As the UK budget of 20 March approaches, this article by Puma Investments examines some of the issues surrounding venture capital trusts.

Editor's note: The following article is by Eliot Kaye, investment director at Puma Investments, a firm working in the area of Venture Capital Trusts, which are UK-listed vehicles holding stakes in fledgling businesses and which offer significant tax breaks on income and capital gains. With the UK budget on 20 March approaching, there remains interest on a sector with such tax advantages. The views expressed here are not necessarily fully shared by this publication but it is very happy to share this article and invites reader feedback.

For many people, investing in a Venture Capital Trust is doing exactly what is says on the tin - entrusting their capital to an investment manager to pick the next big thing in venture capital. That is all well and good if you are fortunate enough to back a real winner but is there another way for the canny investor wishing to use the attractive tax breaks offered by VCTs but with less appetite for risk?

For some, the case for investing in small companies is the opportunity to participate in the next LinkedIn, reaping the potential rewards of getting in early in the life of a young, dynamic company.  However, choosing investments on this basis can be very risky – investing in early-stage companies is fraught with obstacles and many promising businesses will simply fail to live up to early expectations. Despite being well regulated, fully listed investment vehicles, liquidity has long been an issue. So, while VCTs offer very attractive tax breaks, the fear of being perennially stuck in an illiquid investment deters many investors and their advisors from including them within their portfolios.

That said, there is another option. Many VCTs, including Puma VCTs, make their investment primarily by way of asset-backed, secured loans. As many small business owners will testify, banks are still reluctant to lend money to those growing companies who actually need it most. VCTs are helping bridge this gap by lending to smaller companies and, with the banks shut, many VCT managers have a strong pipeline of well-managed, established companies to make loans to.

A major advantage of these fixed term loans is that they give VCT managers clear exit visibility on each investment made and the security taken provides the all-important downside protection for investors. Many of these “planned exit” VCTs are therefore able to undertake that, after expiry of the requisite five-year shareholding period, they will put a vote to shareholders to put the VCT into a solvent liquidation. Shareholders in these VCTs have no need to worry about liquidity in the secondary market as investors are effectively guaranteed an exit after five years.

Although the tax breaks are attractive, they should not be the sole reason when choosing to invest in a VCT. As well as capital growth, VCTs can pay out healthy, tax-free dividends paid from the interest on the loans to the underlying portfolio companies. So, investors need to pay particular attention to the VCT manager’s track record as this is crucial if an investor is to gain reward for backing smaller companies.

With the annual pension allowance recently cut from £50,000 to £40,000 (around $60,500), VCTs that follow a secured-lending, planned exit strategy potentially offering a lower-risk option may well start gaining more prominence in many people’s portfolios, as investors seek to invest as tax-efficiently as possible.