Venture Capital Trusts (VCTs) are gaining more and more prominence in many people’s investment portfolios, as investors seek to invest as tax efficiently as possible.

However, certain myths surrounding VCTs continue to deter some investors and these need a good debunking.

The major concern expressed by many potential VCT investors is, put succinctly, “once I’m in, how do I get out?”

VCTs are well regulated, fully listed investment vehicles but the secondary market in VCT shares is patchy at best. So, while there are very attractive tax breaks when investing in a VCT, the fear of being perennially stuck in an illiquid investment does deter many investors and their advisers from including VCTs within their portfolios.

Moreover, many potential investors get scared off by the “V” in VCTs, concerned that these funds only make very high risk equity investments in un-proven, early-stage businesses.

For the optimist or dreamer, the case for investing in small companies is the opportunity to participate in the next Facebook and reap the potential rewards of the huge upside of a young, dynamic company.

However, choosing investments on this basis is very risky. Companies already showing great promise tend to be expensively valued (and hence probably not accessible to VCTs anyway) while earlier stage companies can turn out to be one minute wonders. It is also important to focus on how you can achieve an exit from an investment in a smaller company. Smaller and unquoted companies often suffer from illiquidity in their shares and the exit route may rely on a trade sale, IPO or management buy-out, none of which are really in your hands as an investor.

So where does this leave the canny investor wishing to use the attractive tax breaks offered by VCTs but with less appetite for risk?

The ongoing effects of the credit crisis mean that banks are still reluctant to lend money to those growing companies who actually need it most. As such, even well managed and established businesses are finding it increasingly difficult to access the credit they need to grow. VCTs are helping to bridge this gap by lending to smaller companies. This allows a much quicker route to financing than is currently offered by the banks, and the entrepreneur is motivated by holding onto their equity stake in the companies they run.

This is often the silver bullet for VCT investors. Many VCTs make their investments primarily by way of asset-backed, secured loans to well managed and established businesses. These fixed term loans 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 are effectively guaranteed an exit after five years.

Investors will also be looking for some reward when backing smaller companies and in spite of the downside protection provided, the opportunity for growth is not lost on “planned-exit” VCTs. As well capital growth, dividends paid from the interest on the loans to the companies will provide investors with a tax-free income. So while the tax breaks are of course attractive, they should not be the sole reason when choosing to invest in VCTs and investors should pay attention the providers track record at returning capital and paying a strong dividend.

So why all the myths? Well, the VCT rules are complex and have changed from time to time. Indeed, some potential investors fear that a change in legislation might adversely affect their investment and/or any tax reliefs.

Aside from the reality that it would be highly unlikely for any legislative change to be applied retrospectively, there was a review of the VCT rules in 2012 so one would not anticipate a further review for several years. But the reality is that VCT managers have innovated, and will continue to innovate, to ensure that the universe of VCT investment opportunities continues to be broad.

Moreover, as government continues to make every effort to encourage and support investment in the country’s small and growing businesses, VCTs can expect to be the beneficiaries of such support.

So, with the annual pension allowance recently cut from £50,000 to £40,000 and with the myths of illiquidity and high risk debunked – at least by the VCTs that follow the secured- lending, planned exit strategy – investing in a VCT may well become a more well-established part of every smart investor’s portfolio.

See article online here on the FT Adviser website