Will political moves to back EIS schemes be enough to stimulate productive investment?
When chancellor Philip Hammond announced a set of new rules for venture capital at last year’s Autumn Budget, he triggered a key moment for the enterprise investment scheme industry.
“We were at an EIS event with fellow providers and mid-event, when the Budget was announced, it immediately changed a lot of people’s opinion on what they were doing. One provider did not turn up the following day, because he realised the EIS market was not for him any more,” says EIS provider Deepbridge Capital partner Andrew Aldridge.
The EIS vehicle was set up to incentivise investors willing to risk supporting innovative companies targeting high growth in the future, rewarding them with 30 per cent tax relief.
The 2017 Budget introduced a “risk-to-capital” condition – defined as “a significant risk that there will be a loss of capital of an amount greater than the net investment return” – to qualify for EIS status to prevent sheltering low-risk investments with tax relief to make sure the scheme was supporting growth investments. Rules on what capital preservation strategies EIS could use were also tightened.
According to research conducted by Intelligent Partnership, seen exclusively by Money Marketing, the amount of open EIS offers last month dipped by 17 per cent compared with December 2017, on the back of closures resulting from the new rules.
Intelligent Partnership finds the EIS landscape has changed drastically since last year’s Budget in terms of how financial advisers assess the vehicle. Thirty-six per cent of surveyed advisers are finding EIS harder to recommend since the rule changes.
Aldridge says his firm welcomed the risk condition, as it supported the scheme’s original purpose. He says: “We always invested in technology and life sciences businesses, and they are at the very front of what we believe the government meant EIS money to be doing. They always met the risk-to-capital condition and we believe they meet the knowledge-intensive criteria as well. We didn’t have to change our business model overnight to try to accommodate government changes.”
Aldridge says the company actually registered increased demand from investors following the changes: “Investors and advisers are very alert to the fact that the market has changed and they are looking to work with providers who are experienced in investing in knowledge-intensive companies.”
Intelligent Partnership’s survey found that now all EIS managers are purely focused on growth strategies, although some EIS investment managers had to close or pivot their offerings to be compliant with the rules, the shift in legislation is widely seen to give new legitimacy to the vehicle.
However, the Budget’s measures to clarify the risk profile of EIS investments might have discouraged some advisers from recommending the scheme to their clients. While last year, 33 per cent of advisers said they recommended EIS to their clients frequently, this year only 17 per cent did so. In the aftermath of the 2017 rule changes, more than 42 per cent of advisers are looking to diversify across more managers.
Though the idea of backing up innovative EIS-qualifying companies, which are working to solve some of society’s acute problems, could be an exciting incentive for investors, only 12 per cent of surveyed advisers listed a “positive social or economic impact” as one of the top three reasons why they recommend EIS to their clients. Tax rewards is the predominant reason, with 85 per cent listing tax planning as a justification and 68 per cent listing inheritance tax planning.
Is knowledge power in EIS investments?
The changes in the 2017 Budget gave EIS back its legitimacy, and grounded the scheme in its original purpose – to inject capital into growing UK businesses.
Some investment managers were clearly working at the fringes of the rules before last year’s Budget, employing capital preservation strategies that really posed no risk to investors. Those investments did not necessarily direct capital to the scale-up companies that needed it.
It is interesting to see Hammond’s focus on knowledge-intensive companies. Although there’s a greater investment threshold, and the introduction of a knowledge-intensive fund structure in the 2018 Budget, advisers still appear to be apathetic.
We surveyed more than 100 advisers, and 80 per cent said that the increased limits for knowledge-intensive companies would not change their approach to EIS investment. This begs the question: has the government made the right adjustments when it comes to knowledge-intensive companies?
Although the shift to growth capital is a welcome and positive move, EIS has become somewhat harder for advisers to recommend, due to its newly increased risk profile. In our survey, over 36 per cent of advisers said the shift from capital preservation to growth capital had made EIS harder to recommend.
Fundamentally, there is less choice in the market. Before the 2017 Budget, there were 65 EIS offers open to investors, now there are only 54. In all fairness, we do expect quite a few managers to open new offers in the coming months, but many will pivot into growth capital areas where they have no track record.
The changes will highlight managers with experience in growth capital investment, and can provide investors with the fantastic investment opportunities available in the UK.
What is clear is the EIS landscape is completely unrecognisable from what it was before November 2017.
John Schaffer is an author of the adviser survey analysis at Intelligent Partnership
Calling in the big guns
The 2017 Budget also saw increased investment limits in EIS from £1m to £2m, in a bid to boost demand while the rules were tightened.
But EIS investments still are not always seen by investors as a long-term hold. The minimum holding period is generally three years from the issue of the EIS shares, but many investors would consider exiting their investment at the earliest opportunity after this holding period, according to Intelligent Partnership’s research.
The government has been on a mission to find a way how to nurture and attract the Facebooks and Amazons of tomorrow, and how to fill the funding gap after the UK’s withdrawal from the EU. The UK has traditionally been a leading beneficiary of venture capital funding from the European Investment Bank, but flows to British venture funds dropped by a whopping 91 per cent to €61m (£53m) in 2017 following the Brexit referendum, compared to a year previously.
In November 2016, the prime minister tasked figures from across the industry to review the existing venture capital environment in the UK and to identify barriers to access to long-term finance for growing firms.
Acting on recommendations of an industry panel, the government then went on to explore how to get pension funds backing growing companies too. This year’s Budget revealed co-operation between the British Business Bank and some of the largest defined contribution pension providers, including Aviva, Legal & General and Nest, in testing options for pooled DC investment in patient capital.
At the same time, the FCA was tasked with reviewing the existing UK fund framework, that would allow unit-linked pension funds to invest in patient capital assets. The regulator is set to publish its first findings by the end of the year.
EIS Association director general Mark Brownridge welcomes introducing institutional investors to the venture capital scene.
He says: “It has been more in the realm of retail investors to try to help small companies to get them off the ground, but institutional investors can cut the market and make a bigger impact.”
Aegon pensions director Steven Cameron says he understands that the DC pensions market, which is predicted to hit £1trn in 2025, would appeal to the government as a good source of long-term investment in the economy, but adds that it should be aware of the purpose of pensions.
He says: “Pensions should always be first and foremost for the beneficiaries. Any decision made about pension schemes needs to be made in the interest of the members.”
Pension funds and patient capital can seem like a good match, when it comes to their long-term horizons, as start-up companies usually need to go through rounds of testing before introducing their product to the market and providing returns to investors.
But the two might not be so compatible risk-wise, as start-ups are inherently more volatile, and not every company will become the next Amazon.
Brownridge says: “The question is if the pension funds will be the right type of investor, keen and comfortable with investing in early stage companies, because obviously no one wants their pension money lost.”
Brownridge recommends investing just 5 to 10 per cent of portfolios in early stage companies.
He says: “There is a great chance of significant return, so if you are prepared to take that risk, which is obviously higher since you are investing at an early stage, the rewards will be higher as well. It is good to see DC open up for that.”
Cameron sees pooling the investments as a good measure to mitigate the risk. He says: “Being able to invest in a group of companies rather than investing in a single company diversifies risk within that asset class. Pooling certainly helps to spread the risk of one start-up company going under.”
However, investing in innovative technology companies might require more research and active investing, which could lead to extra fees for pension holders.
As some EIS managers charge performance fees, Cameron says it will remain a challenge to stay within the automatic enrolment default fund charge cap.
While some of the leading pension providers expressed early interest in exploring the scheme, the industry group will not report until the end of the year.
Cameron concludes that venture capital investment is likely to interest only the very largest pension schemes.
He says: “I think it will be a very niche market”.