Friday, 7 May 2021

Review: Can You Trust VCTs?

My investment instincts are pretty simple, using yield as a signal for out-of-favour securities. However yield has led me to dabble in an area that I would not normally have expected to be involved in Venture Capital Trusts

But I have invested in one - what has my experience been?

Venture Capital Trusts (VCTs) are fairly exotic investment vehicles (to me, at least) - they are fully-listed companies whose shares are traded on the London stock market and whose principle activity is investing in other companies that are seeking capital. Those underlying investments must be predominantly in businesses which meet specific qualifying conditions, and are usually in private (unlisted) companies, but can also include those quoted on AIM and ISDX. Their key advantage is the tax treatment the original investors receive if their money stays put for at least five years.

VCTs must distribute 85% of their investment income, so their typically low dividend cover is not a factor (as it would be for most dividend shares). VCTs do not usually generate a lot of income but rather rely on making net capital gains: the dividend is paid mainly from (hopefully judicious) liquidations of holdings in companies.

A VCT manager aims to provide not only capital but also significant input and advice in helping each company to achieve its business plan, in order to generate capital profits at exit when the business is sold. A VCT will typically look to exit each investment after between three and seven years, by way of a trade sale, a public flotation or a sale to another private equity manager. All or part of the gains generated on the sale of an asset can then be paid out to the VCT investors as a tax-free dividend and the remaining proceeds are reinvested in further investment opportunities.

Consequently there is potential for significant rewards from VCTs which invest in these successful companies, but there is also more risk attached to owning such shares than there is with larger companies. VCTs are principally aimed at investors who understand the nature of smaller company investment, can afford to take a longer term view and accept that the value of their investment can go down as well as up.

Now, I don't pretend to fully understand the inner workings of VCTs. As far as I can see, it boils down to this: they provide capital to smaller companies in exchange for a stake in the company - if the company is successful the VCT can sell that stake at a profit. VCTs invest in many different companies, to offset the risk of any of them failing. Because the original investors' money is 'locked in' for at least five years, the VCTs can invest for the medium term. And because of the diversification, there is some risk mitigation. But it must be understood that VCTs are often working at the very risky end of the market: not all of them will make money for their investors.

Choosing the right target business is obviously the key skill and VCTs use professional managers to help them do this. Knowing when to cash in and - conversely - when to walk away (at a loss) are also key skills. Much like running the DIY Income Investor portfolio.

Rather than investing in VCTs by subscription, there is another way to invest in VCTs: via the shares of the VCT company itself, which are quoted on the LSE. 

My first (and only) selection in this field was Maven Income & Growth VCT PLC (LSE:MIG1) -  which has been running since 2010 and is described on their website as "a generalist VCT which aims to achieve long term capital appreciation and generate maintainable levels of income for shareholders". A 'generalist' VCT invests in a wide range of sectors.

I've held this share for a while - with mixed results. The current yield is nothing spectacular - under 5%. The value of a VCT is measured by its Net Asset Value (NAV) per share based on valuations of its different holdings. As these are mainly unlisted companies, the NAV is by its nature uncertain - and hopefully conservative. Nevertheless, MIG1's NAV seems to have more than halved over the last five years and the shares are currently trading at a discount of around 6% to NAV - indicating that the market is not too keen on it.

However, there are a few things to keep in mind:
  • the dividend is variable: it was 4p in 2020 and 12.55 in 2019. VCTs distribute cash as and when it becomes available from sales of holdings - they must release 85% of their investment income.
  • any dividend paid reduces the NAV by the same amount - so there is an element of 'robbing Peter to pay Paul'.
  • the number of shares has varied over time, as there have been more capital-raising events.
  • the company is buying back shares when the NAV discount is between 5% and 10%

The 2020 Annual Report describes the VCT's approach in more detail (page 13). In particular there are maximum holdings to ensure diversification and no borrowings (as of the date of the report, although up to 15% of NAV is permitted).

So, how has my investing experience been? This turns out to be a rather complicated calculation.

I have a fairly big holding consisting of a number of investments made at different times. Overall my holding has lost 38.1% of its capital value. I don't keep details dividend records but the highest price I have paid in the past is 68.25p per share in 2016. Since then dividends have totalled 34.21p. Added to the current share selling price of 41.40p gives a total return of 41.40+34.21=75.61-68.25 = 7.36p or around 10% over 5 years - not brilliant. The later (and cheaper) purchases have had slightly better returns.

My conclusion is that MIG1 has been a disappointing use of my cash over a number of years - but it has at least not lost money overall. Nevertheless the current yield is below what I expect. Granted that 2020 has been a dramatically difficult year - especially for new businesses tying to establish themselves - it may be worth waiting a year or so before selling, to allow the share price - and NAV discount to recover.

I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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