21
CLASSIFICATION
EIS managers and reviewers have different
terms for classifying EIS investments
according to their investment objective,
risk profile or structure. However,
whatever the terms and definitions
used, most EIS investments can fit
into one of three broad categories:
High Growth:
investment in order to
support rapid organic growth; perhaps
to establish or cement a competitive
advantage or to support a management
buyout. The objective is to provide the
capital to help the business grow, whatever
stage it is at. Investors would be targeting
2-3x capital or more and would expect to
realise their investment within five to ten
years. This is perhaps the riskiest, but also
the most common form of EIS investing.
Capital Preservation:
investment in lower
risk companies, usually asset backed or with
strong revenues, with a focus on preserving
the real value of capital and achieving the
30% Income Tax relief and saving the 40%
Inheritance Tax. The capital is still put
at risk but not to the same extent as in
more speculative EIS investments, and the
expectation is that returns will be much
lower, to reflect the lower level of risk.
Exit Focus:
investment with a focus on
a predictable exit as soon as possible
after the three year minimum holding
period. Even if there is no growth
and the investment simply returns
the initial capital invested, the 30%
Income Tax relief alone would deliver
a >10% compound annual return.
These lower risk strategies can be illegal
if the money is not being genuinely
invested in business growth. HMRC are
very aware of the EU State Aid guidelines
and EIS investments need to be seen as
having a substantial element of risk, with
no defined exit at the time of investment.
The issue attracted the attention of
the Treasury in the 2014 budget:
“The government is concerned about the
growing use of contrived structures to allow
investment in low-risk activities that benefit
from income guarantees via government
subsidies and will therefore explore a more
general change to exclude investment into
these activities, consulting with stakeholders.
The government is also interested in exploring
options for venture capital reliefs to apply
where investments are in the form of
convertible loans, and will be considering this
as part of a wider consultation and evidence
gathering exercise over summer 2014.”
A PORTFOLIO APPROACH
Generally, smaller companies of the
sort that qualify for EIS status are more
risky. There is a much greater chance of
investments returning less than the original
investment amount than would be expected
with more established companies. The tax
breaks are an incentive designed to offset
this risk and make investing in smaller
companies more attractive, however,
based upon the statistics it seems that
investors would still be wise to employ
systematic diversification strategies.
FINDINGS
Our research suggests that even with
the tax breaks to mitigate the risks, it
would still be wise to take a portfolio
based approach to EIS investing. The
returns from business angel investments
are generally found to be as follows:
The average return is 2.2x capital on a
portfolio (becomes 1.9x after tax)
This becomes 3.4x after tax with EIS relief
56% of ventures returned less than cost
35% return 1-5x cost
9% return 10x or more
The Optimum Portfolio Calculation
#1
A portfolio of ten investments would
seem to be the minimum requirement
based on the figures for satisfactory returns
from ‘angel’ investing. A portfolio of 30
is conventionally seen as optimal giving
95% confidence of picking an investment
that returns over 10x capital. Investors
and their advisers should look to diversify
across managers, sectors and funding
stages (depending on their risk appetite).
There is though the risk that different
managers may invest into the same
underlying companies, particularly for
AIM focused strategies. Diversification
should be done systematically following
a rational procedure or strategy.
#2
For investors who do not have
sufficient scale or who are looking
for a less time-consuming way to
achieve the level of diversification
required, an EIS fund makes sense.
#3
Another strategy to mitigate the risk is
to invest in asset backed projects that have
lower levels of return, but have reasonably
secure and predictable revenue streams.
Of course these opportunities are not
without risk, but they are perhaps less
risky than other EIS qualifying ventures.
RESULTS
We looked at building a portfolio of ten
EIS investments and how that portfolio
performed under a number of different
scenarios: Worst Case, Barely Breaking
Even, Evidence Based, Boring and
Mediocre, Imagine Wild Success!
The five scenarios have all been based
on the same following criteria:
Initial investment of £100,000
Investment period of 5 years
Investor is a Higher Rate tax payer and
claims all available reliefs
We have not included any asset
management charges in the calculations
Annual returns compound
On the following page we look at how each
of these different scenarios might play out.
INVESTMENT STRATEGIES
Based on the available research from
NESTA we know that there is a 1 in 10 (0.1)
chance of selecting an investment that
returns 10x capital.
We would like to construct a portfolio
that statistically gives us a 95% (0.95) of
including one of these investments.
Target Confidence 0.95
Probability of Win 0.1
Number of Intervals
Required
28.4331588
Formula
0.9N = 0.05
In(0.9)xN = In(0.05)
