Venture capital trusts: what are the risks when investing?

The centre of Brixton in south London is not the usual sort of place to find a gaggle of City private equity investors, but they're delighted to be there. They are the proud 50% owners of the Ritzy Cinema , one of the earliest purpose-built cinemas in England, opened in 1911 under the name of The Electric Pavillion. Today it's a thriving multiplex, offering blockbuster films next to arthouse projects, and has just benefited from a multimillion-pound makeover financed by a venture capital trust (VCT). Albion Ventures has invested in eight Picturehouse cinemas alongside operators City Screen, helping the company expand across the UK. Meanwhile, Albion investors are enjoying a steady stream of dividends, which, crucially, are entirely tax-free. VCTs and their higher-risk relative, enterprise investment schemes (EISs), both enjoy substantial tax breaks, granted by the government in the hope that it will encourage money to go into start-up and early-growth businesses. Until now, their popularity has been limited, with VCTs and EISs regarded as esoteric tax vehicles for specialist high-net-worth investors only. But two factors are making many in the industry confident of a bumper year. Firstly, VCTs are increasingly being structured to pay dividends, usually worth between 3% and 5% a year. That might not sound like much, but dividends paid by VCTs are tax-free, which makes them attractive to higher-rate taxpayers, especially compared to the paltry rates from deposit accounts. Secondly EISs, and to a lesser extent VCTs, stand to benefit if capital gains tax (CGT) rises, as expected, from 18% to 40% in the 22 June emergency budget. Anyone who has made capital gains can put the money into an EIS, receive an income tax rebate and defer paying CGT for the life of the investment Ben Yearsley of financial advisers Hargreaves Lansdown is a fan, and has put his own cash into them. "I think the perception of VCTs as a very high-risk product is wrong. Yes, they have liquidity problems if you want to sell out, but the majority back small, private companies that are already profitable but just need extra financing which they perhaps can't raise from a bank. They don't invest directly in property [forbidden by HMRC rules] but are in businesses where they have a call over the freeholds. Investors should think of them as income-producing vehicles which pay dividends tax-free, rather than risky venture capital projects." Investors can place money in VCTs at launch to maximise the tax advantages, but it's also possible to buy in the "after market" as they are listed on the London stockmarket. That means you can buy and sell like any other share. Yearsley cites Maven VCT as one he bought in the after market, and which has consistently paid a dividend of 4p-4.5p on the 54p price he acquired them at equal to 8% tax-free. But beware: the underlying share price can move around a lot, and market makers carry little or no stock of VCT shares, so selling out is not easy. Financial adviser Allenbridge runs a website called taxshelterreport.co.uk comparing the relative performance of VCTs. A trust run by Albion, investors in the Ritzy Cinema, sits at the top of the table for funds that have been in existence for longer than eight years. But plenty of VCTs have lost investors money, even over quite long periods. Bottom of the table is Spark VCT 2, which has delivered an internal rate of return of -10.9% per annum. Patrick Connolly at adviser AWD Chase de Vere is more cautious. "A significant increase in CGT rates would give a further boost to VCTs ... but because of the risks, these are investments most suitable for high-net-worth clients or high earners." The tax breaks around enterprise investment schemes are likely to make them bigger winners from any rise in CGT. They invest in individual companies, usually start-ups, so the risks are high. Susan Phillips, director general of the EIS Association, says investors should consider a fund of EISs as a way of spreading risk. "If you take 10 EISs, there will be a couple of failures, some in the middle which return your capital but not much more, then some winners which pay off hugely." She cites Snack Time, a business founded in 2001 with cash from EIS investors, which floated on the stockmarket in 2007 and is now the biggest vending machine operator in the UK. But will new chancellor George Osborne pull the rug from under VCTs and EISs? Most in the industry are quietly confident he will leave them alone. According to the Association of Investment Companies, over the five years to 2009, VCTs earned a 67% return on the government's investment through an increase in the tax revenues of the underlying companies they invested in. How VCTs work A VCT typically raises around £5m-10m at launch, which is then invested in 25 to 35 small companies which need capital to expand. Profits from the underlying companies are distributed as dividends. Usually, after five to seven years, the underlying companies are sold and the money made returned to investors, although some are run to produce long-term dividends. What are the tax breaks? Investors receive an initial 30% income tax rebate when they buy at launch; all dividends are tax-free, and there's no CGT to pay if there's a profit on disposal. For example, if you invest £10,000 at the launch, you get a £3,000 rebate via your tax code, or as a lump sum rebate. But you have to hold on to the shares for five years to keep the tax rebate. Minimum investment? Can be as low as £2,000, more typically £5,000. Charges are steep – expect 5% of your initial investment plus 3% annually. How do I buy? Details of current VCT offers at taxshelterreport.co.uk and Hargreaves Lansdown 's site at h-l.co.uk. Buy or sell existing VCTs through any stockbroker. Any tips? Advisers AWD Chase de Vere recommend ProVen VCT ; Downing Absolute Income VCT ; Ingenious Entertainment VCT 1 & 2 More information? Hargreaves Lansdown has a free guide to VCTs at h-l.co.uk. , a subscription-only publication aimed at financial advisers offers reviews of VCTs and EISs. Enterprise Investment Schemes A start-up company raising a maximum of £2m in any business, except almost anything to do with financial services and property. Lots of independently-made films are structured as EISs. What are the tax breaks? A 20% tax rebate on the initial investment (up to £0.5m); no CGT if held for three years; no IHT if held for two years, and deferral of any CGT the investor has made over the previous three years until the EIS is sold. Minimum investment? £500, although funds of EISs start much higher. How do I buy? Only at launch. They are not quoted, so can't be traded on the stockmarket. Any tips? AWD Chase de Vere rates Rathbones/Downing EIS Portfolio and Ingenious Broadcasting EIS . More information? EIS Association , eisa.org.uk