Following our post in July on the benefits of a portfolio approach when applied to SEIS qualifying investments (see An Interesting Paradox), this month we examine the demand/supply imbalances of tax-efficient portfolios.
Traditionally EIS/SEIS fund marketing has concentrated its focus on the first calendar quarter in the UK, ahead of the end of the tax year. This largely reflects industry norms and the fact that many large operators have well-honed marketing teams for which this timing is optimal. However, it also reflects the historical development of the EIS market, which was neither nearly as popular and developed nor as diversified as it is today. Yet this marketing paradigm seems ripe for disruption. In an investing world where opportunities are constantly in flux, and in a tax-efficient environment where “carry back” provisions provide some considerable flexibility in timing, this “Q1 rush to the entry door” approach to tax-efficient investing seems anachronistic. Investors are increasingly coming to believe, for want of a better phrase, that the marketing tail should not be wagging the investment return dog.
Even if one accepts that EIS (and other tax-efficient) investing strategies are an investment class that should be pursued continuously throughout the year – like pretty well all other investment classes - there are more “investment specific” reasons for pursuing a year-round approach to tax-efficient investing from a fund’s perspective.
First, one should never seek to be in a position where a large amount of funds are chasing a limited set of opportunities. This supply/demand imbalance is particularly pronounced in the SEIS sector, where larger-sized funds invariably have to invest in too many companies because it is virtually impossible (and certainly less profitable) to conduct sufficient due diligence on a large spread of firms. SEIS investing in particular is problematic because the £150,000 investment ceiling is fairly modest and the timing is usually tight, given that the companies are very early-stage by definition. It seems to militate against our “deeper, not wider” investment approach because the reality is it usually takes a number of months and a considerable amount of time for a fund to rigorously assess the investment merits of a company - and this timeline begins after the initial ‘intent’ to invest has been registered. The reality is that the issues to consider are numerous; one needs to assess the business plan in detail, the market opportunity, and the quality of underlying IP (if any) as a precursor to the “deep-dive” due diligence. However, the most crucial aspect of the diligence exercise is the assessment of the management team, which is both crucial in an early-stage environment and time consuming for the fund manager. Most large companies could lose a CEO without much medium-term damage. The Jack Welches and Warren Buffetts are truly the unicorns of large cap equity investing! This is manifestly not the case with early-stage technology companies.
The aforementioned phenomenon is also prevalent with investing in EIS companies, although to a lesser extent due to the fact that the investments tend to be significantly larger and the timing of the investment is usually less pressing. Yet the principle of “deeper, not wider” investing remains, and is supported by more of a continuum in the fundraising effort, thereby being more in line with the flow of investment opportunities.
The second “investment driver” for a continuity approach to both fundraising and investing is a direct offshoot of our previous point. This relates to the ability to help smooth the lumpy nature of the opportunities available in venture capital investing. It is true that investment opportunities often arrive like buses in pre-Ken Livingstone London: Nothing for an hour and then three arrive at once! It is for this reason that a continual funding approach should always be slightly ahead of the opportunity step, but too much excess can lead to an investment hangover.
In practice the best EIS fund managers, VCs and angel networks should have a continual process of deal flow, which seeks to effectively manage the demand/supply conundrum. Most are able to predict the near-term financing needs of their current portfolio, but new investments are necessarily lumpy in quantity and quality.