VCTs are similar to investment trusts but typically invest in very small, dynamic and entrepreneurial companies which are looking for further investment to help develop their business.

They are expected to be beneficiaries of the economic recovery because of their focus on small, domestic enterprises.

The VCT market has grown exponentially since the products were launched in 1995.

According to the latest figures from the Association of Investment Companies (AIC), total funds under management increased by £19m in the first six months of this year, reaching £2.9bn on 5 October 2013, the highest level since they were established.

VCTs offer various tax benefits including 30% upfront tax relief on investments of up to £200,000 a year, as well as tax-free dividends and capital gains.

However, they are considered high-risk investments suitable for the more sophisticated investor.

So, what do investors need to know?

‘PURE’ RECOVERY PLAY

Jason Hollands from Bestinvest says that the VCT market is experiencing something of a “sweet spot” at the moment.

“Managers are reporting that as a result of the UK recovery they are seeing strong pipelines of new investment opportunities,” he says.

“As an investment scheme specifically targeted towards small, domestic companies, arguably VCTs are a purer way to play the recovery than a typical UK-listed equity fund given the UK stock market is so international in nature.

ALTERNATIVE RETIREMENT VEHICLE

The impending reduction in the annual and lifetime pension allowance will force wealthier investors to seek out tax-efficient ways to supplement their pensions.

Oliver Bedford, investment manager at Hargeave Hale, says: “With legislation now in place that limits the amount of money private investors can place into their pension funds, we are increasingly hearing of advisers considering VCTs as an alternative vehicle through which investors can save for their retirement through a tax efficient scheme, albeit one that carries higher levels of investment risk.

“Many are attracted to the sector by VCTs’ ability to pay tax free dividends, which are very attractive when grossed up and compared with returns available from more conventional equity, cash and fixed income products. “

‘EVOLVING’ MARKET

Ben Yearsley from investment platform Charles Stanley Direct says investors now have a better list of managers to pick from, which has done a lot to boost confidence in the industry.

He says: “The outlook for VCTs is especially good compared to ten years ago where there were a mediocre bunch of managers, or certainly a larger selection of managers to choose from – and now that list has been whittled down a degree, leaving better quality managers and an evolved industry from a decade ago.

“The product has evolved too and I think the industry has finally found its niche. I think it has finally realised what it is for and that is to provide a long-term tax-free income stream.

“Now there are quality products, well-resourced management teams – with some exceptions, and a good investment for higher risk, higher net-worth investors.”

CONCERNS

However, there remains concerns that big headlines will draw in investors who are not equipped to invest in VCTs.

Yearsley says that investors should have £100,000 in investments before they look to invest in VCTs and not be attracted to them just to utilise the generous tax break.

“VCTs should be considered as 7-10 year investments. Investors who are not prepared to tie up money for that long are advised to not buy.”

Investors also should note that under new measures included in the Finance Bill, VCTs that invest in smaller companies could lose some of the tax benefits due to a new cap, proposed to comply with European rules, on state-backed investment sources.

From April 2014, investments linked to a share buy-back scheme where the seller of VCT shares re-invests them will no longer be entitled to 30% tax relief on that investment.

Investors will also have to wait six months before re-investing in the same VCT if they want to receive the income, capital gains and tax-free dividends on offer.

Investors may lose tax advantages if companies they invest in receive more than £2m from VCT funding or other state-backed investment.

The Government is also consulting over whether or not to reduce the level of tax benefit attached to solar VCTs as part of its review into its green levies, however nothing has yet been decided.

Bedford recommends investors and advisers stay abreast of developments within the legislation that governs the schemes.

Over the page: which VCT to pick…

Adrian Lowcock from investment platform Hargreaves Lansdown reveals his picks from the VCT market:

It is still early days for VCTs in the current tax year and many VCT managers have yet to begin fundraising. Below Lowcock highlights one fund that is currently open and two that are due to launch in the coming weeks.

Northern 3 VCT (Currently open) – the team managing the Northern VCTs has established itself as among the best in the business. They take a relatively cautious approach, looking to invest in established, profitable companies with strong management. They seek to use their experience to help the business grow and take a hands-on approach, generally appointing a chairman to the investee company and taking a seat on the board.

They began fundraising for their VCTs early this year and demand has been strong with Northern Venture Trust and Northern 2 VCT already at capacity. Northern 3 VCT is managed using the same approach and there is considerable overlap between the portfolios. This is a top-up into a mature, diversified portfolio and early dividends should be a possibility.

Maven VCTs top-up offer (Coming soon) – Maven is shortly expected to announce a top-up into its six ‘generalist’ VCTs. This will provide investors with access to a mature portfolio of over 50 private companies, diversified across a number of industry sectors.

There is a bias towards oil & gas services companies, Maven’s area of expertise. The team’s disciplined, relatively conservative approach has contributed to a strong track record of paying regular dividends and I believe early dividends should be a distinct possibility from this offer.

Hargreave Hale AIM VCT 1 & 2 (Coming soon) – this will be a top-up into two established AIM VCTs which invest primarily in AIM-listed companies, or in companies about to list on AIM. Finding good-quality investments on AIM can be difficult. Giles Hargreave, principal manager of these VCTs, has an enviable track record in smaller company and AIM investing.

Giles and his team are probably best known for running the Marlborough Special Situations and UK Micro Cap Growth funds, but the VCTs are managed using a similar philosophy. They invest the core of the portfolios in high-quality, profitable businesses with the potential for strong earnings growth. They aim to hold a selection of businesses diversified by industry sector and will make use of cash and fixed-interest investments if their outlook for stock markets is cautious.