Risks to Consider

Let’s explain the risks.

Liquidity Risk

Identifying the risk:

Although the minimum holding period to qualify for income tax relief and tax-free growth is at least three years, investors are more likely to have to commit their funds for much longer; EIS investing should be viewed on a 5 to 10-year investment horizon.

Some EIS funds were positioned as lower-risk before the Patient Capital Review, which would wind up soon after the three years. As these EIS schemes are no longer qualifying, they should be discounted as part of the due diligence process. See ‘mitigating the risk’ for tips on how to consider this.

There is no active secondary market for unquoted shares, and EIS managers do not offer share buy-backs. It may be possible to arrange a private sale to a third party. Still, at the point of investment, investors should regard themselves as locked in until the investee company(ies) either list on a recognised stock exchange, achieves a trade sale, or is wound up.

Mitigating the risk:

• Consider any EIS funds no longer qualifying for post-patient Capital Review. Some advisers do this by requesting confirmation from the fund manager or filtering performance statistics from 2018 onwards. Whilst we know that past performance is not an indicator of future performance, consistency in strategy should be considered as part of the due diligence process.
• Set client expectations that EIS investments are long-term, illiquid investments.

Inflation Risk

Identifying the risk:

In periods of high inflation, the value of the investment might reduce by the time the money is deployed into investee companies. The industry average deployment time is 12-18 months. In market instability, deployment times cannot be guaranteed, and funds may be returned to the investor.

Mitigating the risk:

Fund managers with faster deployment strategies ensure investee companies receive funds to begin the EIS investment (reducing additional delays on the long time horizon). This means that investors own shares in the investee companies, and those companies can use the funds to progress growth plans (in line with qualification requirements explained in section 1). Investors can claim income tax relief in the current and previous tax year at the time of investment.

Exit Risk

Identifying the risk:

Any gains in EIS qualifying shares are only “attributed gains” realised at the exit point. As there is no secondary market in unquoted shares, exit is most likely to come in one of three ways:

• Initial public offering: The company lists on an exchange, and shares can be sold on the open market.
• A trade sale or management buyout: Most shareholders agree to sell their shares to another company or possibly the incumbent management team.
• Voluntary liquidation by shareholders: The company is wound up, and the assets are sold, with the proceeds distributed to shareholders. This doesn’t necessarily mean the company has failed; depending on its remaining assets, the distributions to the shareholders may be worth more than the initial price they paid for the shares.
• Zombie companies: There’s a risk of an investment continuing indefinitely with no large-scale active secondary market in EIS shares; this is to the extent that described exit routes cannot be achieved at either a gain or a loss. A loss could at least be offset against other gains. In this scenario, the capital remains tied up, and there is little prospect of recycling them. EIS investee companies in this situation are often referred to as ‘Zombie companies’

Mitigating the risk:

• Diversification, whether within the EIS fund (multiple investee companies operating in different industries) or by splitting investments across EIS fund managers.
• I recommend a portfolio-managed service that drives growth to generate return-generating exits. Investment managers may charge performance fees that align their objectives with investors’.
• Selecting a fund manager with experienced investment managers and a track record of performance.

Tax Risk

Identifying the risk:

Investors lose their tax relief if the company changes its activities or structure during those three years to no longer meet these qualifying criteria.

Relief will be denied on any shares issued that offer investors protection against the risk of investing or which would effectively guarantee, or at least make it likely, that the investor will receive their money back at some point in the future through some mechanism introduced by the provider or the company itself. This would be considered to be part of an arrangement for tax avoidance.

However, simply investing to qualify for relief is unlikely to be tax avoidance.

Mitigating the risk:

They are selecting a fund manager who seeks advanced assurance from the HMRC for investee companies within the EIS fund to provide approval that they qualify for investments at the outset.

Fund managers should guide their strategy to monitor the qualification status of investee companies for the first three years from the point of investment. By identifying the communication strategy of the fund manager at the outset of the investment, advisers recommending an EIS can understand:

• Communication strategy with investee companies.
• How they monitor EIS qualification rules.
• How investee companies prove they are adhering to EIS qualification rules.
• Their plans to continue adhering to rules.

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