Expert View: Would you join the big boys in backing the small fry?

Investment in smaller, unquoted firms is classified as very high risk
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The Independent Online

Pre-flotation investment is normally an institutional play, with the big boys getting in early so they can benefit from the uplift on listing. Usually, the private investor is left out.

There are a number of regulatory and practical reasons why this is so, such as the amount of paperwork required and the resulting prohibitive cost.

But it doesn't have to be the case that the heavyweight financial institutions get all the cream. Venture capital trusts (VCTs) have encouraged backing for smaller, unquoted firms by offering private investors tax incentives in return for a specified period of investment, usually five years. And with the private equity market hitting record inward-investment levels in 2006 and predicted to be as strong in 2007, possibly because private company valuations seem reasonable now, individuals are seeking ways to get involved at the pre-float stage.

But the potential for high returns comes at a price. These investments are classified as high or very high risk due to the potential for failure prior to flotation, or more likely because the company will take a lot longer to reach the listing stage than it predicted, with the result that investors are denied a way out.

In order to balance your portfolio, most pension and investment advisers have suggested a level of 10 to 15 per cent of your assets in high-risk investments. Individuals now have the opportunity to get in at the pre-float stage but, as these investments are classed as high risk, not all are allowed to.

City regulator the Financial Services Authority (FSA) agrees that the only people potentially eligible are those known as intermediate clients.

These are customers who can demonstrate enough experience in financial matters and a high enough net wealth that were these investments to become worthless, their livelihoods wouldn't be ruined.

An additional price that these intermediate clients must pay is that they have to opt out of many of the protections provided by the FSA.

Under the Enterprise Investment Scheme (EIS), ironically, the Government provides tax incentives for individuals to support growing businesses that are looking for a quote at some time in the future.

Unlike with a VCT, where your investment would be spread over a number of companies, you can pick and choose your own. And the tax incentives can be quite substantial.

There is an initial 20 per cent income tax rebate on your investment in the following financial year, and such schemes are also free of inheritance tax after two years, while they become totally free of capital gains tax after three years.

VCTs have a tax break of 30 per cent over a five-year period. If the shares are disposed of at a loss, that deficit can be set against capital gains or income in the year of disposal.

Within the Budget in 2006, the Government paved the way for self-invested personal pensions (Sipps) to invest in private equity. This is a big breakthrough for the private client as it makes it possible to dispose of the stake after a listing and make any capital gain tax free without having to wait for three years.

Whether or not the Sipp administrators will allow this remains to be seen, but legally it is now possible. Over time, pension managers will be advising their clients to invest a sensible proportion of their Sipp fund in pre-float opportunities.

As the Alternative Investment Market, the junior listing of the London Stock Exchange, gains popularity, with more and more companies joining, the opportunities for private investors to get involved at an early stage become more apparent - whether it's through their Sipp, EIS or intermediate client. Not all companies will get a quote, but those that do could generate quite a substantial uplift.

So there are ways to join in with the institutions, but remember, many early-stage companies fail and high potential rewards entail high risk.

Rob Holgate is chief executive at Wills & Co.