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Changes to the ‘qualifying investment’ rules last year, driven by the European Union and HM Treasury, have completely altered the Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) market.

The result of the changes, including the age of investible companies now having to be less than seven years, has seen the overall risk profile increase and the market fragment – after all, generally speaking, the more mature the company, the more established and stable. In addition, HM Revenue & Customs (HMRC) is clamping down on ‘cookie cutter’ companies – that is, those that replicate the same trade to get round the investment limits.

Wyndham North, head of venture schemes at HM Treasury, at a recent EIS Association event, reiterated that the government wants this money to be directed into growth investments and deliver value for money to the economy – in other words, those businesses near the start of their growth, rather than those at a more mature level of development.

There was also a clear message in the Autumn Statement that this government wants to continue to support UK innovation. This is on top of the approximate £4.5bn that already goes into UK universities for research and development (R&D).

Currently, the UK is a market leader in R&D, with 16% of the highly cited research papers, and we also have 1% of the world population for R&D specialists. The amount of technology and intellectual property (patents) coming out of the UK university system continues to grow.

Elsewhere in the EIS market, we have already seen various fund managers give up on their scalable ‘lower-risk’ EIS strategies following continued rejection from HMRC. Earlier this year, for example, Octopus Investments announced it would not be undertaking any further fundraising for its EIS product range.

The result is that financial advisers have been left scratching their heads – their usual ‘go-to’ places for EIS either have no offers launched or have launched offers where they have no meaningful track record in that specific area.

And there will be more growth offers in the market from firms who previously focused on ‘lower risk’ or ‘limited life’ funds. A recent example is Foresight’s new ‘Williams F1′ EIS offer, which will be investing in technology businesses, whereas Foresight is better known for it’s asset back renewable offers.

So the funds are starting to be directed to where the government intended – in the spirit of why the schemes were set up in the first place.

Educational process

Given the majority of the EIS and VCT managed money has gone into ‘lower risk’ products, it will be interesting to see if more financial advisers and their clients subscribe to growth funds.

We have certainly seen advisers support the better growth offers this tax year for the first time. This is good news for the market and the economy but it is an educational process for both advisers and their clients.

Advisers need to be careful of backing unproven ‘black box’ asset-backed funds on the hope the fund manager knows what they are doing and can get things through HMRC. Track record and recent advance assurance from HMRC are both keys to the success of EIS companies.

So the risk profile of these schemes has certainly shifted and, while some clients are comfortable with that risk, others are not. But be aware of any EIS funds that are marketing themselves as ‘lower-risk’ – HMRC will make life difficult for those fund managers.

This might result in cash being invested into companies without a trade of EIS clearance. That would ultimately produce major delays to the issue of EIS3 certificates, which are needed to claim tax relief.

VCTs are arguably impacted even more due to the ban on ‘lower-risk’ management buy-out (MBO) VCT strategies. Any remaining hope there would be a change to the MBO / ‘replacement capita’l rules was squashed in the Autumn Statement. It is now all about growth and there are very few VCTs with the track record in this area while the old MBO VCTs try to change their spots.

What to watch out for in this new world

Advisers therefore need to be aware of a few issues in this new world – particularly given the increased demand on the back of pensions changes and the amount of capital flowing out of previous ‘lower-risk’ EIS and VCT products over the next couple of years:

  1. There is no such thing as capital preservation in the tax-efficient market. The ‘growth and development’ HMRC test means an element risk is a given.
  2. HMRC is making it harder for companies to qualify for EIS and VCT status. Do not invest in an EIS fund unless it can prove it has the relevant ‘qualifying’ investment pipeline (or historically good deployment rate).
  3. Be aware of ‘black box’ asset-backed EIS funds – raising money without a clear ‘home’ or without the track record of deploying money in a given sector will result in long delays in achieving EIS3 certificates.
  4. Just because a fund manager says something is asset-backed or lower-risk, it is not necessarily so. For instance, really think about what the underlying investment is and what the operating risk is even if there is an asset. A good example of this recently has been anaerobic digestion investments, which have struggled – for which, read ‘made losses’.
  5. It takes time for a manager to change its investment strategy – for instance, MBO VCTs are not overnight going to become growth specialists. A general track record is no good – it is all about relevant track record.

So while the risk profile has shifted in the tax-efficient world, there are some good growth investors in the market that produce excellent returns to investors, and achieve back things like EIS3 certificates for investors in a timely manner.

The bigger risk would be investing client money into funds that position themselves as ‘lower risk’ and finding yourself waiting for EIS3 for two or more years.

So watch out – the tax-efficient market is not what it was but, as long as you understand the dynamics, then there are excellent funds to be found and supported. They just might not be from your previous ‘go-to’ managers.

The original article was published in Professional Adviser here