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EIS funds are investment vehicles which allow investors to invest in a collection of companies which qualify for the Enterprise Investment Scheme (EIS). They are meant to offer a degree of built-in diversification, with an experienced investment manager selecting opportunities for the fund to try and maximise returns. However, there is a certain contradiction within EIS funds that is difficult to resolve. On the one hand, UK law obliges EIS funds to declare to investors that they cannot guarantee that the EIS investments contained in the fund will succeed or fail. Yet many EIS funds often point to past performance as proof that they can replicate similar results in the future. With early-stage investing, however, the link between past and future performance is even more tenuous than with large, established companies.
This drives to a crucial question – can EIS funds truly strike a balance between risk mitigation, maximising potential returns and communicating managers’ abilities in foresight? Below, we explain why most EIS funds are likely to fall short in this respect. As such, early-stage investors should be wary of relying on them to achieve sufficient diversification. We hope this is useful to you. To find out more about our EIS and other investment opportunities, visit our portfolio page here. To enquire regarding our latest projects and funding, you can reach us via:
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Why EIS funds lack diversification
How many early-stage investments should feature in your portfolio? Naturally, the answer relies heavily on your goals, risk tolerance, investment strategy and timeframe. Yet any investor who includes them should ensure a minimum level of diversification. However, many EIS funds are simply too small to achieve this on their own. A single fund usually has somewhere between 5 – 15 companies (although some may have 20). Yet an early-stage investor should, arguably, have far more in his/her portfolio – possibly in the hundreds – to ensure appropriate diversification.
EIS funds tend to pick only a handful of companies because fund managers often think they can identify the small group that will perform well. Yet the likelihood of this strategy paying off is very low. This is because EIS investments follow a power law distribution; the more EIS companies you add to a portfolio, the more likely you are to include one or more companies which generate the bulk of the returns. One study backs this up, showing that an early-stage portfolio containing 5 companies has a 40% chance of losing money, yet portfolios holding between 100 and 150 companies have a zero (or very low) chance.
Implications for EIS investors
How can you build an early-stage portfolio of an appropriate size? Naturally, the investor will need to take time to select additional investments to build up a suitable set of holdings. Should you rely on EIS fund managers to do this for you, or should you pick individual EIS investments based on your own criteria? One option is to use an investor network. Here, you can meet other investors who have a history of meeting, investing in and mentoring early-stage companies – learning from their mistakes along the way. Naturally, the multiple investors in this network will have more connections and collective experience than a single EIS fund manager. This widens your selection pool for early-stage investments and arguably leads to a better vetting process.
Of course, the drawback to investing in individual EIS companies is the high volume of deals – requiring a lot of work. Even EIS funds struggle to achieve the workload involved with building large, diversified EIS portfolios. Yet an exclusive network of investors – each trusting each other and willing to share deals – can create the efficient, streamlined system required. The incentive to do this exists due to many angels being willing to take extra capital to early-stage funding rounds to ensure raise targets are met. Investors can also take confidence that co-members have also passed a strict selection process prior to joining the network.
How can you ensure a high level of diversification when choosing EIS investments? Naturally, investors should seek to invest across a wide range of industries, business models and stages of development. Again, an investor network can help with this. Different investors will have their own interests, startups and areas of expertise which you can use for guidance and suggestions. Spreading across different sectors and geographic locations helps to avoid concentration risk. Investors can also help protect their investments via loss-mitigation strategies and schemes. EIS, for instance, allows investors to claim back an EIS loss against their income tax or capital gains tax bill. Occasional rebalancing of your portfolio will also be needed to ensure no single company, sector or location dominates. Be mindful that smaller, early-stage companies usually follow different investment cycles compared to other areas of the market (e.g. public stocks). Simply relying on a yearly investment review with a financial adviser, therefore, may not go far enough for some investors. Make sure you have a review schedule suited to your needs.
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