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transcript
YOUR LOGO
The Magnificent Seven Tips for Due Diligence
By Dr Brian Moretta Head of Tax Enhanced Services at Hardman & Co
Great British Investment Roadshow EIS/SEIS
November 2016
Page 2
Agenda
Objectives 3
Introduction to Hardman & Co 4
Defining due diligence for today’s purpose 5
Magnificent Seven tips 7
Concluding remarks 17
Appendices 18
Disclaimer 27
Objectives
Page 3
To reduce your business risk through better processes
To appreciate the FCA’s direction of travel regarding where the onus lies in the investment decision making process
To have better tools and concepts for due diligence
To feel professionally comfortable with EIS investments
Introduction
Hardman & Co
• Provider of independent research for over 20 years
• FCA Registered
• Entered tax enhanced space in 2015
Brian Moretta
• Fund manager and analyst for over 20 years
• Actuary
Page 4
Defining due diligence for today’s purpose
Page 5
Definition:
“Due diligence refers to the care a reasonable person should take before entering into an agreement
or transaction with or on behalf of another party”. Source: Investopedia
Background - Changing regulatory attitude towards due diligence
Page 6
“…the poor quality of an advisory firm’s research and due diligence is one of the three root causes for poor consumer outcomes.”
What does the FCA see as key?
The nature of the investment
Its risk and benefits
The provider (can you entrust them with client assets?)
…Good news: FCA sees firms of all sizes capable of doing this
FCA Thematic Review TR16/1, February 2016:
“Assessing suitability: Research and due diligence of products and services”
The Magnificent Seven Tips for Due Diligence
Page 7
Source: World of Entertainment
Tax
Investment
Wider range of strategies
Shorter holding time for tax break
Loss relief
CGT deferral
BPR eligible
Advantages of VCT
For most products…
Advantages of EIS
Instant diversification
Greater diversification
Better corporate governance
Ongoing liquidity
Tax free income
Tip 1: Don’t let tax tail wag the investment dog
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Page 9
Tip 2 (1): Balance risk and return
Bank
~1%
Gilt
~2-3%
I.G. Bond
~4-5%
Equity
~6-8%
Derivative
~10%+
RISK
EIS
Tip 2 (2): Balance risk and return
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What do target returns measure?
RISK!
Does the risk of the scheme match the target return?
Can a scheme promising a total of 10-20% over 4 years be risk appropriate?
Tip 3: Evaluate the investment process
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Check there is an investment process
If so, what do you look at?
• What is the pedigree of those investing?
• Are there enough potential projects?
• How does the the manager filter opportunities?
• Is there independent scrutiny of decisions?
• How important is valuation?
Understand where the risks are.
Tip 4: Pay attention to what happens after investment
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Understand how a manager supports and monitors their investments
Very few companies progress smoothly
Immaturity often means lack of internal systems and controls
Ensure you receive and read regular updates
Don’t forget about the exits
Tip 5: Greater skewness requires greater diversification
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Probability of losing money
Compare two schemes
• (a) P(no return)=0.5, P(3x return)=0.5
• (b) P(no return)=0.8, P(7.5x return)=0.2
Both have same expected return i.e. 1.5x investment
But skewed one (b) needs greater diversification to get same probability of avoiding loss 0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1 2 5 10 15
(a) (b)
Two simple investments
Tip 6 (1): Understand how managers are rewarded
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Rational people respond to their incentives
How are manager interests aligned with investors?
Annual fee
• Typically 2% per annum of initial investment
• Incentive – gather assets
• Where is incentive to exit?
Tip 6 (2): Understand how managers are rewarded
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Performance fees
• Typically 20% of performance
• This is a call option on the assets
• Value to manager maximised by increasing return or risk (volatility)
Which is easier to change?
BUT only paid if there’s an exit
Tip 7: Validate your research
Page 16
Good news – others have been doing this too
FCA says….
•…can rely on factual information provided by EEA-regulated firms
•…cannot rely on provider’s opinion
We say…
• Don’t rely on made up numbers!
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Summary
FCA telling us that due diligence is not optional
Tip 1: Don’t let tax tail wag investment dog
Tip 2: Balance risk and return
Tip 3: Evaluate the investment process
Tip 4: Pay attention to what happens after investing
Tip 5: Greater skewness requires greater diversification
Tip 6: Understand how managers are rewarded
Tip 7: Validate your research
Appendices
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I. Intro to Hardman & Co
II. The regulatory environment
III. The key steps to investment evaluation
IV. How Hardman & Co approaches reviews
I. Introduction to Hardman & Co
Page 19
Who is Hardman & Co?
Founded in 1996, Hardman & Co is an FCA registered capital markets research and consultancy business providing a wide range of services to the UK corporate sector. Our expertise covers all major sectors of industry and commerce
Independent research and financial analysis are our core product offering, and combined with a deep understanding of our business and strategic focus, provides the ability to assess, value and advise our corporate clients
Our business is structured to address the ever-changing regulatory landscape and to help alleviate commercial challenges in the financial services industry
We entered the tax enhanced review business in 2015, having been encouraged to do so by industry participants, and after several months of due diligence
We are not a stockbroker. We are only retained by corporates or advisers. We do, however, have a significant network of contacts
I. Introduction to Hardman & Co
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Speaker bio – Dr Brian Moretta
Head of Tax Enhanced Services at Hardman & Co since 2013
Actuary and examiner for the Faculty & Institute of Actuaries
Former fund manager
20 years experience in financial services
Contact details:
Telephone: 020 7929 3399
Email: bm@hardmanandco.com
Website: www.hardmanandco.com
II. The regulatory environment
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What is ‘Research & Due Diligence’? (FCA’s view)
“Research and due diligence form part of a wider range of requirements which, together, combine to ensure firms deliver good client outcomes.”
Competence – the advisory firm must ensure its advisers are adequately competent on the subject of the product or service concerned. Advisers are required to be competent in the regulated activities they undertake, such as advising on investments
Research and due diligence – the process carried out by the firm to assess: (a) the nature of the investment, (b) its risks and benefits, and (c) the provider. The firm needs to understand these factors in order to judge whether the solution is suitable
Assessing suitability – once advisers are competent in the nature of the investments and understand the individual product or service, they should be able to judge for each client if the solution is suitable
Conclusion: “What constitutes a reasonable level of research and due diligence will differ depending on the adviser’s recommendation and the needs of the client.”
II. The regulatory environment
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So…what does TR16/1 have to do with me?
The FCA findings & observations included the following comments:
Many firms did not show consistently good practice across all products and services
“We were disappointed to identify issues relating to platform research and due diligence, particularly having previously published our expectations around this topic.”
The better firms had either in-built challenge in the process and/or individuals who were knowledgeable, enthusiastic and challenged the firm’s approach
File reviews should involve a genuine assessment of the recommendation rather than simply checking the presence of research and due diligence, irrespective of its quality or relevance to the client
Many firms demonstrated inconsistent and insufficient research and due diligence in the selection of platforms. We believe this was caused in some cases by status quo bias and an ‘if it isn’t broke, don’t fix it’ attitude. We also saw evidence of some firms retro-fitting due diligence to justify the outcome the firm had already previously decided upon
When firms have CIPs, they should ensure individual advisers understand the benefits and risks
II. The regulatory environment
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…And there is more to come from the FCA soon
“We will be publishing a second consultation paper on the implementation of the Markets in Financial
Instruments Directive (MiFID II) later this year (2016). Based on ESMA’s Technical Advice to the Commission of
December 2014, we anticipate that this will include requirements in relation to research on products.”
III. The key steps to investment evaluation
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Where will the buck stop?
An intelligent observer might deduce that the onus regarding the investment responsibility (as opposed to tax planning) is being pushed increasingly onto the adviser, as they are best placed to understand the needs of their client.
An Adviser might be asking questions such as:
What do I need to know?
What do I need to do?
Who else, if anyone, can I rely on?
General words of advice:
Ignorance is no defence, nor will “just going with the flow” be an acceptable practice
Acting like a reasonable person is a good sense-check
Get informed help in cases of uncertainty
III. The key steps to investment evaluation
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The appropriate mindset to adopt
The general rules to any investment commitment include:
Appreciate the key drivers to risk and reward
Identify the investment processes that are applied to decision-making
Adopt a constructive approach; and do not accept weak answers to questions and enquiries
Understand the business proposition and importantly the current valuation
Consider management record, contribution and reward structure
Identify any conflicts of interest
Division of reward - who stands to benefit?
Absorption of losses - who takes the hit?
Assess financial resources to accomplish aims – scale of future fundings and timing
Obtaining additional comfort whenever necessary
IV. How Hardman & Co approaches reviews
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What we look for…does it all make sense?
Clarity of fund objectives
Robustness of business case that underpins objectives
Investment process – needs to be clear and consistent
Management experience and credibility; case studies
Valuation calculations; on what basis are these prepared
Corporate governance standards – management of conflicts
Risk management
Monitoring of progress; life is not static
Results of stress testing the business model
Disclaimer
Page 27
Hardman & Co provides professional independent research services. Whilst every reasonable effort has been made to ensure that the information in the research is correct, this cannot be guaranteed.
The research reflects the objective views of the analysts named on the front page. However, the companies or funds covered in this research may pay us a fee, commission or other remuneration in order for this research to be made available. A full list of companies or funds that have paid us for coverage within the past 12 months can be viewed at http://www.hardmanandco.com/
Hardman & Co has a personal dealing policy which debars staff and consultants from dealing in shares, bonds or other related instruments of companies which pay Hardman for any services, including research. They may be allowed to hold such securities if they were owned prior to joining Hardman or if they were held before the company appointed Hardman. In such cases sales will only be allowed in limited circumstances, generally in the two weeks following publication of figures.
Hardman & Co does not buy or sell shares, either for its own account or for other parties and neither does it undertake investment business. We may provide investment banking services to corporate clients.
Hardman & Co does not make recommendations. Accordingly, we do not publish records of our past recommendations. Where a Fair Value price is given in a research note this is the theoretical result of a study of a range of possible outcomes, and not a forecast of a likely share price. Hardman & Co may publish further notes on these securities/companies but has no scheduled commitment and may cease to follow these securities/companies without notice.
Nothing in this report should be construed as an offer, or the solicitation of an offer, to buy or sell securities by us.
This information is not tailored to your individual situation and the investment(s) covered may not be suitable for you. You should not make any investment decision without consulting a fully qualified financial adviser.
This report may not be reproduced in whole or in part without prior permission from Hardman &Co.
Hardman Research Ltd, trading as Hardman & Co, is an appointed representative of Capital Markets Strategy Ltd and is authorised and regulated by the Financial Conduct Authority (FCA) under registration number 600843. Hardman Research Ltd is registered at Companies House with number 8256259. However, the information in this research report is not FCA regulated because it does not constitute investment advice (as defined in the Financial Services and Markets Act 2000) and is provided for general information only. Hardman & Co Research Limited (trading as Hardman & Co) 11/12 Tokenhouse Yard London EC2R 7AS T +44 (0) 207 929 3399 Follow us on Twitter @HardmanandCo (Disclaimer Version 2 – Effective from August 2015)
How to contact us Hardman & Co Richard Angus (Head of Business Development) 11/12 Tokenhouse Yard London EC2R 7AS Tel: +44 20 7929 3399 research@hardmanandco.com www.hardmanandco.com
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