This is the first of a series of articles about the evolving world of UK Enterprise Investment Schemes, still a relatively small part of the overall asset management arena, but with potential to gain further ground.

A “perfect storm” of forces makes one particular form of tax-deductible structure in the UK attractive for a host of reasons, but Enterprise Investment Schemes remain a relatively small part of the landscape to the frustration of some practitioners. Some £10.7 billion ($16.7 billion) of investment has been raised since EIS started in the mid-90s, which isn’t chickenfeed, but a drop in the bucket compared with the investment market as a whole.

And yet the market for EIS – which are designed to back small business ventures – is evolving, with a wider number of ways for investments to be realised, helped by improving economic conditions and a more mature market in a sector that has many of the characteristics of private equity and venture capital, firms operating in the field say.

EIS provide significant tax breaks in terms of income, inheritance and capital gains tax – for example, no CGT is payable on the disposal of shares after three years, or three years after commencement of trade, if later, provided the EIS initial income tax relief was given and not withdrawn on those shares. From the point of view of inheritance tax, meanwhile, shares in certain firms that qualify for Business Property Relief for inheritance tax purposes can get relief from all such tax after two years of holding such investment. It is also possible to defer CGT payments in some cases. Losses can be set against capital gains. On top of these tax breaks are demand for new sources of capital in a world where banks have drawn in their horns - which means EIS can find themselves financing established as well as young businesses. These schemes have the official HM Revenue & Customs badge of approval, so there should be no concerns about them falling foul of government tax campaigns against alleged artificial tax avoidance ploys. EIS has been around during Labour, Conservative and Liberal Democrat/Conservative administrations, so they are also relatively robust through the political cycle.

This publication spoke to a number of prominent managers of EIS schemes about how they are getting on. It asked about how managers are handling the all-important “exit” stage when businesses in which EIS money has been at work is returned to clients. Most exits are through trade sales to other firms; a number are handled via initial public offerings via platforms such as London’s Alternative Investment Market, or AIM. Another route – and arguably growing – are exits involving sales to other private equity groups seeking to put unused cash to work.

A key concept in understanding such investments is internal rate of return, or IRR, which takes account of the timings of when money is put to work and taken out. EIS managers also refer to multiples, such as how their returns equate to X times initial sum invested. There remains debate on what is the most meaningful way to describe returns, particularly given the need for people to consider the time value of money.

This is the first part of a number of interviews WealthBriefing held with practitioners about returns, exits, and the investment climate. The second half of the interview will be published in due course, examining a range of themes in the EIS field.

Alistair Kilgour, partner and a founder of Parkwalk Advisors, a business established in 2009
With exits, what do you consider to be the main route - trade sales, listings, other?
We define an exit as the purchase of our equity by another party or when the holding goes to negligible value. Therefore a listing or IPO does not in itself constitute an exit. Our investment strategy is to invest in UK university technology spin-outs. As such we are able to see exits through multiple routes. We have recently seen one trade sale (at 15 times the initial investment) and two exits through the AIM Market (one at 7x and one at 5x the initial investment) to other financial institutions. We have also had one investment recently go to negligible value.

Exits are governed by the attractiveness of the investment, the valuation and the amount of capital seeking assets in a particular class. These are all heightened by a strong economy leading to a strong stock market which in turn enables corporations to raise money from equity sales and bank debt allowing greater M&A to take place. As such with the economy improving and bank lending beginning to free up over the last two years there is a marked increase in both trade sales and financings on the public markets. This is a trend which appears to be increasing.

Are any of the exit routes becoming more/less busy? (For example, are there more listings than, say, two years ago? Are you seeing examples of other private equity firms buying EIS investments?)
We are not yet seeing any evidence of private equity firms buying EIS investments in our investment strategy.

What, typically, are the factors that decide which sort of exit is best for your investors? Do you have any measures for judging this?
The best sorts of exit for our investors are those that bring them a multiple of their initial investment in cash as soon as possible after the three-year statutory holding period for EIS. This can be either through the public markets, trade sale, or private sale. In our investment strategy we initially invest if we feel the asset has the potential to return 5-10x the original investment.
 
How does the underlying state of the economy and condition of capital markets decide which exit route is most likely?
The underlying state of the economy and therefore the general appetite for risk which leads to a buoyant public markets is crucial to the ability to exit and get a decent valuation.

Can you give an idea of EIS returns?
As of July 2015 the first Parkwalk fund which raised money in the tax year 2010/11 has an IRR of 24.1 per cent (excluding EIS benefits which would decrease the initial investment by 30 per cent income tax relief, thereby increasing the IRR to mid 30s per cent) and the second fund which raised money in the 2011/12 tax year has an IRR of 20.3 per cent (excluding EIS benefits. Including EIS IRR around low 30s per cent) over the same period.

More importantly both funds have had exits which have allowed investors to receive back more than their entire investment in the Funds while still having a number of their investments continue to run before they have exited.

In our strategy we are generally a minority investor which means we cannot dictate an exit rather the quality of the underlying asset has to attract a purchaser. You may have noticed there is considerable financial institutional interest in our investment strategy led by Neil Woodford/Invesco and Landsdowne Partners which has increased the amount of capital available outside the EIS investors leading to greater co-investment opportunities.

John Thorpe, business line manager for EIS at Octopus Investments
With exits, what do you consider to be the main route - trade sales, listings, other?
The route to exit we choose for a business will depend on a variety of factors including the market and sector that company operates in.

Nearly all of the exits we have made from the EIS investments listed on AIM have been through the sale of shares on the market. We are currently seeing a strong pipeline of EIS deal flow on AIM with new companies joining the market and secondary issues.

Within our portfolio of unquoted high growth tech-enabled businesses, the majority of exits have been by way of a trade sale, with one flotation (being Zoopla Property Group, which floated at an initial price of £919 million in June 2014).

Within the energy sector, into which we invest from the ’Octopus EIS’, currently the lowest cost of capital buyers of renewable assets is likely to be institutional investors including pension funds. These buyers are attracted to the long term, often index linked, revenue streams that energy assets can deliver.

Are any of the exit routes becoming more/less busy? (For example, are there more listings than, say, two years ago? Are you seeing examples of other private equity firms buying EIS investments?)
Although liquidity in these relatively small companies remains a challenge, we believe the government’s allowing of AIM shares to be held in ISAs [Individual Savings Accounts, a retail fund product] for the first time has improved the overall liquidity of shares listed on AIM. However we believe trade sales remain the most likely exit route for many of the unquoted companies in the portfolio at the moment.

There have been a number of ‘YieldCos’ listed in the UK and US recently who have a mandate to acquire renewable energy assets but having said that, we also see increasing interest from institutional investors.

 What, typically, are the factors that decide which sort of exit is best for your investors? Do you have any measures for judging this?

We aim to manage each portfolio in line with our investors’ requirements. Naturally each investment must be held for a minimum period of three years so that investors can retain their EIS income tax relief, and then after this point it is up to the investor whether they want to remain invested. Not all necessarily wish to exit their investment given the advantages of remaining invested in an EIS. Luckily thanks to the size of our portfolio we are usually able provide flexibility for both those who wish to withdrawn their investment and those who do not.

Our investment teams monitor investee companies closely and will form a decision to exit (in whole or in part), based on a variety of investment criteria (including potential tax relief). If we don’t believe the value of the business is fairly reflected in the price, then we will continue to hold the shares; we are not motivated to sell simply because the holding has been held for three years. The key consideration is typically our view of future growth, but also timing of future liquidity.

We will always seek to provide liquidity for investors where requested – if this means exiting some of the portfolio but not all then that’s what we will do.

How does the underlying state of the economy and condition of capital markets decide which exit route is most likely?

When it comes to investments on AIM, our investment process tends to be more “bottom-up” with stock-specific factors tending to drive our decisions to sell shares more often than macroeconomic events. However macroeconomic sentiment can have a significant impact on short-term valuations of smaller companies on AIM. Weak market conditions often subdue the valuations of our listed investee companies which may delay the timing of an exit.

Buyers of renewable assets are typically looking for yield and inflation hedge. Therefore buyers will look to other yielding assets when evaluating the relative appeal (often starting with a comparison to government gilts). Returns on renewable assets are viewed as uncorrelated to equity markets and therefore might be seen as arguably more attractive in times of high volatility (or decreasingly returns in those markets). Therefore interest rates, investor risk appetite and inflation expectations all come into consideration for buyers of renewable assets.

Can you give me any idea of EIS returns - are there data sources for how this sector as a whole is doing?

EIS investments are made in a number of sectors: AIM, high growth venture capital or energy, for example.  Return reporting is often by sector rather than by type of funding and, since EIS investments are often made alongside other sources of capital, this means that we don’t know of a consolidated data source.  

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Rupert West at Puma Investments
EIS is best understood as a wrapper, not a specific asset class per se.  Managers can use the EIS wrapper to invest into businesses in very different sectors, and those businesses will therefore have very different characteristics and exit parameters.  Accordingly, investors need to consider the merits of the strategies being presented, looking through the EIS wrapper.  That can be difficult and requires certain expertise which is where fund managers come in; a trusted manager is doing that for you on a professional basis.  

With exits, what do you consider to be the main route - trade sales, listings, other?

The Puma EIS platform prioritises risk management and the timely return of capital.  Accordingly, when considering exit, our priorities are timeliness and certainty, rather than more speculative routes.  For now, that steers us towards trade sales, or more particularly strategies where our investee companies can wind themselves up (voluntary liquidation) and return funds to shareholders.
 
Are any of the exit routes becoming more/less busy? (For example, are there more listings than, say, two years ago? Are you seeing examples of other private equity firms buying EIS investments?)

Listing on the public markets is certainly increasingly viable since the markets re-awoke at the beginning of 2014.  Shore Capital, the parent group of Puma Investment, has raised some £3.2 billion since then, demonstrating the renewed strength.  In particular, the AIM is maturing quickly, so much so that we recently launched a ISA compliant AIM investment service.

Private Equity firms tend to hold pools of capital allocated to specific asset classes.  As per the above, the EIS wrapper is really not material to the exit (as it does not affect the incoming owner); rather, strong businesses with strong assets and / or revenue streams will always attract interest from pools of capital with a relevant mandate.

What, typically, are the factors that decide which sort of exit is best for your investors? Do you have any measures for judging this?

As per the above, the Puma EIS platform prioritises risk management and the timely return of capital.  We build an exit strategy into our investment strategy from the outset and seek a full realisation for shareholders within three to five years of initial investment.  

Common valuation metrics vary by sector but essentially rest on i) some measure of earnings (e.g. revenue, EBITDA, profit) ii) expectations of changes over time, and iii) a multiple / yield. We remain constantly engaged with industry professionals in all the sectors we operate in to ensure that we remain aware of how multiples are developing.  

For our asset-owning strategies the exit is likely to be a larger trade participant looking to build its portfolio and increase its buying power.  An example investee company within this strategy is a managed pubs business which has the additional benefit of acting as an aggregator: purchasing single units or small chains and packaging them together with coherent and detailed financial and trading data.

How does the underlying state of the economy and condition of capital markets decide which exit route is most likely?

[A complex question…!]  The likelihood of choosing any particular exit route is broadly a function of three things: the particular nature of the business to be sold, the underlying economic conditions at the time, and specific conditions affecting particular exit routes.

For example, it could be that your most natural exit is a leveraged buy-out or MBO, but if balance sheet lenders are in shut-down mode due to a recent crisis and unclear incoming regulation (for example), the borrowing for such an exit simply won’t be available and other options must be considered.  For any given business (or type of business) it is possible to identify natural buyers through analysis of the yield available, income vs. capital growth, perceived risk and liquidity parameters.

Where those natural buyers are most active at the given time is therefore likely to be the first port of call when looking for exit.  What different buyers conclude from the parameters of the business to be sold however, will depend on their view of the underlying state of the economy (and, critically, their predictions for the state of the economy going forwards).  

Can you give me any idea of EIS returns - are there data sources for how this sector as a whole is doing?

I’m not aware of an example of this sort of general data source.  The market is made more complicated by the multiple sources of EIS opportunities, which are made available by platform product providers such as Puma as well as private businesses raising capital through brokers.  

In addition, as noted above, there are a range of different businesses taking advantage of the EIS reliefs which makes it very difficult to generalise about the levels of return; clearly asset-backed businesses will have lower return targets than higher-risk businesses (e.g. tech start-ups).