An income alternative

Patrick Reeve, managing partner of Albion Ventures, explains why private equity VCTs are a good option for income seekers. 

VCTs offer a different asset class for investors clamouring for decent levels of predictable income. The benefit of recommending a generalist private equity VCT, in addition to the tax incentives, is the immediate diversification it gives a client.

For income investors the benefit of a tax free dividend is clear; however it is the nature of their investment strategy that makes VCTs suitable as long term income vehicles.

Private equity is traditionally viewed as a growth investment. Funds have to wait for corporate activity of the underlying investment to realise any significant returns; typically an IPO, M&A or a recapitalisation. Investments need to mature before an exit, and therefore, a gain is crystallised. The money involved is large and is therefore suited to institutional levels of investment.

VCTs operate at a different end of the market. Their investments are in much smaller companies, but equally their portfolios tend to be highly diversified, with up to 50 individual holdings. While investment exits are very valuable, within a fund they are not the only mechanism for a VCT manager to generate returns for investors. Many VCT managers structure their investments specifically to generate income for the fund. These can be held for many years to create a powerful revenue stream. If loan stock continues to deliver returns and the company is profitable then we are under no pressure to sell.

Added benefit

We took the decision in 2003 not to use external bank debt in any of our investments which means that interest on debt within an investment comes to us rather than to the bank. This further helped the revenue generation of the fund as it removed an external financier from the equation and it has also had the added benefit of reducing investment risk at a time of some considerable financial upheaval. The high-yielding loan stock that this allows us to create, secured on real assets such as property, provides the steady income further boosted by large exits from the higher risk investments.

The ability of the fund management team to manage income and gains within the fund and to be able to distribute steady, sustainable dividends needed by income investors is crucial. Retaining profits to distribute over time, therein smoothing out any lumps, provides this consistency. Steady dividends also support the share price as dividends are also tax free and are therefore attractive as income stocks, since most VCT shares trade at a discount and can bought cheaply relative to the dividend yield.

So what are VCT managers actually investing in? As is widely reported (and despite their protestations to the contrary) banks are still reluctant to lend to smaller businesses. This is obviously a perfect cue for VCTs to step in and, indeed, generally we see non-bank financing becoming a theme for the future.

But we live in an uncertain and fast changing world and the sectors that we invest in need to have a strong degree of longevity, far beyond the current business cycle. The areas that we have chosen to really concentrate on (though not exclusively) are healthcare and the environment as these are confronted by the inexorable pressures of ageing and adverse weather.

But it does take time to show investors a decent return. Typically, a VCT portfolio takes three to four years to invest and then another three to start to mature. A new VCT would usually take around five years to start paying an attractive dividend to shareholders and many investors cannot wait that long while interest rates are so low. This is not the case for top-ups to existing VCTs.

One of the interesting features about the VCT offers available this year is the number of top-ups. A top-up is a new share issue to an existing VCT; a linked top-up spreads a subscription across a number of a manager’s funds.

The reason a number of VCT managers are offering linked top-ups relates to risk and income. Investing into a number of funds reduces risk and as the funds mature, the companies within the fund will inevitably be at different stages of development with some new and some older investments.

Older investments tend to be less volatile and more cash generative than more recent investments. For investors, the earnings stability of an investee company allows the manager to recoup consistent cash and, rather pleasantly for the shareholder, older larger companies tend to be more profitable.

A win-win situation

For advisers with clients that require income immediately, a linked top-up has clear income paying advantages since the dividend stream has already been created across a number of funds. Investors do not, therefore, need to wait for a portfolio to be created and dividends to rise to an attractive level. It has the potential to be a win-win situation with investors receiving an attractive dividend in the same year that they took the 30% income tax relief.

A final and often overlooked advantage of a private equity VCT investment is that since each trust is listed on the London Stock Exchange as a ‘plc’ it will have its own independent board of directors. The directors hold the portfolio managers to account and ensure that they are delivering their mandate in line with shareholder expectations.

VCT shareholders also ensure accountability as they engage and challenge portfolio managers on performance and strategy. For example, over 200 shareholders attended a recent meeting to talk to us about our performance and investment strategy going forward which only occurred because of the transparent structure of VCTs.

The right VCT

The end of the tax year is now less than three months away so the VCT season has plenty of time for advisers to consider the current offers. For advisers with clients seeking income the right VCT can potentially provide not only the dividend level required, but some welcome asset diversification and, of course, those well known tax breaks.