Dermot Campbell looks at the difference between alternative investment funds and discretionary portfolios in the context of EIS and SEIS funds and explains why advisers might consider recommending them

Enterprise investment scheme (EIS) and seed EIS (SEIS) funds are slightly unusual because, while they do not really exist, according to HMRC figures to the end of January, they have still accounted for more than £12bn worth of investment since their launch.

So why recommend EIS and SEIS funds? There are lots of reasons, including tax reliefs, which – when coupled with competitive fees and thorough due-diligence – can result in lower-risk returns.

In order to take advantage of EIS or SEIS reliefs, your client must invest in the underlying companies directly and there cannot be a legal entity surrounding the structure otherwise they will not qualify for the tax relief. What then are they actually investing in?

There are three possible structures they could invest in:
* A basket of EIS investments with no fund or portfolio structure and no FCA-authorised manager;
* A portfolio of investments run by a portfolio manager under the MIFID investment management regulations (MIFID portfolio)
* An alternative investment fund managed by an alternative investment fund manager (AIFM)

Advisers who do not specialise in corporate finance are probably better off limiting their investments to either a portfolio or an AIF. If advisers want to go further than that and choose a client’s investments directly, then they will need to be skilled in the art of valuing private companies – a specialist role and well beyond the scope of this article.

Alternative investment funds

Alternative investment funds are a relatively new creation and were brought into being by the Alternative Investment Fund Managers Directive in 2013. In an EIS or SEIS context, AIFs are the most simple of funds to manage.

The fund manager must be authorised as either a sub-threshold alternative investment fund or a full-scope alternative investment fund. The majority of EIS funds are sub-threshold funds although a few are full-scope. There are onerous requirements in terms of operations and capital adequacy for full-scope AIFMs, however, the sub threshold managers have a significantly easier time.

The capital adequacy requirements for sub-threshold AIFs are really quite light-touch, and the principle is that the manager sets out exactly what it is going to do in the information memorandum and then follows it – crucially without taking account of the individual circumstances of the investors in the fund.

Alternative investment funds cannot be marketed to the general public and authorised persons arranging investments must carry out an “appropriateness test”. The appropriateness test has a lower threshold than the suitability test, and will be covered by suitability advice.

Once the appropriateness test is compete, then the investment manager can simply get on with the business of investing the client’s money and does not have to concern themselves with the specific needs of individual investors.

MIFID portfolios

MIFID portfolios can either be for retail investors or elective professional investors. A financial adviser may find clients are generally best suited to retail-style funds because retail MIFID portfolios give clients the greatest protection and are the easiest type of fund to refer their clients to. The reason for this is that retail portfolio managers are obliged to carry out a suitability test on each investment they make.

MIFID portfolio managers can be identified because they have the FCA’s permission to “manage investments for retail clients”.

Professional funds are designed for experienced investment professionals who probably come from a background of private equity investing. These funds offer the least investor protection, with no right to complain to the financial ombudsman and no access to the financial services compensation scheme. As a consequence, they are only open to professional or elective professional clients.

In order to qualify as an elective professional, a client would need to meet two of the following three criteria:
* They have acted in a professional capacity in the field of private company investing
* They have in excess of £500,000 investible assets, excluding their principal residence
* They have carried out a large number of transactions over the preceding three years

The vast majority of clients will not meet this standard, which means advisers should generally concentrate on working with retail authorised funds rather than professional-only funds.

At the end of the day, as an adviser, it is important you understand the distinction between the MIFID portfolios and alternative investment funds as there are differences in the way in which the underlying funds are managed. A MIFID manager may take into account a client’s need to be invested before the end of the tax year whereas an AIFM should not.

This article was written by Dermot Campbell and published by ProfessionalAdviser.com on 4th April, 2016.