Editor’s note: This publication has written a number of recent articles
concerning the growing use of UK-based structures called Enterprise Investment Schemes. The EIS model
has been around for over a decade and in the light of recent government
tightening of pension reliefs for high earners, and a widening of EIS tax
reliefs, the model looks more alluring than ever. But as ever there are risks
to watch; with all tax-deductible investments of course, what governments give,
governments can withdraw. To cast some light on the state of the EIS
market, amid a number of recent launches, Kieran O’Gorman, partner at
Deepbridge Capital, gives his views. Feedback is welcome.

In a bid to persuade banks to
increase lending to households and small businesses, the Bank of England and
the Treasury launched the £80 billon ($126.8 billion) Funding for Lending
scheme in August 2012, offering discounted funds on the condition that lenders
passed them on to borrowers in the form of cheaper loans. Early evidence from
the Bank of England would suggest that despite these measures, net lending to
businesses fell by £2.1 billion in December, exacerbating a £2.5 billon
contraction in the previous month.

It’s an undeniable
truth that the recovery of the UK
economy from the current recession will be heavily dependent upon the success
or otherwise of UK small
businesses, the engine for UK
job creation. These are the very same firms that currently face a severe
funding gap due to traditional lenders’ apathy and reticent to lend development
capital to small companies in the UK.

For these reasons,
the Enterprise Investment Scheme offers a vital source of development and
expansion capital to many of these companies. For the period 1993/94 to
2010/11, over £8.6 billion of funds has been raised, invested in over 18,500
companies. In the most recent tax year for which data is available, 2010/11,
£525 million was invested in over 1,900 companies.

Since the
introduction of EIS model, three successive Governments have improved the terms of
the Scheme thus delivering what is now arguably the most generous tax-efficient
investment opportunity available to the UK tax-payer.

Since 6 April 2011,
companies no longer have to spend EIS funds solely in the UK, provided the company has a UK permanent
establishment. Therefore UK
companies can now expand internationally using EIS funds.

In April 2012, the
amount an investor could invest in EIS doubled to £1 million per annum, and the
amount an EIS qualifying company could raise in a year also rose to £5 millon.
The size limit of an EIS-qualifying company also increased, widening the range
of investment opportunities. Also, the 2013 Finance Bill removed the threat to
cap the amount of income tax relief that a taxpayer could receive (from 2013/14
tax year onwards), this proposal threatened to severely limit relief on losses
on EIS investments. In April 2012, the introduction of the Seed Enterprise
Investment Scheme recognised the particular difficulties that very early stage
companies face in attracting investment.

These favourable
developments are set against a rising tax burden for investors, particularly
high net worth investors, who have seen pension tax reliefs dramatically eroded
in recent years. While the rationale for EIS is sound, the EIS market faces
several fundamental challenges at the current time, including the Retail
Distribution Review and the FSA proposals to potentially ban the retail
distribution and marketing of unregulated collective investment schemes (UCIS).

Furthermore, there is
a suggestion that investor interest in legitimate tax-efficient investing has
been unduly clouded by the adverse media coverage of several dubious tax
avoidance schemes that do not subscribe to the ethos of EIS.

It is undeniable that
while EIS offers a range of compelling tax advantages, as part of a
well-balanced, diversified portfolio, such investment is higher-risk than more
traditional investment opportunities. A spectrum of EIS offerings is available,
ranging from sector-specific and generalist EIS, to more specific
opportunities. Some suffer an absence of diversification, whilst others have a
core reliance on the Government’s energy policies (e.g. Feed-In-Tariffs),
whilst others are too specific (e.g. investing in a single company). Therefore,
it is imperative that  investors understand what they are investing in,
and appraise the investment manager of the EIS. Indeed, a capable manager will
take an active role in building the value of the investee companies to
reinforce the chances of success and plan for an eventual exit.

The team at
Deepbridge recommends that the EIS structure is suitable for sophisticated
investors, given the illiquid nature of the investment, and the level of due
diligence required to fully understand the risk/reward profile involved in EIS.
They represent a higher-risk but extremely tax-efficient investment for
suitable investors, and also offers the chance for these investors to actively
take part in the UK
recovery.

Ultimately, investors
shouldn’t let tax advantages drive their investment decision – investors should
explore the underlying investment proposition and the EIS management team, and
demand more transparency in terms of manager remuneration and investor
reporting.

In recent months,
there has been an interesting development in the EIS space. A recently-launched
multi-manager platform can now enable advisers to compare and contrast
differing EIS in a low-cost and time-efficient manner: this is, in Deepbridge’s
view, a vital evolutionary step in the EIS space.

At the present time,
clarity is urgently needed from the Financial Services Authority, the UK regulator,
as to whether EIS structures will be included in the proposed UCIS retail
distribution ban [the ban on marketing of unregulated collective investment
schemes to retail clients). The EIS provider community also needs to get its
house in order and declare a common consensus on how it accommodates the Retail
Distribution Review - without it many advisors are reticent to recommend EIS to
suitable investors. Resolution to these issues is however expected imminently:
given the apparent failure of a number of government initiatives to kick-start
lending to UK
small businesses, a wider adoption of EIS investing is needed now more than
ever before.