17 May The impact of portfolio investing
It amazes me when I hear of investors that are enjoying the buzz and stories around investing in start-ups but only have one or two investments. It is such a high-risk asset class that it is essential to hold a portfolio. Some even argue the FCA should mandate holding a portfolio.
Inherently, seed investing has three outcomes – fail completely; mature into a sustainable business but with no exit; or grow and exit at a multiple (and maybe a significant multiple).
Consider the following portfolio of 10 investments each of £1,000. Things haven’t gone great here, with four businesses going bust and a couple of businesses only returning the investment and no profit. But on a reasonably conservative basis, two businesses have returned the investment plus 100% and two more have quadrupled in value.
The net returns come out as £14,000 – i.e. the original investment back and then a 40% return on that money. I’d prefer this than investing £10,000 in just one business with a 40% chance of losing everything.
But then things get more interesting. We can add the impact of taking advantage of the Seed Enterprise Investment Scheme (SEIS). Investing in start-ups less than two years old and meeting some other criteria set by HMRC (more on this here) attracts generous tax reliefs. In the next example, the returns are the same but the investment at risk is reduced from SEIS tax reliefs.
The investor is getting £5,000 of their £10,000 investment back off their income tax bill. (The investor could also qualify for capital gains tax reliefs that are not shown here.) Furthermore, the investor can claim loss relief – a further deduction from their tax bill – for any investment that has gone bust. (Here assumed for a 45% income tax payer). In this example, the performance of the businesses are the same, but the impact of the portfolio and the SEIS tax reliefs is to boost performance to £14,900 returned from a £5,000 net investment or 198% return on the investment. And these returns from SEIS qualifying investments are free from capital gains tax, as long as the investments have been held for 3 years.
Then what about considering a scenario where we expect a better performance from the portfolio? This might be from making more informed and better-quality choices in the first place, or from buying into the investments at more favourable valuations. These are the types of promises that an experienced investor or fund manager should be able to deliver on – so in the following example there’s a 5% performance fee for a fund manager (most should charge investors less than this).
In this example only 3 businesses have changed performance. One less business going bust and instead returning the investment, one more business doubling in value, and one achieving a 10 x increase rather than quadrupling.
But the impact is significant. Even after allowing for some fees the returns have accelerated to £21,575, a 332% return above the original net investment at risk.
The maths will work if several investments are made in one narrow sector. But the portfolio could be more effective if spread across sectors. Furthermore we need to think about the when exits could be expected to create some liquidity. We never expect any kind of seed investment to create liquidity for 5 or even 7 years (this is called ‘patient capital’). But this is the other advantage of a portfolio. There is a chance that across our illustrative portfolio that some companies might have an accelerated exit (and also every chance that some will take longer). So a portfolio doesn’t just spread the level of returns but also the timing.