Eliot Kaye, director at Puma Investments, reveals how to make a million from venture capital trust investment.

“Ask the audience or phone a friend?” The words are familiar to many from the iconic game show that offers contestants the opportunity to win a million pounds. But there is, perhaps, an easier way of becoming a millionaire – venture capital trusts (VCTs).

From the moment one makes their first VCT investment, they could be on the way to becoming a VCT millionaire in just five years. In theory, it is possible.

So, how does it work?

Well, if a client and their partner each invested £50,000 in a VCT on a yearly basis, annually re-investing the 30% income tax break and all dividends received (tax free), then, with a fairly modest annual return of 5% on the investment, it would take just five years to hit that million pound mark (see table below).

Historically, VCTs were an alternative asset class which many investors, especially those with a lower appetite for risk, steered clear of.

However, with the annual pension allowance now reduced to £40,000 and a number of VCTs delivering attractive returns, the vehicles are starting to gain more prominence in many people’s portfolios, including as a useful supplement to a pension. As investors seek to invest as tax efficiently as possible, those VCTs that pay out income (tax free, of course) look particularly attractive.

In the tax year just gone, more than £400m was raised for VCTs. The lion’s share of this was invested in VCTs that follow the traditional “venture capital” model. For these investors, the opportunity to reap the potential rewards of getting in early in the life of a young, dynamic company is the main appeal.

However, choosing investments on this basis can be risky – investing in early stage companies is fraught with obstacles and many promising businesses will simply fail to live up to expectations.

A Low Risk Alternative

There is another way for the canny investor wishing to use the attractive tax breaks offered by VCTs without taking such risk. Just under one quarter of the funds raised last year were invested into so-called “planned exit” VCTs. These funds make their investment primarily by way of asset-backed, secured loans.

The Department for Business, Innovation and Skills recently released a report entitled Boosting Finance Options for Business which noted that, since the financial crisis, “the UK has one of the highest SME loan rejection rates in the European area” and that “the decrease in the supply of loans to SMEs in the UK has been much sharper than elsewhere”.

VCTs are helping bridge this gap by lending to smaller companies and, with the banks essentially shut, many managers have a strong pipeline of established, well managed companies to make loans to.

A major advantage of these fixed-term loans is that they give VCT managers clear exit visibility on each investment made and the security taken in the business provides the all-important downside protection for investors.

Many of these planned exit VCTs are, therefore, able to undertake that, after expiry of the requisite five-year shareholding period, they will put a vote to shareholders to put the VCT into a solvent liquidation. Therefore, shareholders in these VCTs have no need to worry about liquidity in the secondary market as investors are effectively guaranteed an exit after five years.

Track Record

Although the tax breaks are attractive, they should not be the sole reason to invest in a VCT.

Investors need to pay particular attention to the manager’s track record, as this is crucial if an investor is to gain reward for backing smaller companies.

It is also worth noting that VCTs continue to receive support from the government and it seems unlikely there would be a change in legislation that might adversely affect investment in a VCT and/or any tax reliefs.

Indeed, the AIC’s May 2013 report VCTs: Investing for the future made the point that the tax paid by VCT investee companies in one year alone was equivalent to 82% of the total upfront tax relief available to VCT investors. In short, the Exchequer is getting value for money.

Of course, not all investors can afford £50,000 per annum investment but, with most VCTs accepting investments from as little as £5,000, there is likely to be an option suitable for any client’s portfolio. Even if they do not hit the million pound jackpot, the tax benefits and impressive track records of several managers mean VCTs could be a valuable addition to any portfolio.

See the article here on the Professional Adviser website