VCTs, EIS and SEIS – How risky are they really?
Archived article: please remember tax and investment rules and circumstances can change over time. This article reflects our views at the time of publication.
Mention Venture Capital Trusts (VCTs), Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) and many investors immediately tell us “oh, they are way too risky”.
But what is the reality? How risky are they?
There is no hiding from the facts, these investments are risky for a number of reasons:
- They invest in small companies which are more likely to fail than large ones
- They are illiquid
- The generous tax breaks are dependent on the funds/underlying companies adhering to strict tax rules. If they don’t, the investor could lose the tax breaks.
That said, investing in VCTs, EIS and SEIS can be extremely financially rewarding. For instance the average generalist VCT has outperformed the FTSE 100 over the last 5 years by 6.29%. The FTSE AIM All-Share by 1.96% and the FTSE AIM All-Share by 34.56%. Past performance is not a guide to the future. (Performance figures as of 12/05/2016).
Furthermore if you do lose money you are cushioned by the 30% or 50% income tax relief on the way in and, in the case of EIS and SEIS, are also able to write off any loss after the initial tax relief against income tax.
In addition there are many ways the risks can be mitigated. Some will depend on the choices you make, others will happen as a matter of course.
So, how can risk be mitigated?
Invest with a manager
A VCT is like a fund, an investment company in technical parlance, and will typically invest in the region of 20 to 80 different companies giving investors a good level of diversification, although bear in mind some VCTs invest in only one sector.
Companies which qualify for EIS or SEIS can be bought individually or as part of a professionally managed portfolio. Typically an EIS or SEIS portfolio would include between 5 and 20 different companies.
Investing in a fund or portfolio means the success of your investment doesn’t depend entirely on the fortunes of a single company. If one within the portfolio fails, another could make up for it.
It also means that you have a professional fund manager choosing the investments for you. Their job involves carrying out the research and due diligence, selecting the companies to be included in the portfolio, managing them and negotiating the exit. Crucially, unlike a unit trust manager who would just provide funding, a VCT, EIS or SEIS manager will often be very involved in influencing the underlying companies and helping the management. With unquoted investments, the fund manager normally takes a board seat on the underlying company.
The best managers have years of experience in fund management or venture capital and a track record of delivering value to investors.
Some VCT managers for instance also manage successful and better known unit trusts. Many investors will recognise Giles Hargreave’s name as the long-standing and very successful manager of the Marlborough Special Situations unit trust. He also manages Hargreave Hale AIM VCT 1 and 2.
Other top performing unit trust managers that also manage VCTs include Chris Hutchison of Unicorn, Judith Mackenzie of Downing and Dr Paul Jourdan of Amati. All manage successful smaller company funds.
Different levels of risk
Not all VCTs, EIS and SEIS are the same. Some are focused much more on capital preservation and getting the tax relief. Others are far more concerned with growth and are therefore more risky.
The ones more focused on capital preservation will generally be asset backed such as investments in pubs, crematoriums, nurseries and storage units (typically these have been in EIS and not VCTs). Theoretically if everything goes wrong there should be some value in the company in the form of assets such as a leasehold or freehold. However if the business has run up significant debts, these assets would be used to pay these off first before shareholders received anything.
Risk reduction doesn’t only apply to asset-backed investments.
For example an SEIS and EIS which invests in the music business might decide to pay an artist an advance only once they have sold a certain number of tickets to a live show. They may also decide to only advance an amount equivalent to the tax relief. Similarly, a TV production company (popular in EIS and SEIS portfolios) might only commission a script once it has received a significant advance.
An example is Amplify Music SEIS 4.
More conservative portfolios will be typically looking for a target return of about £1.10 for every pound invested. So you get a bit of investment return plus the tax relief.
Some VCTs, EIS and SEIS are much more growth orientated. They are looking for 3 or 4 times return on capital, perhaps more. The managers would often argue these are the proper investments, i.e. they stand up on their own irrespective of the tax structure. Generally these are more risky. In a portfolio such as this you may expect two companies to go bust, three to be ok and one or two to do really well.
An example is Maven Income & Growth 6 VCT.
What is important to note is that most VCT, EIS and SEIS portfolios aren’t looking to invest in the next Facebook, they are not looking for a needle in a haystack. They are looking for companies which are poised to give investors a solid but unspectacular return which when coupled with the tax relief could be very pleasing.
As very broad rule of thumb if you were to look at VCTs, EIS and SEIS on a spectrum of risk, SEIS should be the most risky and VCTs normally the least.
Tax relief if you win, more tax relief if you lose
The saying goes ‘the tax tail should never wag the investment dog’. That said an investor should not ignore the generous tax reliefs on offer when you invest in VCTs, EIS and SEIS.
After all, the tax breaks can significantly amplify the returns of your investment that perform well and take the sting out of investments that don’t work out.
Income tax relief
When you invest in a VCT or EIS you get 30% income tax relief– 50% in the case of SEIS. On SEIS you also get 50% Capital Gains Tax relief.
In the case of an EIS or VCT every £1 costs you 70p. If it returns £1.10 – quite a modest return – you make 57% on your initial investment.
Because you get 50% capital gains tax relief on SEIS in addition to 50% income tax relief a £1 invested could cost you as little as 40p, so even if your investment experiences no growth you will have in effect made 60% excluding any fees.
Tax-free income and growth
All income from a VCT investment is tax-free. A number of VCTs pay a tax-free dividend of around 5% – this is equivalent to a taxable dividend of 7.41% (higher-rate taxpayers) or 8.08% (additional-rate taxpayers).
Income is not tax-free on EIS, SEIS or IHT portfolios.
As with an ISA or pension, any capital growth from a VCT, EIS or SEIS is tax free.
A perk of EIS and SEIS investing is the cushion that loss relief provides. If your investments don’t work out as you’d planned, you can offset any losses after tax relief against income.
So, in the worst case scenario (100% loss), the effective loss can be as little as 38.5% of the original EIS investment or 17.5% in the case of SEIS for additional rate tax payers.
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