4 areas to focus on when researching EIS
12 March 2019
Researching an Enterprise Investment Scheme (EIS) is never straightforward but taking a methodical approach which considers four main areas can help, says Nicki Hinton-Jones, founder of XPM Investment Consulting.
As the end of the tax year approaches, tax advantaged investments inevitably come under scrutiny. Advisers and financial planners often report that researching Enterprise Investment Schemes (EIS) can be challenging due to the complex nature of the products themselves and lack of standardised structure. We can overcome some of these difficulties by taking a methodical approach with four main areas of focus.
1. Investment Management Company
The company behind the product matters. It’s helpful to gauge the product’s significance to the firm’s strategy and what resources are put behind it. I particularly like to look at how the business owners are incentivised, if they invest in the EIS, and what might happen to the EIS if ownership of the organisation changed. In many cases it’s quite foreseeable that the EIS would be largely unaffected if new business owners came in. Reviewing financial statements can reveal any risks to the firm as a going concern and show what cash reserves are available to service operations.
2. Investment Process
Understanding how holdings are sourced, assessed and selected is critical. The provider might be part of a broader financial institution with a corporate banking division bringing new deals to the EIS portfolio. Or does the firm have a strong enough brand that early stage companies approach directly for finance? You can ask to see the pipeline to get an idea of whether there is a good number of opportunities coming through that could make it to investment stage.
Once sourced, potential investments must be scrutinised. How does the manager review the businesses plan, its financial forecasts and what is the approach to valuation? Managers vary in the extent to which they analyse potential deals. They also vary in their degree of involvement with the company after finance is provided. Some managers require a Board seat so they can influence strategy and contribute to the company’s success.
Consider how individual holdings are assembled in the portfolio – is the product diversified, or focussed on a sector? The success of early stage companies is dependent on their individual characteristics, rather than broad capital market trends so the greater the number of holdings, the more risk can be offset. Although the average number of holdings in EIS vehicles tends to remain low, there are some with considerably higher targets.
It’s obvious that the experience and skills of the people running an investment strategy are key. Within EIS, find out what sectors professionals have built their experience in. Also look for depth of resource and key man risk. Who steps in if a murderous bus comes along? Consider what other responsibilities the lead fund managers have and how much time they can dedicate to this product.
Comparing fee structures is a minefield. EIS products are often layered with different fees, making comparisons appear impossible. There are initial charges, deal fees, management fees, admin charges, legal fees, director fees, performance fees… I could go on.
Part of the problem is that some providers make charges directly to the investor, some to the investee company and many a combination of the two. It’s worth taking time to aggregate charges by product, so they can be compared on a like for like basis. It is sometimes argued that fees to investee companies aren’t relevant, since companies that do well, return multiples of invested capital, while companies that do badly go to zero, so in either case a few percentage points of additional finance costs are neither here nor there. While it’s true that finance costs are unlikely to determine a company’s success or failure, they certainly have an impact on Return on Equity and shouldn’t be ignored.
It’s worth a word on performance fees too; these are unfortunately standard in the industry, but hurdle rates are not and vary widely. Although many providers take a cut of any capital that is returned above the initial investment, there are some that only take a performance fee if capital has grown above a pre-set hurdle rate.
The problem this complexity poses is certainly on the industry’s radar, James Sore – EISA Board Director – Fund Management has stated:
“The EISA works to help the industry thrive and one area we focus on is the ability for investors to make informed investment decisions when it comes to fund selection. At present, there is no standardised way to display fees and make them easily comparable. Solving this issue improves an investor’s ability to choose a fund, the fund managers to compete on a level playing field and ultimately helps the industry grow and mature.”
While EIS due diligence will never be straightforward, simplifying fee structures would be a good step in the right direction.
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