EIS and VCT changes – “but what do they mean for my clients and me”? Part III

In the third of three articles on the changes brought in with the Budget, James Ramsay, an independent tax efficient specialist, takes an adviser’s eye view of the changes and their implications to firms and their clients.

The changes to the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) announced in the Budget have almost all now been settled in. Royal Assent was given on 15th March 2018, and while we still have yet to see the final draft of the Risk to Capital Condition, it will have been effective from 15th March 2018; thus bringing us into the brave new, and knowledge intensive world.

By way of a recap we have covered our concerns for advisory firms and their clients on the back of these changes:

Increased risk profile

Long-term holding periods  

Less predictable allotment schedule (EIS only)

Less predictable exit schedule (EIS only)

The focus on this final article will be on our perceived positives:

No reduction in the initial tax relief

Risk/ return profile

Preferable tax treatment (EIS only)

We will also summarise with three ways we feel advisers can tangibly add value to their clients in this new environment.

No reduction in the initial tax relief

30% initial income tax relief on a investment is very appealing. So much so that many were worried the reliefs were too good to be true. Throw in any gains (and dividends for VCTs) being tax free and many industry experts expected the 30% to be reduced, or for the minimum holding periods to be extended. The great news for clients and advisers is that the reliefs remain unchanged.

There are very few HMRC approved alternatives to obtain these benefits once an individuals pension and ISA contribution have been filled. This popularity has been proven yet again this year with VCTs having had their second biggest fund raising year already, still with some time to go. The ￡625m raised already this year is second only to the ￡779 raised in 2005/6 when income tax relief was still at 40%. We will have to wait some time for the equivalent EIS numbers but they are also expected to be high.

Risk/return profile

Capital preservation EIS and VCT have always been high risk. The concept of “lower risk” has only ever been relative to the Venture Capital space. Every suitability letter you have written for these in recent memory will have warned the client they are almost completely illiquid investment, and all of their capital is at risk. Yes some clever downside protection might have been structured or contracted into the underlying investee companies’ business models, but the main risk has always been the unquoted nature and the size of these companies.

If we take a recent example of what is believed to have been the first instance in the UK of a manager having to notify advisers and investors of a 10% drop in the reporting period under MiFID II; it was a capital preservation EIS.

That it was an EIS is of little surprise. More surprising is that renewable energy generation such as this one was widely considered to be one of the “safer” bets given the price support mechanisms. It transpires that the management team responsible for some of the underlying EIS companies had failed to deliver on their projections. So the risk wasn’t the business plan nor the price support mechanism, but rather management risk – inherent in any company but much more so in unquoted investments.

So at this high level of risk, was a 110p in the ￡1 an appropriate return target? At an IRR of under 2% over five years I would argue not. A 157% return (stretching the numbers by using a net 70p investment) gives you an IRR of roughly 9.5%. While much more flattering the answer remains no. Institutional Venture Capitalist investors will generally target five to ten times money in under ten years. That is a range of 17.5% - 26% IRR. I appreciate products available to retail investors differ greatly to institutional investors but it is an interesting contrast.

It is difficult to make direct comparisons, but a Risk to Capital qualifying EIS or VCT is likely to be targeting a range of somewhere between 150p – 300p in the ￡1 over a space of five to eight years. This gives an IRR of 8.5% - 15% before tax or 16.5% - 20% net of initial tax relief. This is an altogether more appropriate potential return for the amount of risk being taken, and the risk tolerance of the clients investing into these products.

It may take them longer to get their exits, and they will most likely have a few write-offs in the process, but basic risk/return theory suggests clients should make more money in the new world, especially if you build in enough diversification into your advice.

Preferable tax treatment (EIS only)

Most EIS investments are structured so that losses on individual companies can be offset against income tax in the year they exit, while the gains on any of the other EIS are CGT free. The companies are not netted off to give one single return. Therefore the tax treatment lends itself better to more volatile returns. An example is a best way to explain this.

Initial investment: ￡100,000

5 EIS Companies return ￡20,000 totalling ￡100,000

Initial Relief: ￡30,000

Loss Relief: ￡0

CGT saving: ￡0

Total Return: ￡130,000

3 EIS Companies return ￡0, 1 returns ￡20,000 and 1 returns ￡80,000 totalling ￡100,000

Initial Relief: ￡30,000

Loss Relief: ￡18,900 (loss relief of 45% on the net 70% on three companies)

CGT saving: ￡16,000

Total Return: ￡148,900 (ignoring the CGT saving)

While this a very simplistic example is does show that on the same total return, the loss relief means that in the second, more “growth” type return model, the tax treatment is preferable. Of course this assumes the companies survived their three year qualifying period, otherwise the 30% initial relief would have been claimed back.

Three ways you can add value as an adviser

So in summary an adviser should be looking to respond to these changes by:

1.     Adding downside protection through their advice.

Diversification and portfolio construction is one of the primary risk mitigation techniques. A spread of five different managers is likely to deliver between 30-50 different underlying companies. Therefore the adviser has most likely mitigated more risk than was “lost” from the underlying companies, adding very real value for their fees.

2.     Providing ongoing monitoring and reporting.

Most advisers have been guilty of not providing enough of a service beyond investment. These investments are illiquid, but that does not negate the ongoing advice responsibilities. Advisers should bring EIS and VCT more in line with their traditional portfolios where they monitor and add products to balance manager, sector and holding periods. Exits with CGT and IHT must also be tracked to reduce re-investment risk to clients. Clients will see the value in enhanced consolidated reporting and receive tangibly improved service from their adviser.

3.     Managing client expectations.

The changes will have a profound effect on the investment experience for clients: allotments, certificates and exits will be more varied and take longer; more underlying companies and certificates; more losses, but equally more and larger gains. Overall client returns should improve with an increased underlying risk profile, and proactive advisers can easily avoid short-term client disappointment with some basic re-education.

The cost and work required to invest into and gathering information on these products has previously deterred advisers from diversifying further and offering more comprehensive monitoring/reporting to their clients. There are now a number of services and platforms active in this market that can significantly reduce these as well as offering other enhancements.

Conclusion

So despite changes announced in the Budget EIS and VCT are still an extremely attractive proposition for appropriate clients and advisers. Preserving the initial 30% tax relief through the Budget has protected this. The recent changes have added complexity to the market but a well-structured tax enhanced proposition can add tangible value to clients while also being profitable for advisers. These changes have created a very real opportunity for sophisticated advisers to differentiate themselves from their competition, and to add further value to clients above direct investment.