High Growth EIS investments vs ‘Low Risk’ EIS investments

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Date21 Mar 2016
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In this article Dermot Campbell, CEO, of Kuber Ventures and Andrew Kartashov, Director of Kuber Ventures, explore how best to manage and mitigate the risk of your EIS portfolio, whilst not compromising performance. Kuber Ventures is not an advisory company and you must seek professional advice before investing in high risk assets such as EIS or SEIS.

Whilst ignored here, stock selection is critical when it comes to private company. When investing in private companies, due diligence is key and an experienced investment manager will do this for you. In this article, we assume that you have chosen managers who are good at stock selection and are focusing on what you can do to optimizethe performance of your portfolio.

Diversifying a portfolio reduces the standard deviation which means that the results are more predictable.  The chart below illustrates the effect diversification has on a portfolio.

The idea behind EIS and SEIS investments is that the government compensates you for the risk you take. The so-called “low risk EIS” will tend to exit sooner, however, the returns are likely to be materially lower.  The reasons are simple; with EIS you get tax relief on your losses and tax free gains which amplifies the risk: reward ratio.

Many investment managers don’t like to talk about the idea that one of their investments could fail, however, failure of some individual investments in a portfolio is a fact of life.The key is that you want to maximize your chances of getting a collection of successful investments in your portfolio. If you by lots of investments, you will be compensated for any losses on poor performers and the out performers will return tax free gains.

So let’s have a look at some likely scenarios and numbers within and the likely impact of loss relief.

Scenario 1: Investing in 3 lower risk companies

Is based upon the following assumptions:

An individualinvested in SEIS with 50% income tax relief (with relief used in full).
Income tax paid at 40*
Investments are held for 4 years
Delivers a return of 10% per annum for 4 years equates to +46% total return.

* The figures for 45% are better still. These numbers can be changed – please contact us if you would like to receive the financial model, which will enable you to amend the figures used in order to match your personal circumstances more closely. Further examples are provided at the end of this article.

Low Risk Companies Income tax relief Returns Lost amount Loss relief Total return post tax over 4 years Annualised return
A1 50% 0% 0% 0% 50%
A2 50% 46% 0% 0% 96%
A3 50% 92% 0% 0% 142%
Average 46% Total 96% 18.32%

The results

The Average return is 46% (10% p.a.). In total it is 18% p.a. as incometax relief of 50% nearly doubles thereturn, delivering 18.32% vs 10% So it is definitely very positive.

Scenario 2: Investing in 3 higher risk companies

Is based upon the following assumptions

An individual invested in SEIS with 50% income tax relief (with relief used in full).
income tax paid at 40%*
Investments are held for 4 years
Delivers a return of 10% per annum for 4 years equates to +46% total return.

High Growth Companies Income tax relief Returns Lost amount Loss relief Total return post tax over 4 years Annualised return
R1 50% -100% 50% 20% -30%
R2 50% 46% 0% 0% 96%
R3 50% 192% 0% 0% 242%
Average 46% Total 102.67% 19.32%

The results

The Average return is 46% (10% p.a.). One company completely failed and even though if our average is the same – the return is enhanced 19.32% vs 18.32% – because of loss relief. In other words, you were compensated for the losses on the failure and given tax free returns on the successful investment. The issue is that the probabilityof getting the 3 investments to perform consistently is virtually impossible so let’s consider these two scenarios with a portfolio of 20 companies respectively:

Scenario 3: Investingin diversified portfolio of 20 lower risk companies

Is based upon the following assumptions:

An individual invested in SEIS with 50% income tax relief (with relief used in full).
Income tax paid at 40%
Investments are held for 4 years
Delivers a return of 10% per annum for 4 years equates to +46% total return.

Low Risk Companies Income tax relief Returns Lost amount Loss relief Total return post tax over 4 years Annualised return
A1,A2,A3 50% -10% 0% 0% 40%
A4, A5 50% 0% 0% 0% 50%
A6, A7 50% 10% 0% 0% 60%
A8 50% 20%  0% 0% 70%
A9 50% 30%  0% 0% 80%
A10 50% 40%  0% 0% 90%
A11 50% 50%  0% 0% 100%
A12 50% 60%  0% 0% 110%
A13,A14 50% 70%  0% 0% 120%
A15,A16 50% 80%  0% 0% 130%
A17,A18 50% 100%  0% 0% 150%
A19 50% 110%  0% 0% 160%
A20 50% 120%  0% 0% 170%
Average 46% Total 96% 18.32%

The results

We get exactly the same result, +18.32% per year, and since none of the companies failed, we didn’t use loss relief.  The difference is, in case of a diversified portfolio,is that the deviation of your returns will be lower so you are much more likely to get this result.

Scenario 4: Investing in diversified portfolio of 20 higher risk companies

Is based upon the following assumptions:

An individual invested in SEIS with 50% income tax relief (with relief used in full).
Income tax paid at 40%
Investments are held for 4 years
Delivers a return of 10% per annum for 4 years equates to +46% total return.

20 Risk Companies Income tax relief Returns Lost amount Loss relief Total return post tax over 4 years Annualised return
R1 – R7 50% -100% 50% 20% -30%
R8– R13 50% -50% 0% 0% 0%
R14 – R16 50% 100% 0% 0% 150%
R17 50% 170% 0% 0% 220%
R18 50% 200% 0% 0% 250%
R19 50% 400% 0% 0% 450%
R20 50% 500% 0% 0% 550%
Average 46% Total 103.00%  19.36%

The Results

Again it is nearly the same as previous case delivering a return of 19.36% as a result of utilising loss relief, however as with the previous example, the outcome is more predictable because the portfolio is diversified
Now in the following scenarios let’s apply the rule that higher returns are offset by a higher level of risk.

Scenario 5: Investing in diversified portfolio of 20 higher risk, higher growth companies

Is based upon the following assumptions:

An individual invested in SEIS with 50% income tax relief (with relief used in full).
Income tax paid at 40%
Investments are held for 4 years
Delivers a return of 20% per annum for 4 years equates to +107% total return.

20 Risk Companies Higher returns Income tax relief Returns Lost amount Loss relief Total return post tax over 4 years Annualised return
RH1– R6 50% -100% 50% 20% -30%
RH7 – R8 50% -50% 0% 0% 0%
RH9 50% 50% 0% 0% 100%
RH10 50% 90% 0% 0% 140%
RH11 – RH14 50% 100% 0% 0% 150%
RH15 50% 200% 0% 0% 250%
RH16 50% 300% 0% 0% 350%
RH17 – RH19 50% 400% 0% 0% 450%
RH20 50% 600% 0% 0% 650%
Average 107% Total 163.00% 27.35%

The results

Impressive. Half of the companies fail whilst other have soared +27.35% p.a. an extremely positive result.

Scenario 6: Investing in diversified portfolio of 50 Startup companies (4 out of 5 fails)

Is based upon the following assumptions:

An individual invested in SEIS with 50% income tax relief (with relief used in full).
Income tax paid at 40%
Investments are held for 4 years
Delivers a return of 30% per annum for 4 years equates to +180% total return.

50 Companies 1 of 5 is failed Income tax relief Returns Lost amount Loss relief Total return post tax over 4 years Annualised return
Startup 1 – 40 50% -100% 50% 20% -30%
Startup 41 50% 200% 0% 0% 0%
Startup 42-47 50% 1000% 0% 0% 100%
Startup 48 50% 1300% 0% 0% 140%
Startup 49 50% 2500% 0% 0% 150%
Startup 50 50% 3000% 0% 0% 250%
Average 180% Total 246.00%  36.39%

The Results

Average per year appeared to be 36.39% p.a. Impressive result!

Other scenarios

Let’s see how the numbers will change in the above investment examples if we have different situations:

SEIS case. 45% rate tax payer
SEIS case 40% rate tax payer (the above examples)
EIS case 40% rate tax payer
EIS case 30% rtate tax payer
EIS case without income tax relief and Loss relief. Only Free Capital Gains on the investments.
Not EIS. CGT 10% on the investments.
Not EIS. CGT 28% on the investments.

The first 2 scenrios with just 3 companies have been removed as their average income numbers are the same as in the case of 20 companies.

20 Low Risk Companies 20 High Risk Companies 20 High Risk Companies, Higher Growth 50 Companies 1 of 5 is failed
SEIS, 45% tax rate 18.32% 19.49% 27.44% 36.58%
SEIS, 40% tax rate 18.32% 19.36% 27.35% 36.39%
EIS, 40% tax rate 15.18% 16.88% 25.26% 35.03%
EIS, 30% tax rate 15.18% 16.46% 24.97% 34.45%
Free CGT 9.92% 9.92% 19.95% 29.36%
CGT 10% 9.02% 8.27% 17.84% 26.98%
CGT 28% 7.33% 5.08% 13.72% 22.34%

A key consideration is that the low risk companies are likely to have a shorter term to exit which will enhance the annualised return of these investments

It is the EIS Loss relief that enhances the return of the Risky Companies giving a better return than the lower risk companies. If you don’t use loss relief, the stable companies give the better results.
So in conclusion, without the tax relief, specifically loss relief, you should be concentrating on lower risk investments because the risk reward ratio is better, but with EIS or SEIS relief, investing in low risk companies means that you are wasting a valuable tax relief by investing in a company which is low risk.

Another result – that there is no big difference between 40% rate tax payer, 45% and even 30%. The numbers all are nearly the same. It does make sencse if you invest in SEIS or EIS and very big difference if you don’t use relief.

Conclusion

You should not avoid risks when investing in EIS and SEIS. The tax system rewards you for taking risks and by using diversification you are able to dramatically enhance the risk reward ratio.
As you see in all examples above even 50% income tax relief is not that significant compared to the growth results you can get from these investments. Choosing investments with more growth potential but individually higher risk of loss is better, because loss relief limits your downside.

Biogs

Dermot Campbell’s career as a wealth management professional has spanned 23 years across a range of disciplines, including management, private banking, financial planning, product specialisation and as an independent financial adviser. Dermot is a Chartered Financial Planner and a Chartered Fellow of CISI.

Andrew Kartashov’s background is in IT having worked for a number of highly regarded IT companies in Moscow since the 1990s, and has developed various trading algorithms for investing on the Moscow Stock Exchange.