The EIS sector has new rules, a new risk profile and still stands at the start of a new tax year so, believes, Tom Hopkins, now is the time to re-educate clients on growth EIS investing and its associated risks

Last November’s Budget saw Chancellor of the Exchequer Philip Hammond launch various initiatives that the government hopes will help businesses scale up and achieve rapid growth.

We are told a technology business was apparently founded every hour in the UK last year but the Government now says it wants one every 30 minutes. It’s a peculiar measure but, by anyone’s reckoning, that means double.

As part of this ambition, the Government announced further redirection of the Enterprise Investment Scheme (EIS) and venture capital trust (VCT) sector to investment-led strategies rather than tax products.

This effectively puts the final nail in the coffin of limited-life EIS and VCT products and caused the risk profile to shift. Now, more than ever, EIS and VCT investing is about taking risk. But what does that mean for your clients and how you advise them?

EIS investment, being into mainly unquoted stocks, has always been considered high-risk and illiquid – and that will never change. Historically, however, investors were attracted to the sector’s so-called ‘capital preservation’ strategies.

Unfortunately, many of these funds have under delivered, with some investments in areas such as media and anaerobic digestion performing particularly badly. Turns out they were just as risky as the growth funds – and, in some cases, more so.

Growth funds, on the other hand, have always been positioned as ‘risky’ and hence some advisers shied away or hid behind the compliance administrative burden. Now, however, EIS is of course all about growth.

Put simply, if you pick the right funds the returns justify the risk – and remember, the Government underwrites a large part of that risk and provides tax-free returns. A 30% initial tax relief plus loss relief means an additional rate taxpayer is risking 38.5p on every £1 invested. Furthermore, there is the capital gains tax (CGT) deferral option and profits free of CGT.

The days of ‘tax-led’ products, where the investor got their tax back as the return, are over. The main point about investing in EIS is now about generating a profit for investors. As an example, Edinburgh-based growth investor Par Equity recently announced a successful exit that generated a return of more than 60x investment pre-tax, and over 100x if you take EIS reliefs into account. The exit of International Correspondence Schools (ICS Learn) was achieved in five and a half years.

While the scale of the return is unusual, the fact is that in a diversified portfolio you would expect the ‘winners’ to more than compensate for the ‘losers’. And there will be losers. It is important clients understand that and not be overly worried if the first exit is a complete write-off.

Fragmented market

The new focus on growth will result in a more fragmented market so the key issue will now be deployment of capital. The days of raising £100m and deploying into a series of ‘ready made’ EIS cookie-cutter investments are over.

As such, there will be more fund managers to choose from and, importantly, the old ‘asset backed’ or ‘limited life’ funds may fall out of favour, given they do not have a relevant track record in the space.

Look then to pick fund managers who have always focused on growth investors and have an angle, an investment niche, that sets them apart. Deal flow will be attracted to firms specialising in a given sector, asset class or even region. Entrepreneurs want a firm to provide more than money – they are looking for a network and support to help them grow.

MMC Ventures, for instance, has recently focused on a research-led strategy to highlight the key companies in a given sector. Its deep-dive investigation in artificial intelligence (AI) has led to three new investments in that area to date. MMC’s research is also supporting its existing portfolio companies using AI techniques to gain competitive advantage.

As an example, recipe box business Gousto is applying AI to provide significant improvements to customer experience, enabling the company to achieve record low error rates in packaging and reduce food waste to nearly 0%. Food for thought, so to speak …

The most interesting aspect about this asset class is the intellectual property value backing, which has led to one of the most surprising statistics in the industry A recent study by Cambridge Enterprise, the university’s commercialisation arm, showed the five-year survival rate of its portfolio companies is an impressive 97.5%.

Growth with a level of value protection, then – something to consider for the many advisers with clients who have hitherto shunned the growth EIS and VCT sectors as ‘too risky’.

EIS is an important tax planning tool but also can provide a useful growth kicker to a portfolio in a tax wrapper.  Selecting the right fund manager is key to ensure the returns are there – focus on those that have a relevant track record under the new rules and their own niche – be it asset class, sector focus, regional and so on. That way, the risk is mitigated beyond just the tax underwriting.

This article was published in Professional Adviser, see here for more details