Owain Bennallack speaks to Tim Levett of NVM Private Equity about buying second-hand VCTs.
This is the second half of a two-part article. Part one can be found here.
Shunned investments often mean opportunities. Is this the case with the secondary Venture Capital Trust (VCT) market?
Tim Levett thinks so. As executive chairman of NVM Private Equity -- which manages £160 million in funds, including several prominent VCTs -- he probably should. Yet when I met him earlier this week his enthusiasm for buying generalist VCTs at these prices -- and not just NVM's own trusts -- was clear.
"I think there's a short-term opportunity to take advantage of this perception of risk," Tim told me, as he outlined the case for buying the generalist VCTs.
Firstly, VCTs prices have been harder hit than their underlying NAVs so far.
While the value of the companies they've invested in will hardly have soared during the downturn, according to managers' estimations most valuations haven't fallen by anything like the markdown that the shares have endured.
In this sense, discounts that frustrate existing holders may represent an opportunity for new buyers. If the discount narrows as market sentiment improves, today's buyers will make a tax-free profit. As long as the discount doesn't widen further, there's just the big spread to contend with when they sell.
Don't forget the divi
But many won't want to sell anyway because of the most important incentive to buy mature VCTs -- big, tax-free yields.
A VCT's ability to deliver a dividend stream is based not on its depressed price but on its underlying investments, whether through income generated by its portfolio or capital gained by disposals of its investments.
Some generalist VCTs with good track records are now offering double-digit income yields, tax-free.
Consider the Northern 2 VCT (LSE: NVT) trust:
- Market Cap: £25 million
- Current price: 44p
- Dividend last year: 5.5p
- Historic yield: 12.5%
It's not possible to give a reliable forward yield for VCTs, since their income stream is, to put it in technical terms, lumpy. This is because the cash available to pay out as a dividend depends partly on the sale of investments in any year.
Yet Northern 2 VCT has a good track record of decent dividends -- its payout has varied between 5.5p and 8.8p since 2004. And it reported in May that its NAV had actually risen since 31 January, from just under 70p to 72p (I've subtracted out an upcoming dividend that's due).
Investor fear as evidenced by the wide discount would appear misplaced, given that the NAV is growing.
Don't discount those discounts narrowing
In my opinion, at these prices secondhand VCTs are potentially attractive investments for higher-rate taxpayers seeking income. But there's more.
Tim Levett considers a discount of 15-20% is more sustainable for VCTs than the 30-50% now hitting some funds, including his own. If he's right, VCTs on bigger discounts could offer a capital gain opportunity, as well as the healthy yield, if and when the discount narrows.
What could narrow the discount? Institutional activity is unlikely to help -- an income fund probably wouldn't buy VCTs to boost their returns, especially since the tax-free status only applies to private investors.
VCT fund managers hope the attraction of the yield will eventually encourage the discount to close naturally. If it doesn't, some may well consider using cash or debt to buy back shares and manage their discount more closely, especially if they want to raise new money in the future.
There's also the possibility of smaller funds merging, which could make their shares more liquid, although this is something long predicted but seldom actually seen in the VCT market.
On the other hand, the discount could narrow because NAVs fall towards today's share prices, which would obviously be bad news!
Personally, I wonder about the ability of VCTs to sustain their NAVs in the very long term. They must pay out 85% of income generated by the portfolio as a dividend. No such rule applies to capital gains, yet many do seem to pay very large one-off dividends whenever they get the chance, rather than retaining the capital to grow their NAVs.
I'm concerned that over time attractive investments will go at a premium, while less attractive ones stay in the portfolio and the NAV grinds slowly down.
Tim argues this is a bit of a red herring, suggesting the performance of the older generalist VCTs shows a desire to at least maintain a NAV at around the after-tax purchase price of the shares (typically 70p). You'll have to make your own mind up.
You also need to check on the dividend payment history of the VCTs you're interested in.
Don't just go on last year's dividend, which may have been unusually high. If buying for income you want consistent payers, preferably with a stated annual dividend target that looks sustainable.
Finally, if mature VCTs are such a great opportunity you have wonder why the discounts have narrowed so much. Most of the better generalist funds are in the £30 million region. It shouldn't take too much new money to big up prices. Why isn't the smart City money rushing in?
The answer may be that market has the current pricing and discounts for VCTs about right, given the uncertain economic conditions.
VCTs are not for everyone
For very wealthy and likely older individuals facing the Government's new income tax rate or seeing their pension contributions reigned in, some secondhand VCTs do seem to offer an attractive opportunity to generate a substantial tax-free income.
Buying several established VCTs could be an alternative home for some of the money earmarked for an annuity, too.
Remember that VCTs are far more risky than an annuity, though, so consider carefully what proportion -- if any -- of your money you put in them. I wouldn't allocate more than a fraction.
That said I'm not sure it's trivially true to say the big funds from the likes of Baronsmead and Northern have been particularly more risky compared to other quoted investments. At a time when the FTSE 100 is down 30% over 10 years and blue chips have gone bust, "risky" in terms of volatility seems rather moot.
Tim suggests investors might even check out the annual reports of VCTs to see what they're putting money into and to take a view on their strategy, though I think few of us have the expertise to make more than a broad brush judgement about such investments. To be clear, I do think VCTs are risky and opaque. I'm just pointing out that far more straightforward investments like trackers have also proved poor and volatile performers in the past decade.
The illiquidity and discounts are definitely very real issues for VCTs, though.
So for investors of more modest means, the case for putting any money into secondhand VCTs isn't so compelling.
Most people don't even use up their stocks and shares ISA allowance, which permits a much wider range of less illiquid investments to generate a tax-free income. SIPPS do too, albeit it at the penalty of locking money into a pension. And few conventional equity income investment trusts charge anything like the 3.5% or per year many VCT managers do.
I hold a few VCTs that I purchased at issue to take advantage of the old level of tax relief. But as a younger investor with ISAs to fill and a 30-year investing horizon ahead of me, I don't feel short of attractive homes for my money after the bear market we've endured.
If I were wealthier and wrinklier, I'd probably take a closer look at secondhand VCTs.
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