It is well-known that the main attraction to a venture capital trust (VCT) is its tax advantage but they can offer pretty tasty dividends too. 
In a nutshell a VCT is a listed company that invests in small and fledgling UK companies that are either unquoted or AIM-traded and meet a host of different criteria determined by legislation.
In exchange for investing in new issuance of these there is a tax break. If you invest in a new share issue you get a 30 per cent income tax credit, meaning that if you put £10,000 in, when you file your tax return for the year of that investment you get £3,000 back.
Jason Hollands, managing director at Tilney Group, said: “Essentially it is a government backed, state-aided scheme to encourage investment into young growth companies that the government rightly recognises are important to the economy.”
While this may be where the story ends for some investors – for as long as it remains at par investors have made a tidy gain – for the more astute there is the potential to make significant returns through dividends.
“Many investors never sell their VCT shares and just clip their dividends – which by the way are very high,” Hollands (pictured) said.
“VCT dividends are often in the double digits and are attractive to people in the higher rate tax bracket because they are tax free.”
The way it works is that unlike an investment trust or an OEIC fund where income comes simply from paying out the dividends received on the underlying portfolio, with a VCT it pays out all profits in the form of a dividend.
“For example if it invests in a tech business of £1m and four years later sells it for £5m making a £4m profit, it can distribute realised capital as a dividend to shareholders tax free,” he said.
“The logical strategy for many VCTs is to pay out the gains tax free so you can enjoy the return and then if you want to put new money in you can get another 30 per cent income tax credit.”
As such, the capital performance is not really the thing to look at with a VCT, often most of the return is deliberately structured through the dividends.
“That might surprise those unfamiliar with them given the enterprises they invest in are very much high growth companies,” Hollands said.
However, he noted that due to the way income is paid out, dividends can be lumpy and variable and this is likely to become increasingly more so over time given changes to what constitutes a qualifying VCT investment in recent years.
Indeed, the scheme has been refocused on investment into earlier phase, growth companies (typically no more than seven years old) where the outcomes will likely be more variable.
Below, Hollands outlines the three best available VCTs for investors looking to take advantage not only of the tax benefit but the income potential as well.
First up is the £36.8m Maven Income and Growth VCT 3 and £32.4m Maven Income and Growth VCT 4 funds –both generalist VCTs that invest primarily in unquoted companies.
The two funds often co-invest in deals and have a significant overlap in holdings and are currently looking to raise £40m in new capital through a joint offer.
“The existing portfolios are largely mature, already profitable companies that were backed under the old rules and deals into these were typically structured with 70 per cent in loan notes, which helped reduce risk,” Hollands said. “These more mature holdings clearly also provide exit potential over the coming years.”
New deals are being made into younger companies with an innovative technology or a business model that has the potential to challenge an established market.
For example, recent purchases have included anti-cancer therapies developer ADC Biotechnology and compliance solutions firm Contego Fraud Solutions.
Income generated from funds over 5yrs
Source: FE Analytics *Income generated from an initial investment of £10,000 on 12/03/2013
“While neither VCT board has an explicit dividend target, both have a stated objective of generating maintainable levels of income for shareholders and they have paid average annual dividends of over 6p and over 5.4p per share respectively in the past five years,” Hollands said.
The funds currently have yields of 36.05 and 32.32 per cent respectively. Overall they have made a total return of 51.62 and 25.91 per cent.
Up next is the Hargreave Hale AIM VCT 1 fund, which principally invests in AIM-traded, VCT qualifying companies, which provides access to underlying dividend flow from established, listed companies.
However, it also has the flexibility to also take equity positions in private companies too and currently the managers expect to see more opportunities in this space under the revised rules.
“This VCT is expected to complete a merger with its sibling Hargreave Hale AIM VCT 2 later this month (23 March) and the combined portfolio will be one of the most diversified available with 77 qualifying investments, 33 non-qualifying holds plus a position in the Marlborough Special Situations fund which his managed by Giles Hargreave, who co-manages the VCT alongside Oliver Bedford,” Hollands said.
Hargreave Hale has been one of the most active VCT funds in making new investments recently with 22 new investments made over the last 12-months.
The board has a target dividend yield of 5 per cent per annum although the VCT does not offer a dividend-reinvestment scheme.
It is also worth noting that the investment manager is incentivised with a performance fee of 20 per cent of any dividends paid to shareholders of more than 6p per share per annum, provided that the net asset value per ordinary share is at least 95 pence, with any cumulative shortfalls having to be made up.
Over the last five years investors would have received £4,722 from an initial investment over £10,000, as the below chart shows.
Income generated from funds over 5yrs
Source: FE Analytics *Income generated from an initial investment of £10,000 on 13/03/2013
The £61.6m fund, which has made a total return of 64 per cent during this time, has a current yield of 5.21 per cent.
Last up is the Downing ONE fund, which has made a total return of 42.77 per cent over the last five years while earning £3,783 in income payments from an initial investment of £10,000.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
It is a hybrid VCT comprising of an existing portfolio of unquoted asset backed investments which provide a source of income and where deals were structured using loan notes and equity, alongside a portfolio of high growth AIM companies.
Hollands said: “The £92m portfolio is mature and highly diversified with 78 investments. Of these investments, 31 companies were trading on AIM or NEX Exchange, representing 31.5 per cent of the portfolio; 47 companies are unquoted (58.7 per cent of the portfolio), with the remainder held in cash.
“The asset backed portfolio was constructed under previous VCT rules and comprises businesses in the solar and care home sectors and those that are over seven years old; all of which would not be qualifying for new investments.
Other non-qualifying investments include exposure to the Downing Strategic Micro-Cap Investment Trust (5.5 per cent).
Downing ONE has a target yield of paying at least 4 per cent per annum. It currently yields 9.17 per cent.
Hollands also noted that while these investments are attractive, they should not take the place of ISAs or pensions and are not for novices or the risk averse.
“A typical VCT investor will be subject to the higher rates of tax, will be fully utilising mainstream annual allowances such as ISAs and pensions but have further cash to invest and will likely have a significant and well diversified portfolio of existing investments against which any VCT investments will only represent a modest allocation,” he said.
“Investors must also be able to commit to invest for the long-term, because VCTs cannot be sold for five years without sacrificing the tax credit received.”