Changes to the range of investable Enterprise Investment Scheme assets mean advisers must give greater consideration to diversification and other risk management strategies, explains Dermot Campbell
With its five separate tax reliefs, the Enterprise Investment Scheme (EIS) is - according to HM Revenue & Customs - widely considered to be the most generous tax incentive in the world. The tax wrapper allows investment in a wide range of early-stage companies, each with their own characteristics - and carrying their own risks.
In the past, EIS was seen as a single tax-planning product giving an advantageous tax outcome with little risk. This was driven by the Government guarantees for renewable-energy investment, where index-linked returns were guaranteed alongside the associated tax advantages.
Tax law has evolved, however, and renewable energy is now excluded from the EIS regime in a bid to redirect investment towards small and medium-sized enterprises in line with the spirit of the legislation.
As a consequence, there are more risks associated with EIS - which means investment returns and risk management strategies are crucial. It is possible to mitigate the risks of investing in EIS shares significantly through a combination of tax relief and diversification - something that has previously not been required.
The key point to understand is that most EIS companies are not listed investments, and therefore are less affected by ‘systemic' risks, but more affected by ‘specific' risks - that is to say, the risks are attached to the businesses in question rather than fluctuations in major stockmarkets, where shares can react in concert to macroeconomic events such as an unexpected election result.
Examples of specific risks would be a company losing a key member of staff or customer, which adversely affects its revenue. This is unlikely to have a bearing on other companies in a portfolio. Conversely, the entire market may react to a tweet from Donald Trump, when the impact on individual companies is insignificant.
‘Rule of three and 30'
Some venture capitalists use the so-called ‘Rule of three and 30', which states that if you get three successes out of 30 you make money. The rule assumes one in 10 investments ‘fly' - returning, say, five times your capital or more and - one in 10 fail. The rest will sit somewhere in between, ranging from ‘doing all right' to performing poorly.
But if you restrict yourself to just 10 shares, you may be unlucky and not get that one in 10 star performer. The more shares you hold, the greater the chance of such a star performer. Hence the rule of three and 30 - not the rule of one and 10.
This, of course, is precisely the same principle applied in mutual funds. By diversifying through companies, business sectors, countries and so on, they reduce the risk of losing money. As the following diagram illustrates, the effect of diversification is to increase the probability of a mid-case return and reduce the likelihood of a very good or very poor outcome.
Source: Kuber Ventures (for illustrative purposes only)
The amount of diversification actually required depends on the amount of risk associated with each investment -if all of the investments are very risky - for example, a Seed EIS portfolio - then you need a lot of diversification and maybe 45 or 50 positions. If none are very risky at all, however, then you can have less diversification. Some textbooks suggest the optimum diversification for a portfolio of ‘blue-chip' shares is about 15 investments.
If portfolio risk management is one key benefit from diversification, another is the management of risk to the adviser. A third is the ability to manage tax - no-one wants all their investments to mature at the same time; far better to exit over a number of years.
So what is the disadvantage of diversifying? There two main drawbacks: if you are a skilled investment professional, then diversifying may dilute your profits because you increase the probability of having a failure, however, for most people the reduction in risk more than compensates here. The other drawback is the increased administration costs - although new platforms and tools are available that offset this.
The EIS market is changing and increasingly it is embracing the necessity of constructing a diversified portfolio. While some investors will always want to concentrate their bets in the hope of stellar returns, this really remains a strategy for the professionals.
Dermot Campbell is chief executive of Kuber Ventures
Retired in 2014
Dividend tax hike also stayed
Advisers lacking knowledge
Five short video interviews with RLAM’s head of multi-asset
One of two new members