To paraphrase Shakespeare, now should be the winter of growth-focused-EIS-fund-managers’ content.
The EIS investment landscape is undergoing a significant shift driven by changes in HMRC rules for EIS eligibility, the broader government re-focus on activist industrial policy, and – most importantly – the maturing of the UK startup investment scene, with an increasing number of good technology investment opportunities. IFAs and Wealth Managers are already reacting to these changes, revamping their panel selection criteria to reflect a greater focus on understanding EIS investment strategies.
Over the next 2-3 years we may see a realignment in the industry, likely leading to a greater diversity of EIS offerings and the emergence of more specialist players. In 2016 there was approximately £2bn invested in EIS Funds. A hefty proportion of that was deployed toward various types of capital preservation schemes that may no longer be eligible for EIS purposes. As a result, there’s potentially a very large pot of investible money looking for an EIS-able home. We may see conflicting trends where some investable funds exit the EIS industry as capital-preservation products wind down, whilst others enter – attracted by the greater diversity of growth investment opportunities.
It is also possible that EIS Funds and VCTs will see greater convergence with the mainstream VC industry, and divergence from other tax-planning investment tools. This will require new set of skills and knowledge in financial planning that goes beyond the basics of tax planning, and so IFAs and Wealth Managers are now looking to evolve their strategies and approach to evaluating investment opportunities in the space.
Below I examine the various drivers for change and how these are likely to affect the EIS (and relatedly the VCT) investment space:
Key Budget 2017 changes to EIS and VCT rules – and the policy context
As expected, in the 2017 Autumn Budget, HM Treasury started a pushback against the use of the EIS for capital-preservation and asset-backed investments. The focus now is firmly on using the EIS to support/encourage investments into knowledge-intensive companies. In practice this is expected to lead to a reallocation of EIS investments onto true technological innovation types of opportunities, such as those in robotics, artificial intelligence, materials science, and biotech.
This is a welcome and pragmatic development that should help guide the EIS space back to its original mandate – using tax breaks to help investors back entrepreneurs leading knowledge-intensive companies that can fuel productivity growth. Of importance are the following changes:
- For knowledge-intensive companies, doubling of EIS investment limit, both in terms of the cap on how much an individual can claim (from £1M to £2M p.a.), and in terms of limits on the amount of EIS or VCT funding an individual company can receive (from £5M to £10M p.a.).
- Establishing a principles-based approach to screening companies for EIS eligibility, to ensure the scheme is leveraged primarily by entrepreneurial companies looking to fund long term growth, as opposed to capital preservation schemes.
- Promising to streamline the advanced assurance mechanism, to allow a response within 15 days to most applications.
Similarly, there are further changes to VCT rules:
- An increase in the qualified holdings requirement from 70% to 80% of a VCTs holdings by 2019.
- A requirement that 30% of all new funds raised must be invested within 12 months from the end of the accounting period in which the VCT shares are issued.
- Removal of many ‘grandfather’ provisions for older funds.
The net effect of these is harder to predict than for EIS, but the general purpose of the changes is to ensure that VCT funds are invested in smaller, high-growth companies. As such, VCTs will likely have to reduce their sums held in cash and other liquid assets.
For knowledge intensive companies there is an important relaxation of how company maturity is measured with regards to EIS / VCT eligibility. Instead of using the date of first commercial sale to mark the beginning of the company’s 10-year eligibility period, companies can use the date from which annual turnover first exceeds £200k. This is a welcome relief for IP-intensive companies with longer R&D cycles.
These changes are consistent with the Government’s preoccupation to close the ‘scale-up’ challenge identified in the HMT’s Patient Capital review, namely the finding that there are not enough funds for Series A and B investments into knowledge-intensive companies going from first revenues to scale-up growth. It is expected that other measures may further complement and support the growth in the UK VC industry – both its EIS and more traditional components. In other words, this is not a one-off, but a trend. There has been a fundamental shift in government policy, with a more active focus on promoting growth and knowledge-intensive businesses.This is linked to the post-Brexit vision of a UK powered by high-tech growth and export-focused business sectors, which will define this part of the investment landscape for a period to come.
Investors’ reaction – will greater product diversity offset decline of capital-preservation products?
Clearly there will be a move away from many capital preservation schemes which are now simply too risky from a compliance perspective, but how fast or drastic will investors’ reaction be? Not surprisingly, there are drivers both for an increased and decreased allocation to EIS and VCT funds focused on growth and innovation. Some investors (and their advisors) may choose to decrease their allocation to, or exit from, the VCT and EIS space altogether, as the associated risk levels increase, and they choose other (non-EIS-able) capital preservation schemes. However, the EIS space has shown resilience when eligibility criteria were tightened in the past. For instance, when solar and other renewables project finance was excluded from EIS eligibility, there was reallocation to technology and other projects, with the annual amounts staying similar year-on-year.
It may well be that the increasing diversity of different EIS products on the market provides sophisticated investors (and IFAs looking to provide their clients with a deeper service), a sufficient set of diversification options to facilitate an increase in EIS allocations in the next 2 – 3 years. At any point of time, the selection of financial products relates to a range of factors. This includes: whether the investor seeks capital gains or regular income; their investment time horizon; where they are professionally or in their retirement cycle; sectoral interest; and their understanding of the different types of risk associated with different investment products. Each of these factors affects the total allocation of funds to EIS and VCTs in competition with other allocation strategies:
- Passive investor clients may need to have greater diversification across more EIS Funds, and possibly also across different stages of investment.
- Active investors may be using the EIS space as a way to identify larger follow-on investment opportunities. Here an initial investment in an EIS fund may serve as a way to get to know the fund management team, and identify follow-on investment opportunities from the initial cohort.
- Many of the IFAs’ clients are successful entrepreneurs and business owners, and they may be looking for opportunities with more involvement. Here the smaller or newer EIS Funds could provide great opportunities both as investments as well as linking up with a network of investors.
That’s a lot of changes for a traditionally conservative industry! It may well result in many IFAs simply withdrawing from this area, giving their clients the basic facts and allowing them to do their own EIS investment strategy… but there’s too much money at stake for such a gap to remain for long. The industry is already starting to adjust, with IFAs and Wealth Managers evaluating what changes they need to make to serve their clients’ interests better in this transformed environment. What is clear, however, is that the move away from capital-preservation types of schemes may require more active involvement by investors and their advisors in investment opportunity selection.
In the upcoming part two of this article, I will discuss how the IFAs and Wealth Managers may achieve this; providing an examination of how they could change their behavior and evolve their strategies in light of the current post-budget investment climate.