How S/EIS offers Investors a hugely valuable level of downside protection, and tax-free upside they cannot find in the mainstream markets in the current climate.
These companies are the life blood of the UK economy. It is start-ups and SMEs that are driving so much of the UK’s job creation and after the C-19 epidemic this is needed now more than ever. EIS and SEIS are high risk investments; this is due to their unquoted nature, the qualifying criteria, the Risk to Capital Condition and their low liquidity. The Government wants them to receive investment though, to bolster UK plc, and they achieve this by making it more attractive to Investors – offering significant downside protection through multiple tax reliefs. 58% of an EIS qualifying investment and 70% of an SEIS qualifying investment are covered with income tax reliefs alone.
This makes EIS and SEIS a very attractive proposition in the current environment – an investment into an asset class with low correlation to traditional markets, 58% plus downside protection (depending on personal circumstances) and CGT free upside on any gains. Managers in this space who can select and support the investee companies that will weather – and even benefit from – the current storm stand to make their Investors a lot of money. Add a multi-manager selection with a degree of diversification and in S/EIS investments Investors have an investment proposition that is hard to beat in this current climate. Forewarned is forearmed – and Managers allotting now are in a much stronger position to select the right companies than for those allotments at the beginning of this crisis.
Effects of C-19 on S/EIS:
The effects of C-19 are extremely hard to predict at this point. The combination of not knowing how long the epidemic will go on for or how severely means the majority of Managers in this space are planning for a long- term worst case scenario. There are sectors they will be likely avoiding that have already been negatively impacted and those sectors that are expected to get hit badly (more so than others) in the next six months. The additional complication (albeit a positive one) is the announced and possible further Government support, which has the potential (and is intended) to do whatever it takes to keep UK businesses going.
One of the advantages of S/EIS investment is that the size of the companies are such that most of them are fairly niche. The current qualifying rules lend themselves heavily to growth investments, many of which are targeting market disruption or enhancing industries with technology. There are more traditional businesses selling established products and services into an established market, but this is usually the exception rather than the rule. Many of these new, disruptive and tech focused businesses are targeting a specific need or niche market. While EIS investments from 3 months ago or before might well find that their need or niche has been badly damaged by C-19, investments made now by Managers can be targeted into only the companies that are more C-19 resistant. This is one of the great advantages of every EIS tranche of investment being able to be different from the one before it.
In any crisis there is also opportunity. The valuations on most companies will have fallen to varying degrees over the last month and that provides a buying opportunity. All businesses being invested into in the current tranches will have been reviewed in the light of the crisis. Managers will likely only be selecting businesses that will be relatively less severely affected than others, but even those might come in at a slightly lower valuation than before.
I do not want to suggest C-19 will not impact S/EIS, there will be many investee companies that will suffer from the virus and their ability to deliver their products and services to market will likely be compromised, but equally many will not. Therefore, while C-19 is not good news for many companies, at least with S/EIS your downside is limited.
Downside Protection through Qualifying Status:
The Government wants individuals to invest into the type of companies that qualify for S/EIS as already established. To that end they offer a generous package of reliefs to go with it. I would expect the majority of people reading this will know them, but seeing them written down often reminds people just how advantageous these are:
- Initial income tax relief – 30% (50% for SEIS);
- Loss Relief on the remaining amount 70% – 0.7 x 40% = 28% (20% for SEIS) for Higher Rate tax payers;
- Business Relief on death – 40% IHT saving;
- CGT Deferral – Capital Gains can also be deferred for the life of the investments (Reinvestment Relief for SEIS gives 50% CGT relief on any reinvested capital gain); and
- CGT Exemption – 100% of gains are tax free
While historically Advisers and Investors have looked first and foremost at the initial income tax benefit – the reliefs with the greatest value in the post Patient Capital Review S/EIS world are the loss relief on every company and the CGT exemption on the upside. In an extreme scenario to make the point; if a portfolio of 10 companies each with investments worth £1,000 were to see a 90% failure rate but the 10% returned 10x money the return profile would look as per the below:
|Initial investment||Losses||Pre Tax Return||Income tax relief||Loss Relief||CGT Saving||Post Tax Return|
Changed Risk Levels:
This tax infrastructure is specifically designed to be beneficial to high risk/high reward investments. The more traditional markets just got a lot more high risk high reward, however, are without the benefits of S/EIS.
S/EIS are high risk investments. They are illiquid, have very low correlation to the market and are often focused on niche industries or needs. Even later stage EIS will have a significant proportion of failures. As such the tax treatment is extremely beneficial to a portfolio that has complete losses but also a few companies with extremely high returns. Every EIS company that loses money – the investor can claim loss relief of at their highest marginal tax rate; every EIS company that makes money will return that CGT free. That treatment (plus the original 30% buffer) makes these extremely attractive assets to have in a time of high risk.
So yes – the risk levels for all companies have changed to be higher risk, but with the tax reliefs as well as the raft of Government support mechanisms, EIS is arguably one of the best spaces to be invested in.
Working Capital vs Growth Capital:
The majority of S/EIS companies look for additional funding to grow. Very few Managers invest into EIS companies if the funds are lined up for working capital. Many Managers do follow on investment and some of that will go on working capital but that will almost always be with a view to landing a business plan. There is no vested interest in a Manager throwing good money after bad. If they feel a company is failing they are not incentivised to invest further. Many will have companies that are underperforming, and they will dedicate huge amounts of time and resource to assisting and attempting to turn those companies around, they will very seldom give them significant additional funding if they are performing.
In addition to this the Government Loan scheme is specifically setup to support those companies who have been negatively impacted by C-19. It is a loan rather than a grant, but the terms are very attractive and are specifically designed to meet the working capital requirements.
C-19 has investors spooked. It is completely understandable given the extent to which it caught the whole world off guard and there is still so much we do not know about it. We do know an awful lot more about it now than we did two weeks ago though, and we are beginning to get a much clearer picture of how Government, businesses and people are reacting to it. As with any crisis we have seen huge volatility in the traditional markets (with net movements being significantly negative), and we have now seen the Governments initial response to it. “Whatever it takes” is the terminology used and the support package announced has been huge.
S/EIS investments are only suitable for Investors that can afford to lock up their capital for the longer term and will not need access to it. That is more true now than ever when Investors’ more liquid assets might have fallen in value. For those that can take the liquidity and investment risk though the 70%/58% downside protection on all failures and high potential CGT free returns on the successes make for an extremely attractive proposition. For allotments happening in the next week or beyond Managers selecting the companies they are deploying into have factored in C-19 and the portfolios they build will be as C-19 “proof” as is possible.