WE NEED TO TALK ABOUT RISKS

James Faulkner is a Director at Vala Capital and has responsibility for the experience of investors and their advisers. James has enjoyed a successful career in sales and marketing for over 30 years primarily within financial services with PwC, ABN Amro and Dun & Bradstreet but with spells in manufacturing and consulting too. James is a Chartered Member of the CISI and holds the Level 4 Investment Advice Diploma. In this article he discusses how to build your clients’ confidence in EIS by helping them understand the risks involved.

There is no getting around the fact that investing into companies that qualify for the Enterprise Investment Scheme is risky. After all, EIS tax reliefs exist solely to incentivise risk-taking. But it’s also true that risks can seem more severe to clients who do not fully understand them. By demystifying EIS risks for your clients, and by showing them how EIS fund managers try to mitigate risk, you can help them to feel more confident about investing.

Some general risk mitigation themes, like diversification and due diligence, are familiar but worth thinking about in more detail. And all sorts of other factors, including the manager’s experience, their approach to mentoring and even the product’s fee structure can have a bearing on risks. This article sets out some of the risk issues you might have thought of before, alongside some that you may not have previously considered.

Investing in an EIS fund rather than a single company is the simplest way to manage risk. At the most basic level, this is just about spreading investment across a portfolio, so that you’re not putting all a client’s eggs in one basket. But diversification can work on a number of other levels too. Some EIS products seek to diversify a client’s subscription across a number of different industry sectors. This means that if a certain industry is hit hard by economic issues, evolving consumer trends or regulatory changes, it shouldn’t affect the investor’s entire portfolio. At Vala, we tend to invest in the sectors that we know best. And because our investment committee members have a broad range of experience, that means our portfolio is diversified across sectors including technology, engineering, fintech, media & entertainment, lifestyle brands and food & beverages.

Further diversification can be achieved by investing in companies that are at different stages of development. Investing in a company that has not yet sold its product to any customers brings higher risks, but it could also eventually yield higher returns when compared to investing in more mature businesses. Companies that are already generating sales revenues command higher share prices at the point of investment, so the later investors will generally achieve a lower exit multiple than the pre-revenue investors. At Vala, our preference is to invest in companies that have already generated at least some revenues. But to maintain the right balance of risk and reward across the entire portfolio, we do sometimes invest in pre-revenue companies too.

If diversification is such a powerful way to mitigate risk, why stop (as Vala does) at a portfolio of 6 to 10 companies? Why not invest in 100 businesses? Put simply, the bigger the portfolio, the smaller the chances of extreme outcomes. As the size of your portfolio grows, you are less likely to lose your entire investment. But you are also less likely to achieve a really exciting return. If you split your investment equally across 10 companies, then successfully sell one company at a 10x multiple, you have recouped your entire investment.

Within a 100 company portfolio, the same outcome only returns 10% of your original investment.

At Vala, diversification is baked into our investment thesis. And because we invest in tranches, clients are able to see a preview of the companies we plan to invest in next. As such, clients can sense-check the diversification we are aiming to achieve for them, before they commit to investing with us.

Good due diligence processes, carefully carried out by an investment manager, can also serve to strip out some layers of uncertainty. Clearly due diligence cannot remove all risks. But it should be of some comfort to know that the investment manager is carrying out a detailed assessment of a company’s business plan, financial model, management team, intellectual property and more, before committing to making an investment. At Vala, we often invest in companies that have come through accelerator and incubator programmes we are involved with. This provides a useful additional source of practical knowledge to supplement our other due diligence processes. We have the chance to see the company and its founder in action over a prolonged period of time, in order to build our confidence in their abilities prior to investment.

Managing risk does not end with the selection of companies to invest in. The way in which funds are released to companies can play a part. At Vala, we often reach agreements with our portfolio companies where we commit to provide a certain amount of funding, but release it gradually rather than in a single payment. Each phase of the investment acts as a review point. We revisit our due diligence and assess the company’s progress before providing further cash, giving us regular chances to evaluate the risks involved.

The support provided to companies by EIS fund managers throughout the investment holding period can also serve to mitigate risk. At Vala, all of our investee companies receive monitoring from our team of seasoned entrepreneurs. They have all enjoyed success in creating, growing and selling companies, but they have also learned lots of painful lessons along the way. This experience really comes into its own in a crisis. We’re able to offer our investee companies calm, constructive help whenever they face challenges and obstacles. This is in turn helps to manage risks for our investors.

It’s also worth thinking about how an EIS product’s fee structure will affect the provider’s attitude to risk. For example, the Vala EIS Portfolio does not collect any initial or annual charges from investors. Our costs are covered by a 6% fee charged to investee companies, and our profit incentive comes from a 20% performance fee on successful investments. This closely aligns our interests with those of our investors. We are incentivised to generate strong investment returns. But if we take excessive risks we may end up with no reward, since we do not have the cushion of annual fees to fall back on.

Finally, it is worth coming back to where we started this article – the connection between EIS tax reliefs and risks. Whilst tax-free gains on investment returns enhance the potential upside, income tax relief reduces the cost of investment and loss relief limits downside risk. When an eligible higher rate taxpayer invests in EIS, these tax reliefs restrict their potential loss to just 42% of the amount invested. And an investor paying tax at 45% can only lose 38.5% of their EIS investments.

So, are clients right to worry about the risks of EIS investing? On one level, yes. Investing in start-up companies and early-stage companies is difficult and risky, and always will be. But by choosing an EIS provider who takes a strategic and disciplined approach to managing the inherent risks, and by remembering that the EIS reliefs reduce the overall amount of money at risk, investors might feel more confident about their decision to invest in EIS. GBI