A venture capital trust, or VCT, is one such investment vehicle.
The closed-ended investment scheme offers private equity to small companies in the very early stages of their development, right when they are often poised to offer their highest growth potential.
For investors, VCTs have the benefits of tax relief and high returns. However, like everything in the investment world, they come with a catch – VCTs come with a lot of risk and for that reason they are not for novices by any means.
Rob Gleeson (pictured), head of research at FE, says VCTs are extremely risky and the average investor should steer clear of them.
"I like VCTs but not as part of an everyday portfolio," he explained. "They’re just really volatile and they usually invest in only about 20 start-ups. You only need one of them to be Facebook and you’re loaded, but the odds are they’re going to collapse."
A long time horizon
Many advisers run shy of VCTs unless an investor has a track record and money they can lock away for a long period of time.
Darius McDermott, managing director of Chelsea Financial Services, says VCTs have a lot of benefits for the savvy investor, but he admits they can be scary if you are not prepared to go in for the long-term.
One of the great things about VCTs, he says, is that because they invest in small, unlisted companies, they are not correlated to the wider market – making them an excellent tool for diversification and one that is often overlooked by investors.
"It’s nice from a diversifying point of view because unlisted companies are not very correlated to markets," he said.
However, he adds that the primary reason investors turn to VCTs is because they immediately offer rewards through tax relief.
"Right away you get 30p back on the pound, so it’s very attractive from that point of view. And the dividends they pay out are free of income tax, so it’s also attractive on that level."
A rich man’s game
McDermott reiterates that the nature of small companies is that they are illiquid and inherently more volatile, so investors need to take a long-term time view.
In spite of the red flags, McDermott says there are plenty of investors who turn to VCTs to supercharge growth in their portfolios, the majority of whom are already wealthy.
"We have plenty of investors who use VCTs, but it is often people who are already maxing out their ISA allowance," he continued. "It tends to be higher net-worth investors."
"For investors who are just starting their savings careers with maybe £1,500 a month to invest, VCTs are clearly not for them."
McDermott says VCTs are often well ahead of open-ended funds in terms of their dividend yields, which are often approximately 5 per cent. Yields at this level are especially attractive because fixed income funds that focus on investment grade and government bonds currently have yields of around 3 to 3.5 per cent.
Types of VCTs
There are two main types of VCT – generalist, which McDermott says are likely to be the first step for investors looking to buy these products, and planned-exit VCTs.
Investors who do not mind taking on high levels of risk to get high returns may want to consider generalist VCTs from providers such as Hargreave Hale, Baronsmead and Northern.
Planned-exit VCTs deliver lower potential returns but add a layer of security by investing in companies with a proven revenue stream. These trusts tend to have a fixed five-year investment period and the majority of returns would come from tax relief.
However, with both products there is no guarantee you will get your money back, so the tax benefit is of little comfort if the underlying companies go bust.
How to buy VCTs
Because VCTs are closed-ended investment vehicles, they are much like investment trusts in that they can be bought and sold on the secondary market. However, if you’re buying a VCT on the market like an equity, you lose out on the 30 per cent tax relief but still pick up the risk of holding small, illiquid companies.
McDermott says the best way to buy a VCT is directly via the provider when they are raising funds.
He adds that Northern, one of the best VCT providers on the market, will be raising money for its generalist VCTs at the end of July.
One major drawback of going down this route, Gleeson says, is that they often require a £10m minimum investment for direct entry. Because investors should not hold more than 5 per cent of their portfolio in VCTs, this means you would have to be running a portfolio of £500m to make it worthwhile.
The ever-present issue of charges is not absent from these types of products either: the barriers to entry for VCTs are often significantly higher than investment trusts or open-ended funds.
The average initial charge for VCTs is roughly 5 per cent, with ongoing charges of around 3.5 per cent. Managers also take performance fees if the VCT does well.
How to sell VCTs
The difficulty of getting out of VCTs is often cited as one of their main disadvantages. McDermott again stresses that investors need to hold these companies for the long-term and should not expect to be able to sell them easily.
There are ways out of the market, but investors do need to be aware of how much these cost.
"Often the existing provider will buy [the VCT shares] back, but you can also sell them on the secondary market," he said.
"However, they always tend to trade on a discount to net asset value."
Another thing investors need to consider before they even buy into a VCT is how much a company may charge to buy back shares.
"You do need to check the buyback structure," McDermott said. "If you get 30 per cent tax relief on the way in but get a 20 per cent penalty on the way out, it’s not as attractive."
McDermott says VCT providers Hargreave Hale and Baronsmead have the best share buyback schemes in the business because they only charge 5 per cent.
"You’re only going to technically lose 5 per cent on the way out," he said.
