Barely a week goes past without exhortations from the government to set up in business or give support to enterprise and entrepreneurs.
One way of doing this is to invest in funds that provide capital for new business start-ups. This type of finance, known as venture capital, has been encouraged by the government through very generous tax reliefs. In fact, it’s the most tax-efficient investment that anyone can make.
Venture capital has become all the more important for fledgling businesses these days given the well-publicised problems that companies of any sort are having in obtaining loan finance from banks.
So I was surprised to read last week of a move by the Financial Services Authority (FSA) that would have the effect of putting venture capital trusts (VCTs) beyond the reach of private investors.
Its consultation paper on restrictions on the retail distribution of unregulated collective investment schemes sets out proposals to ban the promotion of such schemes and similar funds to ordinary retail investors in the UK. VCTs have been included in this category, creating a severe restriction on the ability of the vehicles to be promoted to retail investors.
The Association of Investment Companies has taken up the issue with the FSA. Ian Sayers, AIC director-general, said: “VCTs are listed investment companies overseen by an independent board and regulated by the listing rules and company law, in the same way that investment companies are. We will be calling on the FSA to exclude VCTs from the proposals, in the same way that investment trusts have been excluded.”
The effect of the ruling would be to restrict the sale of VCTs to “sophisticated or high net worth individuals”. But who is to define exactly who these are?
The move is part of a wider drive by the FSA to restrict the promotion of more unorthodox investments and assets in the name of investor protection – or perhaps more accurately, protecting investors from themselves. Even though independent financial advisers and brokers would stress the high-risk nature of VCT investment (and it would be remiss if they didn’t), the assumption here is that investors are not capable of assessing these risk warnings and that “nanny knows best”. The long-standing principle of caveat emptor which has been central to the investment market for centuries is now being widely discarded across the financial services sector in the face of a tidal wave of legal actions and mis-selling claims.
So what are VCTs and why are they so risky? First introduced in 1995, they are investment trusts specialising in very small and untested companies which are looking for money to build their business. The businesses in almost every case have no track record and profits may be some way off – assuming any are ever generated. So they are inherently more risky than a conventional investment trust.
Many people can – and do – lose large amounts backing companies that subsequently fail. The idea that every new high-tech start-up is the next Microsoft or Google is for the birds; such successes are very rare. Indeed, because of the high risk of loss – and that can be 60 per cent or more of the sum invested – these are not for widows or orphans.
However, the FSA notwithstanding, the government wishes to promote venture capital. And a key attraction of VCTs is their tax benefits. Taxpayers receive an income tax rebate of up to 30 per cent of the sum invested in a VCT. You can invest up to £200,000 a year in a VCT and receive income tax relief on the entire sum. For this reason, they are indeed attractive to high net worth individuals keen to mitigate their annual tax liability.
Dividends paid out by a VCT are free of tax and any gains made on investing in a VCT are also exempt from Capital Gains Tax.
Too good to be true? These generous income tax rebates are restricted to purchases of new issues of shares in a VCT or a top-up, and not on shares of VCTs bought on the secondary market. And you have to hold your investment for at least five years to qualify for the tax benefits. On any sale within the five-year period, the tax rebate has to be paid back.
Some VCTs have performed spectacularly well. But for every one of those there is a long tail of those that have not performed well or have incurred substantial losses – it is little wonder that investors tend to invest in top-ups where a VCT with a good performance record offers new shares. But this is subject to the same cautionary note that governs all investments: a good track record in the past in no way guarantees that such a positive record will continue into the future.
So, these are not investments that will be appropriate for everyone. But all that said, it would be a mighty loss to the industry – and to the equity market generally – if only large-cap, “proven” investments were open to the private investor. Equity by its nature is inherently risky. While the FSA proposal is well meant, it could starve Britain’s enterprise sector of vital capital – and just when it needs it most.