The key point is that LMS Capital has been winding down its investment portfolio and returning cash to shareholders, something I have been capitalising on, having initiated coverage at 54.5p ('Capital returns', 11 Feb 2011) and recommended participating in four major tender offers pitched at net asset value (NAV) per share. Total cash returns received since I commenced coverage exceed the initial investment made.
What is being proposed now is that Gresham House takes over running LMS’s portfolio with the aim of maximising shareholder value through the sale of legacy assets in the near-term, some of which will be returned to shareholders through further tender offers, and redeploying the balance of the cash proceeds to focus on new investments in the smaller quoted company and private equity space. Specifically, LMS’s portfolio will be aimed at investments capable of generating a 15 per cent net internal rate of return over the medium to long term and with potential for value creation through management, operational or strategic initiatives. The investee companies must demonstrate strong underlying operational cashflow characteristics and returns on capital invested. At most 20 of these investments will account for at least 80 per cent of LMS’s net asset value, of which half will be in private equity.
It’s the same Strategic Public Equity investment strategy Gresham House has been pursuing at investment manager of Aim-traded investment company Gresham House Strategic (GHS:780p) since winning that £38m mandate last summer. It’s been successful too. Despite volatile markets, Gresham House Strategic’s net asset value per share is up around 3 per cent since August 2015, representing a 10 per cent outperformance of the FTSE SmallCap index.
The latest mandate win is clearly a good deal for Gresham House shareholders as the company will receive an annual management fee of 1.5 per cent of assets under management below £100m, plus a performance fee of 15 per cent of the value created for LMS shareholders on new investments made subject to hitting a hurdle rate of net asset value growth of 8 per cent a year. To put this into some perspective, LMS had net assets of £92m at the end of the first quarter and I estimate proforma net assets were around £96m at the end of June following sterling’s plunge since the EU Referendum. Two thirds of LMS’s portfolio is held in US assets so this will have had a very positive impact on the sterling value of those investments. The mandate should generate annual fee income of around £1.4m for Gresham House, and will “accelerate his company’s move to profitability” according to Mr Dalwood.
He has yet to brief the company’s broker Liberum Capital so no new forecasts are in the market yet, but I feel this is a game changer and could prompt a move into profitability next year rather than in 2018 as previously predicted. Liberum was previously forecasting a trading loss of £1.1m on revenues of £3.8m in 2017 after factoring in a rise in asset management fees from £2.65m in 2016 to £3.76m, so the LMS mandate win is clearly material.
Furthermore, the broker had not factored in any rental income into the 2017 forecasts from Gresham House’s legacy property in Speke, Liverpool, known as Southern Gateway, a fully-let multi-let office and industrial complex. The property is currently being marketed for sale at £7.6m on an initial yield of around 10 per cent, but the company is willing to hold out to get the optimum price for shareholders. Given the uncertainty in the property market post Brexit, then it’s only realistic to expect a sale to take longer than previously anticipated. In the meantime annual rental income of around £750,000 will make a very useful contribution to the bottom line while the board expands its asset management operations.
Impact on LMS shareholders
I would also point out that the directors of LMS, and the 53.62 per cent of shareholders who have already signalled their support for the change of the company’s investment mandate, including Schroders, Majedie and AVI who control 19.58 per cent of the share capital, are fully aware that a balance is needed to be reached between meeting the needs of existing shareholders who have been holding LMS shares for the likely hefty capital returns, and those who want the company to scale up its operations.
As a result, LMS’s board is planning to return £6m through a tender offer next month at a 5 per cent discount to net asset value per share. The tender offer could be pitched at around 90p a share. That’s because in my article earlier this month I estimated that following sterling’s devaluation against the US dollar, LMS’s spot net asset value could be as high as £98m, or 95p a share, up from £92m and 89p, respectively, at the end of March 2016, reflecting the fact that two thirds of LMS’s portfolio is held in US dollar denominated investments.
The company can easily afford the £6m payout as it had net funds of £15m at the end of May. In addition, half of the next £22m of cash proceeds from the disposal of legacy investments will be returned to LMS shareholders through two further tender offers pitched at a five per cent discount to net asset value.
I would make the point that Gresham House only receives a performance fee on new investments for LMS. This means there is an incentive for it to maximise the sale proceeds on all legacy disposals so that it keeps LMS shareholders happy and retains this valuable mandate, but equally there is an incentive to make material divestments so that it can pursue the new investment strategy. Moreover, once these three tender offers have been made then 30 per cent of all cash realised profits from investments made pursuant to the new investment strategy will be returned to LMS shareholders, this providing a regular dividend.
LMS shareholders will also benefit from the value being created for Gresham House shareholders through this mandate win. That’s because as part of the three-year mandate agreement, LMS is being awarded £1m shares in Gresham House at 300p a share, and will receive a further £1.25m shares based on the average price in the 20 business trading days prior to the second anniversary of signing the asset management agreement. This will give LMS around 7.08 per cent of the enlarged share capital of Gresham House. In addition, LMS’s board have agreed to invest £1.5m in shares and warrants of Gresham House by mid-October this year to give the company an interest in a further 1.37m shares.
Clearly, with Gresham House’s share price around 300p and only 9.85m ordinary shares and 1.4m warrants in issue, then there is a possibility that LMS will be unable to meet this investment target by the mid-October deadline. So, Gresham House has agreed to issue warrants to LMS priced at 28p each upto a maximum of 492,608 warrants and which have an exercise price of 323.27p if this is the case. This means that LMS could potentially have a 17.78 per cent interest in the enlarged share capital of Gresham House, so its shareholders will also benefit from any value being created for Gresham House following this mandate win.
Bottom line
True, this is not what some investors had in mind when they decided to hold LMS shares for the bumper capital returns. However, I feel there is enough incentive for the new investment manager to make material divestments from LMS’s legacy portfolio and at prices that maximise shareholder value, while at the same time pursuing a new investment strategy that is likely to reduce the 33 per cent plus share price discount to net asset value. Indeed, implementation of the new strategy should make LMS shares an attractive investment to long term family office, high net worth and specialised institutional investors who want exposure to Strategic Public Equity investment strategies.
So, with LMS’s shares trading at 60p, valuing the equity at £62m and well below the last reported net asset value of £92m, the board outlining plans for three tender offers worth a total of £17m, and a smart fund manager now in charge of the portfolio, I feel LMS’s shares offer scope for decent capital returns over the coming years.
I would therefore vote in favour of the resolution at next month’s general meeting and tender your allocation of shares in the tender offer too. Please note that the tender offer opens on Wednesday, 17 August and closes a fortnight later. On a bid-offer spread of 59.5p to 60p, I continue to rate the shares a value buy.
Gresham House insider’s view
As I alluded to at the start of this article, my call with Mr Dalwood was very enlightening. In fact, I can also reveal that he expects the first close of Gresham House’s new forestry fund to close in the second half with subscriptions north of £12m. Gresham House will earn a 1.5 per cent annual management fee on the new funds managed and typically a 2 per cent transaction fee too. In other words, the initial forestry portfolio should earn the company year one fees in excess of £400,000, and possibly significantly more because although the company has a £25m target size for the fund, the cap is actually £40m if investor demand warrants it.
Bearing this in mind, sterling’s fall against the euro and US dollar is very good news for UK demand for forestry as it makes overseas imports of wood far more expensive and less competitive. This is highly supportive of the investment case and very positive for prospects of the new forestry fund.
In addition, I can reveal that Gresham House will be launching a Limited Partnership vehicle adopting the same Strategic Public Equity investment strategies that it has been pursuing as investment manager of Aim-traded investment company Gresham House Strategic . Mr Dalwood says that the new vehicle has a target size of between £50m to £75m and he expects first close to raise around a third of this sum in the second half this year. Institutional investors, listed plcs, wealth managers, and family offices are the target market. Progress on this front can only highlight demand for these specific investment strategies which are also being adopted by LMS under the new mandate. That’s worth noting. Also, with a new fund being launched, the fee income generated will accelerate the company’s move to profitability.
Seriously undervalued
It remains my considered view that the value being created in Gresham House’s growing asset management business is simply not being factored into its market value. That’s because the company also has rock solid asset backing through property assets worth nearly £11m including the cash due from the disposal of a Royal Mail sorting office in Edinburgh; deferred consideration from Persimmon of £6.3m which is being released through a £7m bank facility with Kleinwort Facility; a holding in Gresham House Strategic shares worth £5.9m; investments in cemeteries worth £620,000; and the £4.3m initial investment (excluding an earn-out) made in forestry asset manager Aitchesse.
In effect, with the shares trading on a modest 15 per cent premium to net asset value, the current valuation is seriously undervaluing the company’s asset management operation which now has mandates in excess of £350m.
So, ahead of likely analyst upgrades in the coming weeks, and with LMS set to start buying shares in Gresham House to meet the requirement I outlined above, I rate Gresham House’s shares a great value buy on a bid-offer spread of 290p to 300p. Please note that I last updated my view around the current price in April (‘Scaling up for profitability’, 20 April 2016).
