Products Venture Capital Trusts
VCTs are high risk, long-term investments. Be sure you understand the snags before being seduced by the tax breaks.

Venture Capital Trusts (VCTs) are a special form of Investment Trust. If you invest you become a shareholder, you may disinvest by selling your shares in the market (when you can, see 'liquidity' below) and you can see the value of your shares quoted in the newspaper every day. So far so normal.

Where VCTs are different is that they are structured so that the initial investors can take advantage of a set of tax breaks designed to encourage investment in new and growing companies. VCTs must restrict their investments to such companies and obey a few other rules to retain 'VCT status'.

Tax breaks
The tax breaks change periodically and it's much safer that you look up the current regulations yourself. As we write you have to hold the shares for a minimum of three years and be the first buyer of the shares.

But there are snags:

Because your shares have a quoted price does not mean you can sell them. After the initial launch the tax concessions disappear. So who wants to buy a trust without the financial incentives that are its raison d'etre?

Well, there's always somebody - at a price. The moral is that you should plan to hold this investment for a long time. You must get your rewards from the long term success of the VCT's investments, paid out to you in dividends and - eventually - capital profits on the disposal of individual investments by the Trust. A sale of your shares is always likely to be a distress measure.

To be fair, this aspect of VCTs is now receiving attention from sponsors. Many new issues have share buyback programmes to provide occasional liquidity at a reasonable price. The likely effectiveness of these programmes, and their effect on the remaining shareholders of the Trust, is a complex matter for discussion at another time.

Every VCT is different: different investment objectives, different cost structures, different performance incentives, different liquidity. To understand what you are investing in you will have to read the prospectus (which will typically be a 40-page document), or trust your adviser to read it for you.

Here are some things to look out for:

Pressure to invest
VCTs must find suitable investments. They are not allowed to stay in cash (an anti-avoidance measure). Nor can they chose to put money into non-qualifying companies (meaning bigger or foreign companies). Nor can they put too much into any one company. If they fail on any of these points the VCT either fails to launch or loses its qualifying status - with all sorts of nasty financial consequences (for the investor).

Worse, VCTs have to find opportunities in competition with everyone else who is launching VCTs and with all the private equity firms who are in the same game on their own account. 500 million was raised through VCTs in 2004/5 and the target was 750 million in 2005/6. That is a lot of small start-up companies.

Trust managers are remunerated as a percentage of the size of the fund, not as a percentage of its beauty.

So you can imagine there is some pressure, when looking at a potential investment, for the VCT manager to suppress doubts, accentuate the positive, say 'what the hell!' and put your Trust's money into it.

A typical VCT will incur annual running costs of 3.5%. These will (should) be detailed in the prospectus. The biggest item will be the investment manager's fee (say 2.5% + VAT). Then there will be other expenses such as directors fees and admin and secretarial services. So over a reasonable investment horizon of seven years the Trust will incur expenses of 24.5%.

Your VCT may also pay performance fees, which we dislike.

The costs of launch will be born by the initial investors - typically 5%. You may have to pay a further introductory commission - up to 5% depending on who you buy from.

Your fund may pay a trail commission to your financial advisor - 0.5% per year. This should already be included in the expenses detailed in the prospectus.

Arrangement fees
Investment trust managers are allowed to charge arrangement and syndication fees to companies they help to finance. This goes to them, not to the VCT that is doing the investing. There's nothing immoral in this - it's the way the game is played. But don't you think there is a teensy weensy bit of conflict of interest here? And re-read the earlier section - 'Pressure to Invest'.

Think of VCTs as high octane, illiquid small company funds. If you can find an adviser who can chose one of the best VCTs for you they may have a small place in a rich man's portfolio.



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