Can you trust venture capital?

The panel members on the BBC TV show Dragons' Den who recently bought into contestant Levi Roots' start-up venture look to have made a sound investment Sainsbury's has just agreed to stock his Reggae Reggae Sauce in 600 of its stores. But investing in start-up companies through venture capital trusts (VCTs) has proved far less rewarding for the typical investor. VCTs invest in small firms (since April, only firms with assets of no more than £7m are eligible), aiming to grow the firms prior to selling or floating them. To compensate for the risks, the Government has offered investors a series of generous tax breaks. From 1995 to 2004, investors could claim 20% tax relief on their investment which jumped to 40% in 2005 and 2006, before falling to 30% this year as long as they keep their money in the trust for at least five years.

A third of venture capital trusts show negative returns

But even after 20% tax relief, a third of the VCTs monitored by Tax Efficient Review (TER), all at least three years old, have shown negative returns, says Ben Laurance in The Sunday Times. According to Martin Churchill of TER, this is because many VCTs were launched around the turn of the millennium when equities were sky-high and so suffered badly when the bottom fell out of the market. Another reason is that "lemons ripen before plums". In other words, when you buy a pool of small risky firms, some will turn sour quite quickly; but sound investments take time to emerge typically five years or more.

On top of this, fees are "eye-watering", says Laurance. Churchill estimates that the initial charge on a typical VCT is around 5%-6%, while management fees come in at 3%-3.5%. And if the VCT does well, you will usually have performance fees to pay once certain return rates are reached. Not only do these costs wipe out the tax gain (certainly for those who invested on 20% tax relief), but they also compare very unfavourably with charges on a standard tracker or exchange traded fund (below 0.5% for the cheapest options), or even a typical actively managed fund (1.5%).

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Venture capital trusts can be illiquid

VCTs can also be illiquid, warns Thisismoney.co.uk tax relief does not apply to second-hand VCT shares, eliminating a key attraction for new investors.

Of course, not all VCTs have performed badly one of Foresight's technology VCTs, launched in 1997, has delivered an internal rate of return of around 30% a year since launch, or 19% excluding tax relief, says Laurance. Advisers asked by Thisismoney.co.uk, including Ben Yearsley of Hargreaves Lansdown, tip the Foresight 2 VCT, which is accepting new money, as a good bet for anyone interested in getting into the sector. But we suggest that investors should ignore those seemingly tempting tax breaks there are cheaper, more transparent homes for your money, such as exchange traded funds; these also offer exposure to a range of exotic markets (see www.ishares.com).