Why you should steer clear of venture capital trusts

You want to save yourself a bit of tax? Well, of course you do. Tax is the greatest personal wealth destroyer there is. So you do all you can to pay as little of it as possible. You put money into your pension. You use your full Isa allowance. You buy Aim-traded shares that are exempt from inheritance tax and stamp duty. And you think about investing in things such as venture capital trusts (VCTs) and enterprise investment schemes.

But here’s a question for you. How much of any tax you save are you prepared to give up in fees to the guy who structured the tax-saving product?

With Isas and Sipps you don’t have to worry too much about this – you don’t pay much extra for the wrappers and transparency is gradually competing prices down anyway. The tax saved goes directly to you. But look to the rest, and it is another matter altogether.

VCTs were designed to encourage UK investors to invest in unquoted companies. You hand over up to £200,000 and you get 30% income tax relief on it; any dividends come tax free, and if you hold for five years, capital gains do too.

For investors the attractions are obvious. UK tax rates are high and likely to get higher and the amounts we can save into pensions are being cut.

But put money in a VCT and, once you have added up the reliefs, you can afford to make a great deal less on the investment than you would have on a regular investment, but still be better off.

Say you expect to pay £70,000 in income tax this year. You invest £200,000 in a VCT. You can claim £60,000 back straight away – an instant effective return on your money of 30%, courtesy of HMRC.

For providers, the attraction is also more about the structure than the product. They know you just made 30% for doing nothing. And they know that you have to stay with them for five years to keep it – and that as long as you stay ahead, you either won’t mind or won’t notice that you’re sharing your 30%. That puts them in a better position than most fund managers to fleece you.

So to the charges. Most VCTs come with management fees of 2-3% a year. They also have initial charges of about 5%t, though platforms may discount some of this.

Then there are ‘normal annual running costs’. Add up the management costs and the other ‘normal’ costs and it can come to 3.5%. Next there are ‘arrangement fees’.

You may think that arranging investments should be covered by the annual management charge, but it isn’t. There is a fee of something like 2% for each investment actually made.

You get the picture. Over five years, all this is going to eat up close to the 30% you saved on income tax. The running costs alone will do over half the job.


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But you’ll have made loads of money, right? Not necessarily. Average VCT performance isn’t madly impressive. Even if it is, we must look to the performance fees that are the icing on your manager’s cash-take cake. I get a lot of complaints from readers (note to industry: my readers are your clients) about this.

A recent one concerned VCT manager Albion Ventures. Last year, at the same time as proposing a sensible merger between two of its funds, it suggested that the incentive arrangements for the managers be changed.

One of the funds had a performance fee that was to pay out at a rate of 20% of any rise in net asset value above 8% in any one year, providing that the firm’s net asset value was above its launch value. Now, I hate all performance fees, but this one did at least have the virtue of being relatively difficult to achieve.

The managers clearly thought so too. So they changed it – to RPI (retail price index) plus 2%. I hardly know where to start with this. It’s less than a bank account offers in normal times.

Performance fees are supposed to be paid out for genuinely superior performance, but for an investment as risky and volatile as a VCT, 2% over inflation isn’t superior. It isn’t even acceptable. For that kind of risk, you should be insisting on inflation plus 5-6%.

I asked Albion about this. They were helpful. They said they know it is a “sensitive issue”. So, to “help” shareholders, they aren’t now going to take 20% of the “excess performance” should they ever improve performance enough to hit even their newly enfeebled targets. Only 15%.

Albion’s definition of what is and what is not exceptional is not, I’m afraid, an outlier. Another reader writes in to complain about a ProVen VCT. It has a complicated performance fee, but it boils down to the managers having to produce a total return of about 26% from the level of net asset value in 2011 or a return of the base rate plus 1% from the same start date – whichever is greater.

I think we can all agree that 26% is a perfectly reasonable hurdle over the medium term, but it is worth noting that if the UK base rate ever normalises (if…), it wouldn’t take too many years before the base rate plus 1% was more than 26%.

It’s still not the long-term inflation plus 5-6% that I think makes sense at this kind of risk level. Note that you can get 3% on a five-year fixed-rate cash Isa with Leeds Building Society for no risk at all.

One day someone will set up a good VCT. Its prospectus won’t justify high and complicated fees by blathering on about “industry norms” and “normal VCT practice”, but will be set out in a clear and comparable way.

There won’t be a performance fee based on matching cash Isas. And it will be sold on the basis that the investments are exciting, rather than on the basis that it will save you tax. On that day, investing might be a good idea. Before then, I’d steer clear.

A press release out this week said funds were pouring into VCTs as investors “become much more comfortable with the sector”. That may be so. But anyone becoming comfortable clearly isn’t reading the small print.

• This article was first published in the Financial Times.

• This article was adjusted on 24 February 2014 to add more detail on the ProVen VCT fee structure. If you want more detail, you can read all about it on page 26 here

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11 Responses

  1. 18/02/2014, mr clyde wrote

    Yes, VCT charges are excessive and managers ‘get away with it’ because investors are blinded by the tax relief on offer. But are they a bad investment? Not all VCTs are the same and in some the risk is badly mis-priced. I have invested in VCTs since 2005 and run a small algorithm to drive my selection each year. I have yet to read any of the prospecti(?) let alone the small print, yet am very comfortable with my overall compound return of ~18% pa (tax free) on the capital invested over the last decade. Sometimes you just have to know when to hold and know when to fold!

  2. 18/02/2014, Biometrician wrote

    Hmm. “You can get 3% on a five-year fixed-rate cash Isa with Leeds Building Society for no risk at all.” Any chance that interest rates will rise so that I regret being tied in for 5 years? The 30% tax rebate that I shall get on my recent VCT purchase really is without risk, and will be in my bank within a few months. I’ve had money in VCTs since the 90s and done well. I don’t like paying charges (any more than I like paying tax), but the universe in which VCTs must invest is complex. Read a few annual reports and you’ll see that evaluating the tiny companies that are candidates for investment must be time-consuming (which is not to say that VCTs always make the right decisions, only that they have to put in expensive time). And, for what it’s worth, the money goes into British very small enterprises. My holdings were chosen for income and I’m still getting 7% pa with no tax payable. Some VCTs perform badly, some are run by schysters (I had and sold a small holding in the Albion VCT you mention). But if you dismiss all VCTs as high-risk, expensive and unreliable you loose an opportunity.

  3. 18/02/2014, Rob C wrote

    Charges are undoubtedly high. Unfortunately, Merryn always focuses on cost and dismisses value. With VCTs you get tax relief up front but there’s also the dividends which, whilst already franked at the basic rate, have no liability for higher rate tax payers. For this reason VCT managers will try and distribute profits as dividends rather than a return of capital. You need to see the total return of capital and dividends. For a properly informed comment go on line and Google: Tax Efficient Review and/or Tax Shelter Report. Merryn may like to have a chat with these guys.

  4. 18/02/2014, DiggerBarney wrote

    I’ve got to say that, like Mr Clyde & Biometrician, I’m not entirely on-board with Merryn on this issue. She’s tarring all VCT providers with the same brush – unfairly in my opinion. Whilst many or all may charge highly for their service, some provide good value for money and to my mind value is more important than cost. I’m more likely to buy a Mercedes, BMW or even a VW than a Proton or whatever.
    I’ve invested in VCTs for many years and have found Baronsmead & Northern to be excellent providers. My satisfaction is based on the high tax-free income that is provided and the increased capital value compared to my net investments – what else matters?
    Any time that these particular providers look for top-ups I’ll be jumping in without scrutinising the small print in great detail. By the way – for anyone interested Baronsmead has a current top-up offer which I have subscribed to (as have many others – the allocation is disappearing fast!)

  5. 18/02/2014, IanB wrote

    I agree with the comments above. I think of VCTs as a sort of annuity that is available to younger people. In my 30s I put some money into a range of VCTs, and have since, after allowing for the tax rebate, received tax free dividend income of over 5% per year ever since. Getting the capital back is probably difficult, but I don’t want to, and in my mind I have more or less written it off (yet if I needed to, a forced sale would probably return well over half my original investment).

    5% tax-free in perpetuity is more than worth my original outlay, and I wish I had bought more. I am not so sure they’re such a good choice for anyone approaching retirement, however, because of the risk.

    I am less convinced that they are such an attractive investment

  6. 18/02/2014, mr clyde wrote

    If not all gone already!

  7. 18/02/2014, alan wrote

    Couldn`t agree more with the author. From the 5 VCT`s I have together with my wife, since the year 2000 the best, Northern VCT2, is down 22%. Of the others, 3 have changed their name and management one more than once, 2 of these are down 80% and 1 *50%. while the last one, that had at least the decency to stick to it`s original name, is now down just over 60%. Of course the `new` management only has to achieve the capital that the last management left and all still claim the 30% tax allowance as if it was they and not the gov. that gave it.
    In effect I`ve been paying myself the dividends out of capital and not one `special dividend` was had.
    These were all as recommended by my advisor.
    I wouldn`t touch any VCT`s or EIS`s and would be very careful with anything the government is `giving` with a tax incentive.
    My worst investments ever.
    regards
    alan

  8. 18/02/2014, mr clyde wrote

    Alan, I suggest you change your advisor.

  9. 18/02/2014, 4caster wrote

    I agree with you Merryn. I invested in some VCTs in 2001. The only one that did any good invested in residential property and paid a predetermined return. Those deals were banned shortly afterwards.
    I invested in another VCT whose only asset was a big hotel in the home counties. The VCT owned the freehold, and I figured that, even if the hotel business did badly, the property and land should more than compensate.
    What did the managers do? They sold the freehold and rented the hotel back. They then invested the proceeds into another hotel business, also rented. Both businesses were loss-makers.
    What are the odds the VCT managers were investors in the freeholds, setting an impossible rent for the VCT, and making a packet out of the misfortune of investors?

  10. 18/02/2014, Woodberry wrote

    I’ve just invested (modestly) in a VCT for the first time and this article crystallises the worries that I have developed about the process. Two aspects bother me in particular:

    1 A number of prospectuses do not seem to use standardised total return data (like OEICs do) and focus on that. They cite successful investments but it is sometimes difficult to extract the figures on overall return – which is what matters. In addition some take the 30% tax-rebated capital sum as a starting point for measuring performance. In other words dividend yields and capital growth are not related to a baseline of the original sum invested, but to a singnificantly lower baseline of 70% of that figure. The tax relief is mine, not theirs, and it rewards me for the extra risk – it should not be a cushion for them against poor performance.

    2 I see that the firm’s staff usually co-invest with the VCT. Does anyone know if they carry the same charges as we do or are the costs of investigating prospective investments loaded onto the VCT investors?

    Having looked at performance data, I accept that it does look as though some do indeed make gains based on the original sum invested by shareholders. And I don’t mind paying for good service or successful investment. I do, though, feel that if the VCTs are as good as they say they are they should not need to rely on doubtful logic about where the the tax benefits accrue to attract investors.

  11. 19/02/2014, alan wrote

    Believe me I did get rid of my advisor and sued him and got 50k, unfortunately these vcts had just been bought so couldn`t be considered a loss on bad advice at the time and I had to sign for the insurers that this was settled.
    They are since down double that.
    Prepared as an investor to take a loss but 5 out of 5 seems more than a coincidence and the often used tactic of changing names and swopping executives
    a bit iffy to say the least.
    Is there anybody `straight` in the finance industry ?

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