PRESS RELEASE: New FounderCatalyst research identifies portfolio sweet spot for angel investors

FounderCatalyst has today (22nd January 2021) revealed new analysis which shows the number of start-up investments needed in order to receive the optimal return is approximately 25, leading to a 2.77 times return, or a 3.19 times return, when taking into account the 30% tax relief with HMRC’s Enterprise Investment Scheme (EIS) (returns would be even higher if using the Seed Enterprise Investment Scheme (SEIS)). The story has been exclusively covered in Business Leader, the website and magazine covering the top breaking business stories for UK entrepreneurs.

This optimal number of investments is higher than the actual average number of investments made by angel investors, which is 17, showing that many angel investors could optimise their portfolio by increasing its size over time.

The findings use data from a report by UK British Angels Association and British Business Bank: The UK Business Angel Market 2020 (p20 & 22). FounderCatalyst’s analysis uses a Monte Carlo simulation to drill into data covering 300 exits from 2018/19 and the rate of return on original investment.

Bar chart showing the rate of return on the number of EIS investments

The item in blue represents the average number of angel investments reported in the UKBAA survey data. The item in green represents the optimal portfolio size identified by the analysis.

The analysis shows it doesn’t pay to put all your eggs in one basket: the return from just two investments is 1.5 times the money invested, excluding any EIS tax relief. But it also reveals that an investor gets diminishing returns beyond 25 investments - though more investments still means greater returns overall. The data shows a peak return of around 2.77 times for a portfolio without the benefit of EIS or 3.19 times with the benefit of EIS.

According to the analysis, a ‘concentrated’ portfolio of 3 investments is likely to yield, on average, worse returns than a portfolio of 10 companies. So rather than investing £10,000 each in three companies, it would make sense to invest £3,000 in 10 different companies.

The findings suggest that, despite the Coronavirus pandemic, UK start-ups are an attractive asset class for investors, especially given the SEIS and EIS tax relief. And though increases to Capital Gains Tax and Inheritance Tax look likely, SEIS and EIS investments are exempt from both.

Sam Simpson, COO at FounderCatalyst and angel investor said:

Angel Investing is increasingly seen as an attractive asset class especially at a time when tax reliefs are being squeezed and Capital Gains and Inheritance Tax are under review. Angel wisdom has always dictated that you ‘shouldn’t put all of your eggs in one basket’ but I’ve never been able to find an analysis of exactly how many eggs I should have to optimise my portfolio. This analysis shows a portfolio of 25 companies is the sweet spot.

It would be remiss not to acknowledge that angel investing isn’t for everyone - it is a relatively illiquid asset class - and to take advantage of the SEIS and EIS schemes you need to hold the investment for at least 3 years. Before investing, you should also consider the potential impact of Coronavirus and Brexit on the business model of the investee company.

Jenny Tooth, Chief Executive, from the UK British Angel Association said:

Diversification is important for any investor, especially in these difficult times when new investments should be made carefully. But it is reassuring that high performing portfolios can be achieved taking a relatively lean approach - delivering good returns for angel investors at a time when we need many more investors to see the benefits of backing entrepreneurs across the UK.

Jez Williams, serial angel investor and Non-Executive Director said:

I know about the portfolio effect. I knew that the more businesses I invested in, the greater the chance of a good return. I planned to keep on investing year on year, but knowing there is a point where I can stop and be sure of getting the best return is really interesting.

ABOUT THE RESEARCH

Data Source

The underlying data used to perform this analysis was taken from the report “The UK Business Angel Market 2020”, jointly published by UK Business Angels and the British Business Bank.

We based the analysis on the chart below, figure 26, p22.

Methodology

We first modelled figure 26, taking into account the tax relief benefit of EIS under the assumption that all investments are made via that scheme:

We then ran a Monte Carlo simulation using the expected return percentages and the level of return from that outcome (the fourth and last column). We ran 10,000 simulations and modelled the outcomes against various sizes of investor portfolios in order to answer a number of questions:

1. What is the optimal number of investments to have in an angel portfolio?
2. When do you start getting diminishing returns?
3. What return can you expect from a sufficiently large portfolio?
4. What is the overall impact of EIS on an investor portfolio?

A Monte Carlo simulation is a probabilistic method commonly used in investing circles to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables.

In this case, the UKBAA report kindly provides portfolio outcomes data but we need to model a ‘real world’ model portfolio. Rather than just replacing the uncertain variable (in this case the portfolio performance) with a single average number, the Monte Carlo simulation provides a better solution by using multiple randomised values.

Assumptions

For the purpose of this analysis, we have used the following assumptions / approach:

• Data is based upon a survey (with n=300) rather than objective ‘outcome’ data.
• We assume all investments are made under EIS. This offers a modest tax relief when compared to SEIS, but the investment is made in a more mature business so the risk should be less. Investors still get the generous CGT and IHT exemptions with EIS.
• The model ignores the "Prefer not to say" and "Don't knows" entirely as it is impossible to model the impact of these items.
• The model takes a pessimistic view of the return ranges (i.e., for 6-10 x return, we've assumed 6x). For <1x return we assume 0.5x. We also assume 21+ times return equals 21x exactly for simplicity of modelling but, if anything, this understates the expected returns for a large enough portfolio which should offer high-return, long-tail exits.
• These figures use data from 18/19, so don't take into account Brexit or coronavirus. This is a look back rather than forward.
• These are average returns – some people will be better at picking investments (by doing extensive due diligence for example) whereas some people will invest in a more carefree manner due to the generous tax breaks.
• These figures assume no fees – if you invest directly then there would be no fees. If you invest via a fund or equity club that takes a fee then your returns will be less.