The EIS fund landscape can be confusing to newcomers. There are approved funds, non-approved funds and funds that aren’t really funds at all. Then there are the recent changes in EIS eligibility rules that have forced many funds to change their investment theses – many managers with long expertise in asset-backed, defined duration low risk investing are now having to reinvent themselves as experienced growth investors. It’s a moot point whether tax breaks should ever have been given for guaranteed returns, but it’s a huge positive that EIS funds are now more accurately understood to be genuine venture capital funds, and the risks involved in such investing are becoming more widely understood.
Overriding these fund-specific factors, however, there are also general industry and manager issues that investors should consider as part of their due diligence and prior to entrusting their capital to any fund.
The first is, who exactly is paying what? There has been a trend in the industry towards lower fees – but this demands scrutiny. Headline fees paid by investors may be low, with nothing but a performance fee to reward hard work. It’s important to understand how the fund manager is keeping the lights on (it might take 5 or 7 years for those performance fees to be earned). In most cases, these apparently low funds will be charging their investee companies a range of fees, including up to 10% of capital committed and high “monitoring fees” on an annual basis. How can a company that desperately needs this capital to fund its growth afford to pay these fees? Unbelievably, funds may invest at an artificially high share price so that the company raises more capital than it needs, and can afford to pay the excess back to the manager. The underlying investors still pay in this scenario – they have bought shares at the wrong price! Sophisticated investors may prefer to pay their manager a fair and transparent fee for the work they do.
Performance fees are another murky area. Fund managers should be remunerated for their work in finding great businesses and supporting them as they grow. However, they should be paid on a whole fund basis, meaning that if an investor invests £1 in a fund, performance fees should accrue only after £1 has been returned in cash (ignoring the effects of EIS reliefs). The idea that a manager should be paid on each successful individual investment through performance fees, even when their investors make an overall loss, is unfair but possible where managers are paid performance fees on a deal by deal basis.
EIS reliefs are hugely powerful, and have been instrumental in helping early stage companies raise capital for 25 years. However, no investment should ever be made purely for tax reliefs.
Any investment must stand on its own merits – factoring those reliefs into the expected return is a sure-fire way to end up disappointed. The presence of expert non-EIS investors in the same round is a good way to prevent valuations drifting up to reflect the impact of those reliefs, which are there to help investors bear the inevitable losses that will occur in early stage investing, not to allow companies to raise at a higher price than their fundamentals and potential should permit.
Finally, there is a misalignment of interest that sits between managers and their investors. Early stage investing carries risk, and there is an expectation that a reasonably high proportion of companies will fail. The majority of managers are investing other people’s money and are incentivised solely through upside – if a few companies in their portfolio fail, that was only to be expected anyway. Managers that invest their own capital alongside the investors in their funds have downside risk as well and will care deeply about each and every failure. Losing money is always more painful than giving up potential upside rewards and this sharply focuses managers’ attention. The incentive this creates to extract the maximum value from each and every investment made can swing overall returns markedly. Genuine skin in the game is a rare feature these days but, given the amount of capital available and the number of investment opportunities in the market, it is more important than ever. If the manager is investing their own money, it probably isn’t eligible for EIS relief, which means that individual investors co-investing are in fact buying those businesses up to 30% cheaper than their manager.
The Hambro Perks Co-Investment (EIS) Fund has been designed to avoid these misalignments. The partners and employees of Hambro Perks have long histories and deep expertise in founding, building, scaling and exiting businesses. Hambro Perks always invests meaningful capital from its own balance sheet before investors in the fund co-invest alongside in those same opportunities. We aim to take early risk in businesses, investing where we can add significant value through applying our combined experience. The Hambro Perks Co-Investment (EIS) Fund enables individuals to co-invest alongside and on a fully aligned basis with Hambro Perks, thereby benefiting from this extraordinary access and proprietary deal flow, while utilising EIS reliefs.
Authored by Nicholas Sharp.