EIS can bring rewards for clients but advisers must be clear about the risks associated with alternative investments, says Ian Warwick, Managing Partner at Deepbridge Capital
According to HMRC data, during the 2014/15 tax year the amount raised by UK companies seeking funding via EIS was a record £1.7 billion. Much of this was raised via financial advisers seeking tax-efficient investment opportunities for clients that either have a specific tax need or have an interest in investing in small UK businesses.
In previous years, the growth in appeal of EIS investments has often been attributed to the rise of renewable energy within this space and the asset-backed, subsidised nature of such projects offering ‘capital preservation.’ With the Chancellor removing subsidised renewable energy projects from EIS eligibility it is good to see that there remains growing appetite for provision of equity funding to UK SMEs via EIS.
However, it is important that advisers and investors understand the unique risks associated with such investments.
Investment risk
Investment managers take varying approaches to mitigating investment risk. Most of us agree that a diversified portfolio approach to investing is one way to mitigate risk, but I would temper this by arguing that diversification across too many companies restricts the ability to gain significant returns from what should always be considered a high risk investment. My team’s approach to mitigating risk is to invest only in specific sectors where they have knowledge and experience and to take a proactive hands-on management approach with the investee companies to ensure that they are growing as expected. This is how we believe we have the best chance of delivering real growth to investors whilst mitigating investment risk.
As with any investment, the value of shares can go down as well as up. Investors should be aware that investment in smaller unlisted companies carries with it a high degree of inherent risk regardless of any steps taken to attempt to mitigate that risk.
Investment risk may be mitigated in a number of ways, with some providers advocating investment in ‘asset-backed’ projects where there is a physical asset within the investee company that could potentially be sold if the worst came to the worst and an investee company was to fail. If looking at such a proposition, it should be assessed as to what the secondary market and the value of the underlying asset would realistically be if the company was no longer trading. For example, a storage company may be deemed to be ‘asset-backed’ as the storage facility is a physical asset. However, if the storage company were to fail then the value of the prefab building without any trading company is likely to be minimal. There are other ‘assets’ within companies that could be considered, for example if considering a technology based investment then attention should be given to the importance the manager attributes to intellectual property as this could actually be a valuable asset in its own right.
With loss relief available under EIS it could be argued that a focus on asset-backed opportunities is unnecessary. Loss relief is available for EIS shares which are disposed of at any time at a loss (after taking into account EIS income tax relief which is retained). The loss could potentially be set against the investor’s capital gains or his/her income in the year of disposal or the previous tax year. For losses offset against income, the net effect is to limit the investment exposure to as much as 38.5p in the £1, depending on the investor’s marginal rate of income tax, if the shares become totally worthless. Alternatively the losses could be relieved against capital gains at the prevailing rate of 18% or 28%.
Liquidity
EIS shares are usually held in unlisted companies, from which investors might only be able to exit via a refinancing or company sale. EIS investments should be considered as a medium-term or long-term investment and investors are unlikely to have access to their capital during the investment period. Having a pre-arranged exit is not permissible under EIS rules and investors should be wary of any provider suggesting the guarantee of an exit.
EIS providers should be exit focused and, by understanding the investment rationale and experience of the investment management team, investors should be able to ascertain how focused they are on generating real exits for real returns. I’m confident most investors would rather wait a few months for an optimum exit rather than a ‘churn’ of an EIS investment at three years to just claim the tax reliefs.
Tax risk
It is expected that the new Chancellor will continue the work of his predecessor and scrutinise EIS opportunities which do not adhere to the original spirit of EIS, i.e. seeking to create jobs or innovation. Two things that should be considered on this point are that propositions which do not fund companies that are seeking to generate jobs or innovation will likely cease to be eligible for new EIS funding and there is the chance that the HMRC, with their increased budget and appetite for challenging tax mitigation, may retrospectively review companies that have raised funds via EIS.
Investors should seriously question any EIS proposition where it is marketed as having reduced or little investment risk. Such propositions are likely to be at risk of HMRC review in future and it could be argued that the ‘challenge risk’ with such propositions is markedly higher than an investment where the underlying investee companies are genuinely seeking growth and the creation of jobs or innovation.
Deal flow risk
By the nature of what we do as tax-efficient investment managers, we face a constant balancing act. We have to ensure that we have enough investment inflow to fulfil the funding requirements of our investee companies, yet we also have to ensure that we have enough capacity to satisfy investor demand. We have very stringent investment criteria so identifying and then investing in companies which meet these criteria can be a challenge.
We see this balancing act as being a fundamental part of our business and our raison d’être. Working closely with academia, science parks, funding specialists, government supported agencies, networks of innovators and independent advisers there are always a number of companies looking for funding via EIS and SEIS. This is especially true in our focal sectors of technology and life sciences, the trick for us is finding those that meeting our stringent criteria.
Potential investors should be checking with their proposed investment managers as to where their funds will be deployed. Understanding how they source their investee companies and knowing their investment criteria will help advisers and investors avoid a scenario where funds are invested in any old business just because it qualifies for EIS or SEIS. It should be assessed as to whether the investee companies are appropriately matched with the skillset of the manager.
This issue can sometimes be highlighted towards the end of the tax year as advisers rush to invest prior to tax year end. My team’s objective is therefore to ensure that an investor in March can be confident that their money will be invested in companies in which we wholeheartedly believe in, just as they would at any other time of the year. Unfortunately this philosophy isn’t shared by all in our industry and those who merely invest to claim tax reliefs may not have the same desire to find genuine growth companies. As our investment team is predominantly made up of experienced business builders and entrepreneurial minded individuals, we are fortunate to be referred numerous companies from our extensive network of innovators who all understand our expectations.
Investing in EIS propositions is not for everybody but anybody considering such an investment should clearly understand the additional risks associated with such propositions.
As one adviser recently said to me: “All EIS investing is high risk and if a client is suitable for such an investment, and is of appropriate net-worth, then they should want to make real returns from their EIS.”
This is not the case for everyone but I understand this adviser’s sentiment that as only a small part of a client’s portfolio, why shouldn’t they seek to make real returns from their EIS investment?
Tax-efficient investments bring with them different risks to your traditional mainstream investment products. Therefore, adviser should take a moment to understand where their client’s money is being invested and understand the rationale behind the investment.
