The rewards from enterprise Investment Scheme (EIS) funds and Venture Capital Trusts (VCTs) are often considerable, but many would argue so too are the risks.
These highly tax-efficient vehicles are therefore not suitable for all investors, with analysis showing that as many as half of small businesses fail within their first few years of trading.
Yet even though unlisted smaller companies are, in general, inherently riskier investment propositions than, say, stocks listed on the FTSE 100 index, the benefits can be considerable, both from a growth and diversification point of view.
Typically, there are three main differences between EIS and VCT investments and a listed company: risk profile, liquidity and the availability of tax reliefs.
EISs and VCTs are higher risk. At each individual company level there is a greater chance of losing money, but there is also the potential for much higher returns. If you invest in a big listed firm, such as Marks & Spencer, you know it’s not likely to go bust, but you also know the upside potential is limited. The opposite may be true for an unlisted smaller business. Factor in the tax reliefs and the expertise of a specialist investment manager, and the risks are arguably much reduced and the upside potential enhanced.
EIS and VCT shares are typically much less liquid than listed equities. They must be held for three and five years, respectively, to benefit from the 30 per cent income tax relief they provide. Even after these periods have passed, you cannot always readily sell your shares.
Part of the skill of an EIS and VCT manager is finding a buyer – at the right price – for investee companies. This can involve a lot of time-consuming negotiation and detailed work, and so investors must be patient.
The most successful EIS and VCT investors tend to look for certain key attributes in firms they believe will lead to outperformance. These might include a differentiated product or service within a growth market and/or a proven and experienced management with a clear strategy for implementing growth plans and realising shareholder value.
Ensuring a company has these should always come first, but tax reliefs will make an already attractive investment case even more compelling. Their presence – in particular 30 per cent income tax relief and loss relief (EISs only) – affects the risk-reward calculation and this can be seen by the fact returns from a single company within an EIS fund or VCT commonly reach triple digits. Conversely, EIS loss relief places a cap on the amount an investor could lose from a single investment.
When the economic outlook is uncertain, EIS and VCT-qualifying companies may provide a degree of insulation against macroeconomic chills and stockmarket volatility.
It is not that unlisted companies are immune from macroeconomic trends, but that the impact of those trends are generally outweighed by company-specific factors. For a small business, factors such as whether it is genuinely able to innovate and bring disruptive products or services to market, and has a good growth strategy in place and high-calibre management, are much more important to its immediate prospects than whether GDP is likely to rise by only 0.5 per cent. Neither are their valuations subject to the daily irrationalities of a sentiment-driven stockmarket.