Scarcity of capital for small and medium-sized enterprises opens up opportunities to invest in good quality businesses at attractive valuations.
The enterprise investment scheme offers substantial tax incentives to encourage private individuals to put equity capital into SMEs. However, previously private investors have had disappointing returns from investing in SMEs through the enterprise investment scheme. What is going wrong?
The roots of the problem
- Ill-equipped EIS managers: Often EIS managers are fund managers with no front-line experience of how to help an SME through growing pains. Many entrepreneurs need more than just capital, they need practical advice. Plans are formed but things rarely go to plan and just when EIS managers should be active owners they are too often unwilling or unable to engage.
- Tax-driven investment: EIS investments are treated by the financial advisory community as tax products, sold by tax experts, not investment experts, and they are mostly sold at the end of the tax year. The tax tail wags the investment dog.
- Conflicts of interest: Though they are making private equity investments, most EIS managers have not adopted private equity investment models. They typically do not “put their (own) money where their mouth is”. When investing other people’s money, EIS managers are rewarded through upfront and annual fees and charges that generate healthy revenues irrespective of investment performance.
- Inadequate due diligence: EIS funds and their underlying investments are generally too small for wealth managers or IFAs to conduct meaningful due diligence. Typically this is outsourced and becomes a tick-box exercise. Private clients who invest deal by deal don’t usually benefit from independent, professional due diligence.
- No control and oversight: Private investors can become minority shareholders in illiquid investments with limited opportunity to see what is really going on or to influence events.
Five steps to successful EIS investing
- Battle-hardened EIS managers: EIS managers who less experienced and spend much of their day at a computer are unlikely to get the results investors are looking for. You want experienced hands on your side with front-line experience of helping SMEs through the inevitable bumps and shocks of a small, growing business. Entrepreneurs may have great ideas and products but if they haven’t successfully grown a business before, they can fall into any number of traps, like not focusing on cash flow. Having an EIS manager who has been there and done it before will greatly improve the chances of success.
- Investment driven: Tax incentives should be a bonus not a core driver for any investment. Ensure the investment is assessed purely on its investment merits, irrespective of any tax perks.
- Aligned interests: Work with EIS managers whose interests are fully aligned with investors. Ideally find EIS managers who are putting meaningful sums of their own personal wealth into each deal. Having skin in the game is the best way to ensure an EIS manager cares deeply about investment performance.
- Robust due diligence: Ensure that hands-on due diligence is conducted by experienced private equity investors not side-tracked by flashy and unrealistic presentations.
- Control and oversight: Work with EIS managers who act as lead investors and proactive owners to ensure that management is held to account and working in the best interests of investors.
Even when these five steps are followed, there are still many random and unpredictable events that can blow a good investment off course. Never get too carried away with one deal but use an EIS manager who can spread your risk across numerous investments.
David Pitman is a partner at Oakfield Capital Partners