New investments in Enterprise Investment Schemes have yet to be made – but when they do, investment managers will have taken into account the risks posed by the pandemic, reasons James Faulkner, Director at Vala Capital.
Just as last year’s parliamentary drama was settling down, storms Ciara and Dennis rolled into town, and the Covid-19 virus began its spread across the world. Stock markets collapsed and governments put us all in lockdown, throttling the life out of entire economies. Central banks are struggling to find any aces up their sleeves, having played their best hands over more than a decade of printing money and keeping interest rates at rock bottom. Against the current backdrop we’re often asked what it all means for investing in start-ups through the EIS. At times like this, EIS providers are prone to a couple of standard responses.
The first is to draw attention to any companies in their existing portfolio that are not just surviving but thriving. Food delivery companies, games developers and med-tech businesses are the cherries du jour at the moment, being pushed to centre stage to demonstrate how clever venture capital investors are. At Vala, we have portfolio companies that are proving more than resilient through this crisis. The likes of play.works, Terralogix and pirkx continue to show strong growth throughout this period.
But we are acutely aware that short-term increases in revenues brought about by exceptional circumstances are not necessarily worth getting excited about. EIS investments are typically held for 3-5 years. By the time these companies are sold, any growth enjoyed as a result of the current crisis could be smoothed out by years of less flattering business-as-usual results. The second stock response is to argue that times of great economic difficulty are the perfect time to be investing in alternative investments. If the markets are in trouble, invest in EIS because it is uncorrelated to the markets. We think this response is a bit of a stretch. Yes, some investors might want to consider allocating a small proportion of their wealth to assets that aren’t correlated to markets. But whatever the prevailing economic conditions, the features of EIS investments remain unchanged. They are highly-risky but with the potential for significant gains, bolstered by a set of tax reliefs that provide a cushion against downside risk – investors could have more than 60% of their initial investment protected in the event of a zero return from any of the companies in a portfolio. So uncorrelated, yes, but also unpredictable.
It’s also impossible to escape human nature at times like this. The fact is that most investors have a flight-to-safety instinct and cannot be persuaded to take a risk-on approach to investing. That said, we believe there are two big factors that make EIS portfolios an interesting investment to consider at times like this. Firstly, the fact that EIS ‘funds’ are not funds in the conventional sense. Investors are not buying units in an existing portfolio of companies that have already been invested in. They are subscribing to buy shares in a portfolio of companies, through a series of investments that are yet to happen.
The companies are chosen by experienced investment managers, who will only invest after completing a due diligence process. Good investment managers will take into account the risks posed by Coronavirus and other factors, before completing an investment in a start-up. So, while the investments remain risky and will face other uncertainties during the holding period, clients who subscribe to an EIS now should end up with minimal, if any, exposure to companies that stand to be hit hard by the pandemic.
And then there is the diversification argument. If there’s any lesson from the past few months, it’s that having a broadly diversified portfolio across different asset classes is vital. You can take a punt on one or possibly two particular industries – med-tech or entertainment or food delivery – but who knows what the next challenge or technological development is around the corner that imperils that sector.
In short, subscriptions made to EIS portfolios now will be invested into shares only after the investment manager has taken into account the possible implications of Coronavirus for the intended investee companies. This, combined with the government’s continued commitment to EIS, should improve a client’s confidence in deciding to invest.