Where should venture capital trust investors look in 2017?
Readers keen to reduce their income tax liability by investing in newly issued venture capital trust (VCT) shares need to get a move on, as the better ones are being snapped up fast.
However, they should tread warily, as almost all VCTs have higher risk profiles than they did a couple of years ago.
This is primarily due to the tighter criteria for VCT investments that came into force in November 2015.
The most important changes included prohibiting the use of any VCT funds in the acquisition of existing businesses, for instance by supporting management buyouts.
VCT MANAGERS FOCUS ON THE NEW
The new rules have also set a lifetime limit on investment by tax-advantaged funds such as VCTs, of £12 million per investee company (£20 million for 'knowledge-intensive' companies), and banned VCTs from initiating investments in companies that made their first commercial sale more than seven years earlier (10 years earlier for knowledge-intensive companies).
In two more turns of the screw, new rules last March prohibited any new investments in energy-generating projects and restricted VCTs' non-qualifying investments to cash and listed securities.
As planned, the changes have forced VCT managers to focus new investments on younger and smaller companies than in the past, impacting both generalist and Alternative Investment Market (Aim) VCTs.
The managers of Unicorn Aim VCT, for instance, warn that their investments are now more likely to include companies that are not yet profitable and therefore intrinsically riskier.
Just as importantly, the managers of generalist Elderstreet VCT caution that the new rules could impact their ability to provide ongoing support for existing holdings.
Meanwhile, Downing, which has specialised in VCTs making asset-backed investments, says these must now be based around relatively young companies developing new sites, which may raise their risk profile.
The managers of the Amati Aim VCTs say the rules have restricted their choice of investments sufficiently to make them more careful about fundraising, while NVM Private Equity, Livingbridge and Mobeus Equity Partners (who respectively manage the conservatively managed Northern, Baronsmead and Mobeus VCT ranges) are not offering any new shares to the general public for a second successive year.
For the first time in many years there is also no limited life offer from Puma Investments or Downing, with Puma's Eliot Kaye explaining that this is because they are still awaiting clarification on exactly what the new restrictions mean, as there are dire consequences for transgressions.
Meanwhile, Triple Point's so-called limited-life offer requires investors to wait 10 to 12 years for it to wind up, rather than six to seven years as was the norm in the past.
VCTs that already focused predominantly on younger, smaller growth companies have been least affected by the rule changes.
Offers by Proven and British Smaller Companies VCT2, which fall into this category, have already sold out, but there could still be time to invest in Octopus Titan VCT.
Octopus Titan is attractive because it has achieved the best five-year net asset value (NAV) total returns in the generalist VCT sector.
Its large management team, led by Alex MacPherson, looks to invest in a portfolio of around 50 high-growth companies with ambitious managers, most of which operate in technology-related sectors; around three-quarters of each year's investment is devoted to follow-on support of existing holdings.
NEW SHARES GOING FAST
Although Octopus Titan is the largest VCT and has been offering a lot of new shares, these have been going fast.
If they are still available, investors should note that although the trust invests for total returns, it aims to maintain rather than grow its NAV per share, while paying out annual distributions totalling 5p plus special dividends following successful realisations.
A 5p payout implies a tax-free yield of over 7 per cent on shares issued at around 100p, net of 30 per cent tax relief.
On the downside, charges are on the high side (see table below, click to enlarge), especially now that the managers are eligible for a performance fee of 20 per cent of annual total returns.
The Elderstreet VCT offer also looks interesting. Its managers have achieved strong five-year NAV total returns by close engagement with an exceptionally concentrated portfolio of smaller companies, mostly unquoted.
They are seeking a substantial increase in funds because they expect a greatly enhanced deal flow following a November link-up with an Aim-quoted venture capitalist. Draper Esprit has taken a 30.7 per cent stake in Elderstreet Holdings, and has an option to acquire the balance.
It specialises in backing technology companies 'which create new markets or disrupt old ones', and is expected to give Elderstreet access 'to larger deals in companies that enjoy higher revenues and operate in higher-growth sectors'.
The catch is that Elderstreet warns it may have to cut its target dividend by 1p, to between 3p and 4p plus specials, if the top-up offer is fully subscribed.
However, the board says the reduced target will help to deliver consistent returns, and is still attractive as it is equal to a tax-free yield of between 6 and 8 per cent on the expected offer price net of tax relief.
It claims the upside from the link-up will more than compensate for 'any short-term reduction in historic yield'.
TAX-FREE YIELD ATTRACTION
Leaving aside the upfront income tax relief, VCTs' key attraction for most investors is their tax-free yields, which can be funded from capital as well as income.
Most trusts pull out all the stops to meet their target dividends, and like Octopus Titan are content to maintain rather than grow the NAV per share. However, they must be careful not to undermine their NAV by consistently over-distributing, as this may force them to cut their dividend target.
This has happened, for instance, with a couple of the six VCTs in Albion's linked offer for sale, namely Crown Place and Albion Technology & General VCT; Albion Enterprise VCT may be next, as its NAV per share has fallen 14 per cent over the past five years.
This undermines the attractions of Albion's linked top-up offer, as does the fact that Albion Development VCT and Albion Venture Capital Trust are already fully subscribed.
With only four of the Albion VCTs now on offer, later subscribers will not receive the monthly distributions, which are one of the linked offer's attractions.
Unicorn Aim VCT's relatively small top-up offer sold out quickly, as it has a strong record and a highly regarded management team.
Unlike most VCTs, it aims for capital as well as dividend growth, so its distributions have been relatively low, but they have been progressive - rising from 5p to 6.25p over the last five years - and five-year NAV total returns to end 2016 were even better than those of Octopus Titan VCT.
If Unicorn is fully subscribed, those wanting an Aim VCT could consider the top-up offers by the two Amati Aim VCTs, as they have been performing well under the new regulations and the small but experienced management team reports an improved flow of investment opportunities in recent months.
The Amati portfolios are well-diversified in terms of maturity and industry, although the team's penchant for running its winners means they both have several large holdings. Non-qualifying investments are predominantly in TD Amati's UK Smaller Companies fund.
Both VCTs are targeting annual payments equal to 5 to 6 per cent of year-end NAV, indicating a prospective tax-free yield of 7 to 8 per cent on the issue price less income tax relief.
The recently launched offer by the two very similar Octopus Aim VCTs also offers exposure to a pair of well-diversified trusts with respectable records.
Octopus Aim VCT targets a minimum dividend of 5p a year, which it has achieved or exceeded in each of the past six years, while Octopus Aim VCT2 has achieved or exceeded its target of 3.6p a year in each of the past three years.
Buying both secures a dividend every quarter. Both have been successful in restricting their discounts to around 5 per cent, which means those who want to sell in the secondary market get a good deal.
Triple Point Income E shares are the only mainstream proposition in the limited-life section. As stated earlier, the fund has a long life for a limited-life VCT, but it hopes to compensate by targeting a total return of £1.40 per share (i.e. twice the initial price less tax relief), starting with dividends of 5p a year from March 2020.
Triple Point favours investments with capital security, liquidity and predictable returns, which it has found in the past in renewable energy.
With that route closed, it is focusing on sectors such as crematoria, food production, transmission networks and small private hospitals, with 30 per cent of a typical deal in quite high-yielding debt.
In line with previous limited life VCTs, there is a performance fee of 20 per cent for distributions over £1 a share.