As we slide gracefully into the season of Christmas parties, mince pies and mistletoe, we are also moving into the season of investment decisions.
After two or three days of festivities, many grown-ups retreat into a period of recreational reading, which can often mean perusing the latest investment offers and making a selection of the ones they fancy before the end of tax season rush. The New Year period gives people the time to read the small print! After initial and annual management fees, hurdle rates are often next in line on the list of considerations.
In the world of capital budgeting, a hurdle rate denotes the minimum acceptable rate of return for a project to be deemed viable. In financial services, a hurdle rate is the level at which the manager of the scheme starts to draw an incentive fee from the investment pot. We have recently undertaken a brief survey of the current hurdle rates in the EIS market and have been fairly shocked by what we have discovered.
So what is a minimum acceptable level of return from an EIS investment? And what is an appropriate share of the return for the manager to take above this level?
The level at which the hurdle rate should be set obviously depends on the risk profile of the particular offer. In general, the higher the risk (and also the reward), the higher the level of the hurdle rate. And the lower the risk, the lower the hurdle rate.
There are several different categories of EIS offer this season: “downside protected” schemes where the degree of risk is limited, but the upside is also limited: “growth” schemes, which have a much higher upside potential but with an equally higher level of risk; “super growth” schemes which are usually start-ups and very high risk; and finally “generalist portfolios” where the risk is mitigated by portfolio diversification and where an investor is substantially relying on the expertise and experience of the manager.
Among the generalist funds, there is a fairly broad consensus. They tend to take a 20% performance fee above the level of £1 returned for a gross £1 invested (i.e. before the benefit of tax relief). The assumption appears to be that a nil uplift is an acceptable return, which seems to us to be a debatable point and a somewhat cynical manipulation of the tax relief as representing a real return. In the downside protected space, the average level of hurdle rate seems to be £1.20 and the average “management take” above this level is around 25%. We were shocked to see one where the hurdle rate was £1.20 but the management take above this level was 80%. In fact, we had to re-read it a couple of times to make sure we had understood it correctly!
In the growth space, again the hurdles tend to be around £1.20.
This seems to be setting the bar quite low for an investment where the return could well be above £2. When we first launched our Leisure Fund four years ago, we set the hurdle rate at £1.50, with a management take of 25%, as we felt this was a fair threshold for an investment which was targeting a mid case return of £2.50. As far as we know, this is to this day far and away the highest hurdle rate in the EIS market. And yes, we are confident of easily beating the hurdle and earning a success fee.
Martin Sherwood, Partner
Martin Sherwood has many years’ experience of small company fundraising and in particular, the tax-efficient investment market, specialising in the Hospitality & Leisure Sectors. Martin is currently chairman of the four British Country Inns companies and of Halcyon Hotels and Resorts plc, a joint venture with Luxury Family Hotels, which he helped launch 20 years ago. He was founder and head of Tax Efficient Solutions, first at Teather & Greenwood (1997-2004) and subsequently at Smith & Williamson (2004-2010), which he left to found Enterprise.
Martin has been closely involved in both Venture Capital Trusts and Enterprise Investment Schemes (EIS) since their inception and is a founder director of the EIS Association, the official trade association of the EIS industry.
Martin works very closely with a wide range of Hospitality & Leisure entrepreneurs and has a significant network of investors and professional contacts as well as being a serial investor in his own right.