receive a fair price for their shares on exit.”

And while many are lamenting the pre-budget statement increasing the effective rate of taxation from 10% to 18%, the changes may be a catalyst for the secondary VCT market to flourish. For those individuals who own shares in VCTs on which existing capital gains are being deferred, the new 18% taxation rate for chargeable gains crystallised in excess of the annual allowance could potentially prompt some VCT shareholders to seek to realise their investment and sell onto other investors interested in gaining exposure to the sector.