15 May 2008

Returns from tax advantaged Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) are lagging far behind the average performance of private equity funds, says our experts. VCTs and EIS are traditionally one of the main routes for individual private investors to access private equity.

According to figures from the British Venture Capital Association , UK private equity (excluding VCTs) delivered an average of 18.7% per annum internal rate of return over the last ten years. Data from investment research house Allenbridge Group reveals that the internal rate of return for VCTs has been running at around 2.1% per annum over the same time frame .

There are no comparable figures for the Enterprise Investment Scheme, but a 2003 study from HMRC had already found that 22% of EIS investors in the sample had lost all or most of their money, 10% lost part, 20% made a modest profit and 18% a substantial profit.

Comments Rob Durrant-Walker, Tax Manager at our York office: “Because VCTs and EISs invest in smaller companies they are carrying a lot of risk. So far that risk hasn’t meant better returns. While the tax breaks they offer are attractive these latest figures demonstrate that their returns are lagging behind private equity returns as a whole.”

“The exposure of private equity funds to small companies will vary but on aggregate they will have a greater exposure to more mature and stable companies.”

VCTs are closed-end collective investment schemes run by fund managers and are aimed to provide capital finance to a portfolio of small, young, unquoted UK companies with growth potential. EIS tend to be single company investments. VCT and EIS investments have attractive tax incentives to compensate for their higher level of risk. Dividends are free of tax and there is an income tax break of up to 30% if assets are held for a qualifying period. VCTs and EIS are also exempt from capital gains on their disposal.

Our experts say that VCTs should be considered as illiquid, high risk and long-term investments.

HMRC has highlighted the risks linked to VCT and EIS investments in a recent study which reveals that companies in the schemes have a lower survival rate and lower profit margins than a matching control group of small companies not in the schemes. The report’s initial data suggested an average loss for scheme companies compared to an average profit for the control group, but this may have merely reflected investee companies being at an early stage of growth with high set up costs.

Comments Rob Durrant-Walker: “Private investors who are concerned about the performance of more traditional asset classes like quoted equities and who are looking for more rewarding alternatives such as private equity should not just consider the tax breaks in isolation. EIS is however very useful in attracting business angels to a specific company. In the worst case scenario of shares becoming worthless, the maximum loss for an investor after tax relief is at best 48% of his investment in an EIS, and 70% in a VCT.”

“Private investors who are keen to access private equity might want to consider other avenues such as investing in private equity through a private investor syndicate or a listed private equity group, which may not offer the biggest tax breaks but may have a better track record in generating a higher total return.”

According to HMRC, VCTs are estimated to have raised £1,710 million over the last five years, with EIS raising £5,403 million.