Recently I was presenting on a webinar for advisers and, in passing, said I thought EIS’s lack of liquidity was a red herring. In the discussion, I received the following question:
I think illiquidity makes EIS high risk
The focus of my talk had been about taking appropriate risk and reducing it through diversification, so my answer focused on that. I agreed EIS was high risk, though it wasn’t just the illiquidity that made it so. Reflecting afterwards, I wondered if the question had suffered in translation. A typed comment had been relayed through a chairman. Maybe the question was really about liquidity, not risk? With my focus on other issues, I’d skipped over the topic, so here’s my alternative answer.
Liquidity in EIS and SEIS
Firstly a little scene setting. The vast majority of EIS and SEIS investments are shares in unquoted companies. AIM- and NEX-listed investments are permitted, but the scheme rules mean these are much less common than unquoted companies. With no quote, EIS & SEIS shares are hard to sell on demand.
Although there have been several attempts, noone has established a reliable secondary market. Sometimes investors can make secondary sales in later funding rounds. While this has become increasingly common, it is far from guaranteed. Mostly, liquidity is only available if and when a company exits. Most successful exits are trade sales, with only a small minority of companies getting to an IPO. Unsuccessful companies usually exit though liquidation. And if a company doesn’t exit, then an investor is stuck with the shares.
Clearly, this creates a potential problem for investors. If they need cash, or if the company is doing badly, then they can’t sell. This makes illiquidity a meaningful contributor to the risk of EIS investments, albeit probably not the largest – that would be the risk of operational failure.
So why isn’t EIS liquidity that important to investors?
As alluded to in the previous paragraph, investors generally sell an investment for one of two reasons. The first is a need for cash. This can be pre-planned, such as school fees or retirement, or unexpected, such as a job loss or accident. The other main reason for selling an investment is to reinvest it in something that is doing better.
Good financial planning should go a long way to mitigating the former. Planning investments around expected cash needs is simply common sense. However, the timing and value of EIS exits is uncertain, so they are not really suitable for fixed cashflow planning.
For unexpected cash demands, the standard recommendation is to have at least six month’s of cash in reserve. This can be fine tuned, depending on age and financial position. For example, wealthier investors may want 5% or 10% cash or more in their asset allocation, even if this is larger than the 6 month requirement. This may be “dry powder” in case asset prices drop. Or it may be the comfort from a large buffer that is affordable as not all assets need to be working. Younger investors may prefer to be fully invested and accept the short-term risk. Regardless, this amount should cover most unplanned needs, such as living expenses until a new job is found or replacing a car.
Its the whole portfolio that matters
EIS illiquidity is only relevant if the cash need exceeds the available reserve. Now, EIS investors tend to be better off and their typical portfolio will contain the following:
- Primary residence
- Pension fund
- Mutual funds
- Cash
- EIS & VCT investments
Investors will often also own other investments such as premium bonds, crypto-currency or secondary property, like a holiday home or buy-to-let. These are normally a small part of a portfolio, but some investors do go all-in! An imbalance often arises for small business owners. Whether EIS liquidity is a potential problem depends on the mix of assets.
The residence and pension fund are usually the largest assets. They are also effectively illiquid. A residence can be sold, but it will take time. However, it is also held for non-financial reasons – ownership gives reassurance and control, to say nothing of somewhere to live! In theory, the investor might be able to take a mortgage against it, but increasing borrowing creates different issues. A pension fund usually invests in liquid assets, but investors cannot access these until after retiral. Even in retiral, it may be only be available as income or at the (prohibitive) price of a large tax payment.
What could be emergency sources of cash?
So, if an investor needs more cash than their reserves then it has to come from their other investments. Depending on their risk profile, most investors should have between 5% and 15% in venture capital, preferably tax-advantaged investments. VCTs do have liquidity and, if they have been held for more than five years, then there is no tax liability on disposal either. Some alternatives, like premium bonds or crypto-currency may be easy to sell too. However, in most cases mutual funds will be the key source of additional funds.
The key issue then is whether the mutual funds are large enough to constitute a suitable secondary reserve. There is no right answer to this, and its not discussed much in the usual advice circles. This is probably because the base assumption is that most assets outside the two largest and cash will be mutual funds. Introducing EIS challenges that assumption.
As usual, extreme cases illustrate the challenge and give insight into solutions. Suppose that, apart from cash reserves, the portfolio was 100% mutual funds. Then, from a liquidity perspective and ignoring asset allocation considerations, moving 15% into illiquid EIS is absolutely fine. That still leaves 85% in liquid assets.
Now suppose that the only assets outside cash are a pension fund and primary residence. It is clear that directing all new savings into illiquid EIS would be imprudent. Mutual funds are the obvious choice. VCTs may be a more plausible addition to the mix. Any EIS investments at this stage should be very limited until there is a larger reserve of liquid assets.
What proportion of assets should be in mutual funds or other liquid, non-cash, investments?
This then becomes the key question. And, truthfully, there is probably no correct answer. It depends on the cash needs for an unseen emergency. Which, by definition, is inevitably unknown. We might suggest some rules of thumb, depending on circumstances:
- Suppose the cash reserve is 6 months of normal expenses. Having another month in liquid investments doesn’t seem material. Investors would probably want to be able to sell investments to at least double or triple that.
- The higher the cash buffer, the less the rest matters. Someone with a cash reserve of five years of normal expenses can probably tolerate more illiquidity elsewhere.
- Those with smaller cash reserves should probably build those up first.
Additional allowance may need to be made for the asset mix. Say someone wants at least 20% in equity mutual funds. Then starting out at, say, 25% will give a buffer in case the market falls before the cash is needed. Having said that, the uncertainty about requirements is so high that this sort of fine tuning may be unjustified exactness.
What about the second reason for selling investments?
So what if an investor sees a better opportunity, but can’t sell. Or, for EIS investments, can’t get out when a company starts to go wrong.
Standard asset allocation should sort this out. The allocation to venture capital is a small proportion of the overall assets, and EIS is probably not all of that. The EIS portfolio needs to be well diversified: it is almost certain that some investments will go bad, but the aim is these are more than offset by the winners. If an investor has 10% in venture capital and 20% of investments go wrong then that’s a 2% portfolio hit. Basically, a bad day on the stock market. But this requires the right diversification, which is a whole different argument.
Was EIS liquidity a red-herring?
Not entirely – sometimes it does matter. But these are not really that common for investors well enough off to invest in EIS. Suppose someone whose house is a third of their assets, has a third in a pension fund and a third in cash and mutual funds. Then moving 5% or 10% into EIS is unlikely to raise meaningful liquidity issues.
IMHO EIS liquidity, or illiquidity, is something that is often used as an excuse. If someone isn’t comfortable with EIS or SEIS investments, then they need to look for the real reasons because this one doesn’t really stack up.