Changes to the rules of the Enterprise Investment Scheme (EIS) announced in November 2017 have removed capital preservation strategies from the scope of EIS but the investment case remains strong according to Oxford Capital
Despite these changes, experienced venture capital EIS investment managers are well-versed in mitigating the risks of investing in the early stage, high growth potential companies that have always qualified for EIS.
With their generous tax reliefs (which are untouched), EIS is well worth considering for your clients’ portfolios. And despite the changes, well-managed EIS portfolios still have strong potential for downside protection.
The right manager, the right risk mitigation
Many EIS providers have been forced to pivot their investment activities to comply with the new regulations. Choosing an investment manager experienced in risk-based portfolio management is a key risk mitigator for your clients. It’s not just the manager’s track record or their successful exits that are crucial – there are a number of key skills to look at in choosing a fund. The experience and expertise of the investment team and their selection process are important. Other factors include their relationships and reputation amongst the entrepreneurs in the industries they’re investing in.
Venture capital investors rely heavily on contacts developed over their careers. A good reputation can attract opportunities and open doors. It will have a direct effect on the number of investment opportunities they see, which in turn has a direct impact on the quality of the investments they make.
Another factor is the level of a manager’s ongoing involvement with the companies in their portfolio. This is a good indicator of how much influence they have on the specific risk that applies to that company and its decision-making in the interests of investors. Investee companies must make absolutely certain they will maintain EIS-qualifying status. HMRC advance assurance gives a stamp of approval that a company and investment structure appears to meet EIS-qualifying criteria. But this doesn’t guarantee the company will not, at some point, fall foul of qualification by undertaking activities that break the rules. Proper monitoring of what investee companies are doing is vital to reduce or remove the potential for a company to become ineligible for EIS, leading to clawbacks of the tax reliefs.
Beyond monitoring, the provision of specialist business support to help nurture an investee company can be invaluable. Early-stage businesses can be easily distracted by the volume of day-to-day operational challenges. Expert input into prioritising the strategies that will drive value creation may not be accessible to the investee company unless an investment manager can deliver it. And managers with board presence and the ability to set and access key metrics to compare progress against strategic milestones can introduce an important degree of focus and accountability.
Many early stage EIS managers recognise that managing these investments is an active process. What’s more, the experience of these close working relationships can put them in a great position to identify other companies with positive metrics that are ready to scale.
Putting all your eggs in one basket by investing in a single company can be a big issue. It might be a winner, but it might not, leading to total loss other than loss relief. Good EIS managers actually plan success by expecting some failures among their investments. Of course, they target companies that fit a considered investment strategy, reviewed against a rigorous selection process after in depth due diligence, all undertaken to significantly improve their success rate. But the reality and the statistics cannot be ignored; smaller, younger companies are more prone to failure.
Experienced managers mitigate this risk by building diversified portfolios of EIS-qualifying companies to spread risk and improve the chances of good overall returns. This can be achieved by varying the sectors, geographic regions, managers or maturity stages of the investee companies. This last method balances early-stage investments that have high potential but are higher risk with later-stage investments with a higher valuation but lower risk.
Another risk that should not be overlooked by advisers is the risk of not engaging with EIS. Some commentators expect a drop in demand from advisers and investors with a singular interest in low-risk schemes. However, a broader view should take into account a likely increase in demand from those looking for CGT shelters. Although not a direct alternative to pensions, EIS may also be attractive to those looking to build funds tax efficiently for later life in the wake of tighter restrictions on pension contributions.
Although not a direct alternative to pensions, EIS may also be attractive to those looking to build funds tax efficiently for later life in the wake of tighter restrictions on pension contributions
There is no lack of companies with ambition to grow. The new rules seek to incentivise investment in innovation and entrepreneurship. EIS has not been singled out and punished with the new regulations. Instead, it has been identified as a crucial driver of SME prosperity and grassroots economic growth – with the potential for impressive gains for investors. The new rules put a much greater emphasis on risk-based investing (as opposed to capital preservation and income). But the combination of substantial tax reliefs and selecting an experienced early stage EIS manager can potentially deliver the type of returns your clients need whilst mitigating some of the risk to capital.
Oxford Capital is an experienced venture capital investor. Its EIS opportunities can be accessed at www.OXCP.com