Andrew Castell, Partner at Par Equity, identifies why EIS is beneficial and which advisory clients it is suitable for.
As other tax-advantaged long-term saving opportunities are chipped away at, EIS stands out.
There’s no such thing as a free lunch, though, especially where HM Revenue & Customs is concerned, so their continuing commitment to such an apparently generous incentive tells us something. Advisers need to understand why EIS exists – and the asset class it’s intended to stimulate – to understand which clients are likely to benefit from EIS investments.
What and why is EIS?
Venture capital involves taking an equity stake in businesses with high growth potential. Returns can be many times the amount invested but, if things don’t go well, capital is genuinely at risk.
According to PitchBook, which analyses the venture capital market, recent returns have been especially strong – median internal rates of return (IRR) for venture funds have increased from 4.4% for the 2005 vintage to 16.4% for 2011, with a drop to 12.8% for the 2012 vintage.
The top quartile of funds in the 2010 vintage has posted a 32.5% IRR (sufficient to grow £1 to £5.41 over six years). Despite this, and for a variety of reasons, the UK has struggled with a capital shortage in relation to venture. Although originating in the dotcom bubble at the end of the last century, this capital shortage continues to be a problem for early stage companies.
EIS is one of HMRC’s two venture capital schemes aimed at solving this problem. A powerful bundle of tax reliefs, it’s aimed at stimulating investment in growth companies, encouraging investors by giving them the chance to mitigate their investment risk. In this way, EIS ups the flow of capital into high growth potential companies and the high-value jobs they create. The government is content to see taxes foregone through EIS because the benefits (company formations and job creation) outweighs the costs to the Exchequer.
According to PitchBook’s research, the median fund TVPI (the ratio of fund value to paid-in capital) is above breakeven in each of the twelve years they look at (2001 – 2012, as the most recent funds aren’t yet producing meaningful data), with 1.17x the worst year and 1.56x the best. Adjusting for EIS, this would equate to a median TVPI in the best year of 2.23x and 1.67x in the worst. Better yet for EIS investors, gains are usually tax-free, while losses can be offset against income tax.
EIS should therefore be seen for what it is, a tax incentive to encourage investors to provide capital to a vital part of our economy, by allowing those investors the opportunity to mitigate investment risk and improve their investment returns as a result.
Which clients might be interested in EIS investments?
Venture capital has a low level of correlation to major asset classes such as listed equities and bonds. As a result, it sits well within a portfolio, with a positive effect on expected returns at little or no increase in the overall portfolio risk. A client with an investment portfolio of £1 million could potentially accommodate an allocation to venture of £100,000 without materially increasing the overall portfolio risk – but with the benefit of EIS, this decision becomes a lot easier.
If that £100,000 allocation were to be built up at a rate of £20,000 a year, the client would be reducing their annual income tax bill by as much as £9,000, as well as deferring capital gains tax (CGT) of £20,000 a year (£5,600 of CGT deferred).
One way of looking at this is that it greatly improves the tax-efficiency of the client’s overall portfolio, which is likely to give rise to an ongoing flow of taxable income and capital gains. Put another way, the £100,000 allocation to venture might only cost £70,000. The cash cost to a client building up the venture part of their portfolio over several years can fall further with the potential to benefit from exit proceeds before the portfolio has been fully built up.
A client with an interest in venture capital can therefore achieve his aims at a significantly lower cost – as the analysis of TVPI ratios illustrates, venture capital returns can be materially enhanced by EIS, with additional advantages in the form of loss relief and CGT relief. Other reliefs, such as rollover relief and IHT relief, can drive significant further value for clients with specific tax objectives, for example if they:
- are paying high marginal rates of income tax;
- have CGT liabilities they wish to manage;
- are looking at estate planning; or
- are at or approaching the limit of their pension allowance.
Which clients are EIS investments suitable for?
EIS is a complex scheme and increasingly subject to detailed anti-abuse provisions. For these reasons, it’s not guaranteed that EIS relief will remain available across an entire portfolio. It’s therefore important that clients are comfortable with the underlying investment first and see EIS as an extra (and potentially considerable) benefit, rather than fixating on tax.
As venture capital is a long term asset class, with a high level of investment risk at an individual company level, it’s for investors who understand that losses will happen within their overall portfolio and that they may often have to wait patiently for the good investments to come through. An allocation to venture should be from money that the client isn’t relying on in the short to medium term.
Even within the venture portfolio, diversification is key. It’s wise to diversify over time as well as over sectors and sub-sectors. Clients should therefore be able to commit to investing most, if not all, years over a period of several years. If things go well, exits should start coming through within that horizon, providing the cashflow, if required, to fund the next five years – and so on. If you consider that doubling one’s money over five years pre-tax represents an almost three-times multiple post-tax, it’s easy to see how an ongoing investment programme can become self-financing.
In considering suitability, therefore, it’s likely that the client will have:
- a sophisticated grasp of business and investment;
- the appetite to assume risk; and
- a long term investment horizon.
Particularly, the client will need to be prepared for early losses within the venture capital portfolio, often coming through before the profits.
How are advisers using EIS investments?
Investors can choose from a variety of routes if they want to access EIS investments. As well as funds, they may look at single company EIS opportunities, whether on a rifle-shot basis, as part of a portfolio service, or through equity crowdfunding sites.
However it’s done, the challenges of building a portfolio one company at a time are not to be underestimated and few advisers have the expertise or indeed time to advise clients on the suitability of single company EIS investments. As a result, advisers rightly tend to focus on EIS funds.
Advisers have been quick to appreciate the value of EIS funds as a tax planning tool, but unfortunately this has too often been reflected in a desire for structured products with supposedly low levels of investment risk.
With a growing realisation in the market that EIS is getting back to its roots as a measure specific to growth companies, its effectiveness as a tax-planning tool remains, but advisers are having to think a bit harder about portfolio theory. Considered as a stand-alone investment, venture capital is risky. Considered as part of a well-diversified portfolio, venture capital investment in the form of subscriptions to EIS funds has little or no effect on overall risk and can materially enhance portfolio returns on a post-tax basis – even before the returns from the venture capital investments are factored in.
