What is our VCTs’ dividend outlook – and how are they coping with Covid?
Our two venture capital trusts seem to offer very attractive incomes but we need to establish whether they are sustainable
HOW do funds whose purpose is to get new businesses off the ground manage to be behind some of the highest yields you will find anywhere on the stock market?
These specialised portfolios, called venture capital trusts or VCTS, have every reason to pay good dividends – their special status makes their divis tax free – but how can they fund dividends when they invest in fledgling firms that are too immature to pay divis themselves?
There are two answers: first, they can use the proceeds of any sales of these businesses; second, they often lend money to the firms in which they invest as well as own shares in them. These loans produce interest. It’s fair to say that, in relation to the first of these sources, the money represents capital
rather than income.
But these twin sources have enabled the two VCTs in our Income Portfolio, Baronsmead and Northern, to produce a stream of dividends since we bought them. We paid 83p and 70p respectively in October 2016 and the two trusts have, coincidentally, each paid (or declared) divis of 23.5p since then.
The current share prices of 68.5p and 55.75p hint at the fact that some of the dividends have in effect been paid from capital. At current share prices they yield 9.5pc and 7.2pc respectively; relative to our purchase prices they yield 7.8pc and 5.7pc.
As you would expect from the unpredictability of the sales of VCTs’ holdings and hence of the inflow of funds available to pay dividends, payments have varied. Baronsmead paid 18.5p in the full year before we bought it, then 6.5p in 2017, 7.5p the following year and back down to 6.5p last year. So far this year it has declared an unchanged interim payment of 3p. Northern paid 13p in 2016, then 11p, and then 4p in 2018 and 2019. Its declared interim of 1.5p this year compares with 2p at the same stage last year.
Baronsmead’s annual dividend target is to pay 7pc of the net asset value at the start of the financial year, which would mean a target of 5p this year, while Northern’s is 5pc of starting NAV, equivalent to about 3.5p.
The trend downwards reflects changes in the VCT rules that have pushed them towards investing in riskier early-stage companies. This prolongs the period for which VCTs are likely to have to stick with their holdings before a successful sale can be made. The trusts’ earlier ability to invest in steady income-producing assets such as green energy sources has disappeared.
What can we expect by way of dividends from VCTs generally, and our two holdings in particular, in future, especially now that coronavirus has wrought such havoc?
We put these questions to Alan Sheehan of Micap, an investment research firm that specialises in VCTs and other niche vehicles such as the Enterprise Investment Scheme.
He said: “The effect of Covid-19 on a VCT will depend heavily on how it invests. Some specialise, for example, in backing retailers and we can expect some of those companies to suffer. Others concentrate on technologybased start-ups that spend a lot on research and development. That kind of business can be less affected by the pandemic or may even be able to benefit from it – as long as it is able to meet any continuing funding needs.”
Where do our two VCTs stand on that spectrum? Baronsmead has almost half of its money in technology businesses, 19pc in health and education and 23pc in business services. Ten per cent is in “consumer markets”, which include hard-hit retail and travel. This mix strikes Questor as well suited to these exceptional circumstances.
Northern did not give such a breakdown in its most recent update but a glance at its top 15 holdings shows several in software and e-commerce, along with others in entertainment. Again we can feel reasonably confident about its positioning in light of the pandemic.
We will hold on to both trusts.