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UK founders – avoid high-fee EIS fund money

28/03/2017

The UK’s tax incentives for early-stage investors rank amongst the best in the world, so it seems counterproductive to have it all eaten up in fees. In public markets there is a well-documented inverse correlation between fund performance and fund fees. The lower the fees, the higher the returns. We’ve not seen this quantified in private markets but the stark difference in fees between different early stage funds must impact fund manger behaviour.  “Good” funds take as little up-front as possible, leaving over 90% of invested money to go to work. They earn their money from the fee on performance, typically a 20% share of any profit on the investment above a hurdle. Investors running a high-incentive-to-perform fund will have a wealth of experience to share with you. 

The acid test for an early stage fund is that at least 90%, and preferably closer to 95% of the fund investors’ outlay is invested in the business. Funds typically charge an initial fee and withhold annual management fees, leaving less than 90% of the outlay available to actually invest in businesses. A benchmark beating example would be the recently launched London Business Angels LBA Ventures scale-up EIS1 fund that charges a little over 4% in total. This fund earns its main fees from the “carry”, 20% of all profits generated above a 20% return hurdle, and so is well aligned with its ultimate investors, and with the interests of its investments.

We compared the LBA Ventures fund charges with a typical “specialist tech startup” EIS scheme.

£100k investment fee and performance analysis over 5 years

Target returns

Target returns are cited before the tax-relief benefit of EIS schemes. The LBA targets a 15% IRR (internal rate of return), which over 5 years compounds to 101% of the original investment. The specialist targets a 60% total return, which sounds impressive but equates to an IRR of just 10% over 5 years. Given that’s only a couple of percent higher than long-run stock market returns, on a risk adjusted basis it is not good. LBA notes that it’s current EIS funds average 17% unrealised IRR. The specialist doesn’t mention past performance.

Minimum fees and amount invested

We calculate the LBA fund minimum fee at 4.24% leaving 95.76% available to invest in businesses. The specialist’s is 16% leaving just 84% to invest. The LBA doesn’t charge an annual fee, just a 0.25% when making an investment. The specialist scheme cites in its literature its small portfolio allowing it to spend more time with each company and better helping them to achieve success compared to the big funds which have a “short term view of maximising the funds raised”. In reality the specialist is the one with the short-term view, charging more as a minimum irrespective of fund performance, and so depriving its portfolio of capital.

Performance fees

Both funds charge a 20% performance fee, though the LBA won’t charge until the fund is worth 1.2x the original investment. These fees mean the underlying company investments need to work even harder than the promised required return.

We looked at what that underlying performance would have to be to double investors’ money in the two funds, before tax-relief. The LBA investments would need to yield a 126% return to pay the funds fees and double original investors money. The specialists’ would need to yield considerably more, 162%. The LBA takes a little over £20k in fees in this scenario, the specialist £36k, more than the tax benefit of the scheme.

Comparison of fixed and performance driven fees on £100k investment making 100% return over 5 years (£)

Founders may be tempted to take the money, whatever the source, but if investors who are remunerated on performance are not biting, it may be better to give your strategy good hard truthful look before accepting money from a fund aimed at enriching its managers rather than supporting you.

 

 

The EIS Association website lists EIS and SEIS funds, however it is not possible to easily rank them by fee structure. Most EIS funds seem to fail the “invest more than 90% of client funds” rule. Ones we have seen with lower initial fees include larger institutional funds such as Octopus’s historic EIS funds, Mercia Fund management’s EIS Fund, and Syndicate Room’s Fund Twenty8.

Oakhall is a specialist and unique firm of consultants that helps boards and executive teams answer the question “what does our strategy mean when translated into numbers?”. Our aim is to maximise long-term performance and valuation, avoid short-termism, and build a stable, informed investor base. Founded by top-ranked investment bank equity analysts, we bring that analysis and articulation expertise in-house to private and public companies. 

Image source: DeathToStock