Five reasons not to let tax tail wag the investment dog

Is there an investment case for investing in smaller companies as an asset class before taking potential tax incentives into consideration? The short answer is yes - and this is seemingly understood by investors more than advisers at present.

According to survey data published in the latest Alternative Investment Report, 36 per cent of investors cited tax relief as the main reason to invest in Enterprise Investment Schemes, compared to 91 per cent of advisers.

Here are five reasons you shouldn’t let the tax tail wag the investment dog:

1. Potential for substantial capital gain.

Some smaller companies go on to be the giants of tomorrow. According to research from NESTA around 10 per cent of investments into smaller companies return greater than 10x capital.

2. Diversification.

Small companies are somewhat wedded to the business cycle, but as unquoted investments in companies at different stages of development or in non-mainstream activities, EIS exposure can provide some diversification from mainstream markets.

3. It’s a buyers’ market.

Venture Capital funds only make investments of typically greater than £2m, and banks aren’t lending. Smaller companies are starved of capital and therefore it is very much a buyers’ market. There is no shortage of dealflow and investors can take their pick from a very wide range of attractive opportunities.

4. It’s interesting and exciting.

Investing in EIS is about more than just financial returns. Supporting new ventures is more engaging than the abstract concept of stock-market based investing.

5. It supports the UK economy.

According to the House of Commons, there are some 5,000 small and medium-sized firms accounting for over 99 per cent of UK businesses and some 50 per cent of the total turnover in the private sector (approx. £1,578bn).

So there you have it. Five great reasons to consider investments into smaller companies.

Initiatives such as EIS are the ‘cherry on the top’: most smaller company investments will qualify and that means 30 per cent income tax relief, no capital gains tax, no IHT (potentially) and loss relief if the investments don’t work out.

Of course these can be risky investments. Small companies fail - one if five angel investments return less than capital according to NESTA - and the position of a small shareholder can be vulnerable. But by diversifying, using a good manager and harnessing the EIS reliefs, this can be mitigated.

There is a compelling investment case for this sector; the tax breaks can be seen as a bonus or additional risk mitigation.

A version of this article first appeared in Intelligent Partnership’s annual EIS industry report, FT advisers can download a complimentary copy of the 70-page report here.