This article is taken from fund strategy, where Intelligent Partnership was featured in. Click here to read the original article
Enterprise investment scheme investments are becoming an increasingly popular option for investors seeking to take advantage of the tax benefits. The market was estimated to be worth £500m annually in 2011 and is forecast to grow to £1bn annually by 2014.
In our previous paper we looked at the performance of EIS investments relative to other, similar investment options. In this paper we are going to examine the possibility of re-investing the gains from EIS investments in other EIS offers, and using ‘exit focused’ EIS investments to try and build a tax-free source of annual income for the future. Once again, the spreadsheet we used to calculate the returns is available on request and a web based version is currently in development.
Methodology
We looked at a hypothetical strategy where the investor has a surplus £10,000 annually and has used (or nearly used) their lifetime allowance within their pension and their annual Isa allowance. Clearly we are thinking about wealthier investors here, perhaps nearing retirement age and mortgage free homeowners.
By investing the annual £10,000 surplus into EIS schemes with an exit focus, the capital can be recycled into another investment at exit. In our simple example we have recycled the capital after every three years and assumed each investment returns 1.3x capital, although we have also included a more complex spreadsheet where readers can experiment with differing timeframes and levels of return.
We implemented this strategy with the surplus £10,000 a total of eight times (Pots A–H in the spreadsheet). This means that the Pot A can be crystallised in year 10 and the total return of £21,970 can be taken as a tax free gain – and the same can be done with all the subsequent pots until year 17, providing a tax free annual income – potentially in the early years of retirement when spending is highest.
More Complex Scenarios
Of course in reality the initial investment amounts are likely to fluctuate as client circumstances change; the level of returns will vary greatly, EIS managers may take longer to achieve an exit than planned at the outset and advisers and investors may work over differing timeframes. We’ve included the ability for readers to manipulate all of these variables to explore more volatile, real world scenarios.
In our final table we’ve set the level of returns based upon NESTA research that indicates that of early stage, EIS style investments, 56 per cent return less than cost (0.5x capital in our table), 35 per cent return 1.5x cost and 9% return >10x capital. We’ve distributed this range of returns randomly across the 24 investments the strategy calls for, but of course in reality achieving higher returns earlier would have a positive effect due to compounding.
It’s interesting to note that even with such a high number of poor performers the performance of the two investments that return 10x capital offsets the poor performance of the majority.
Conclusions
These conclusions should be considered in the light of our previous paper, A Review of the Advantages of EIS Investing, with a Focus on Using a Portfolio Approach. As the NESTA research indicated, small company investing can be risky and therefore a portfolio approach is necessary. If only one in 10 investments is going to be a stellar performer, statistical maths suggests that a portfolio of 28 investments would be optimal to give a 95 per cent chance of including the high performer.
This level of diversification may be beyond many investors’ resources, which leaves advisers with a couple of options: either using a fund or choosing to invest in lower risk, exit focused EIS opportunities. These are often based around established businesses with predictable revenue streams and are very different to the growth focused investments EIS is traditionally associated with.
If the emphasis is on exit focused EIS, they can be combined in a portfolio approach similar to the one we’ve outlined here and advisers can help clients build a satellite portfolio of tax efficient investments that will provide income in the future.