Ben Yearsley: Right type of VCT is well worth a punt

It is sometimes easy to lose sight of the point of investing, instead getting caught up in other issues such as tax, risk and timing. This is especially true of venture capital trusts. Many people focus either on the tax breaks or the excitement of investing in risky, high-growth, entrepreneurial companies. What often gets forgotten is the purpose of investing in a VCT is to make a profit, and that profit is generally distributed over the longer term via tax-free dividends.

As VCTs have evolved over the past decade the industry has consolidated. There are now fewer management groups, but they are larger and better resourced. Managers have also become more conscious of the importance of delivering consistent dividends to attract investors. Having been a proponent of VCTs for many years now, I for one love the tax-free dividend cheques that come through the letter box.

VCTs are speculative funds investing in small and entrepreneurial companies. Investment limits, like ISA limits, are tax-year specific. You either use the annual allowance or lose it. However, the annual limit is large at £200,000. The VCT shares have to be kept for a minimum of five years to retain the upfront 30 per cent income tax relief, and any dividends or capital growth are tax free. Due to the risks involved they are for more sophisticated investors.

With interest rates close to zero, investors are increasingly searching for alternative sources of income. While VCTs historically had erratic dividend payments primarily based around profitable sales of companies, greater emphasis is now being placed on deal structures that provide regular income for the VCT, which can then be distributed to shareholders. The method is to provide the majority of the investment as a loan to the underlying business with a smaller amount in shares. As well as providing income, loans rank ahead of equity in the event a business fails, making the deal less risky if the company has assets that can be sold.

How well are VCTs faring in delivering these dividends? There is currently £2.5bn invested in VCTs, ranging from high-risk, early-stage start-ups to limited-life VCTs that seek to control risk and are mainly for the tax breaks. In between sit traditional, generalist VCTs. Last year £123m in dividends were paid out by the VCT sector as a whole. From the present capital base this equates to an average dividend yield of just under 5 per cent, tax free. In times of very low interest rates, this is an attractive yield, and definitely one worth considering if you have a large portfolio. When choosing VCTs it is a good sign of a successful VCT manager if they have consistently paid a high level of income without depleting capital.

So which of this year's offers to look at? Thankfully after last year's solar VCT bandwagon, this year provides a return to normality. The majority of offers are either top-ups to existing VCTs or limited-life offers with established records. I have always been sceptical of limited-life VCTs designed to offer the tax break with little investment into proper, growing businesses. It is clear HMRC want VCTs to focus on long-term, growth-orientated companies. Therefore my suggestions are unashamedly all traditional, generalist VCTs: Maven Income & Growth, British Smaller Companies 2 and Edge Performance H Share.

I would strongly urge reading the relevant prospectus prior to investing, but as a very brief summary, Maven looks to back profitable companies in a broad range of areas. It has particular expertise in the oil and gas sector, which is not normally found in VCTs. British Smaller Companies 2 historically had a technology bias, but in recent years has broadened its approach. It tends to invest in earlier-stage businesses than most VCTs, consequently is higher risk, but offers the potential for higher reward. Finally, Edge Performance H Share aims to profit from the exciting growth available in the media and entertainment sectors, fields in which the UK excels.

Importantly, each of these funds invests the majority of its portfolios in the areas that VCT legislation always intended. I believe today's absence of bank lending is presenting plenty of opportunities for just such funds. Venture capitalists are in a strong position and small, successful companies starved of investment are accepting capital on favourable terms to investors.

Ben Yearsley is investment manager at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent