Mercia aims to double assets under management to £1bn within three years

Mercia provides capital across four asset classes – balance sheet, venture, private equity and debt capital – initially nurturing technology businesses through investment from the third-party funds it manages. The company also provides funding to the most promising companies by deploying direct investment follow-on capital from its own balance sheet. It has a strong UK regional footprint through its eight offices, 19 university partnerships and extensive personal networks, providing its investment teams with access to high-quality deal flow and at favourable entry points, too.

As I flagged up ahead of its annual results (‘Mercia’s asset management value creation’, 11 June 2019), the company has a track record of successfully investing in innovative UK technology businesses with high growth potential, having delivered a 14 per cent annualised internal rate of return (IRR) on its directly owned portfolio since its IPO in December 2014.

In the 12 months to 31 March 2019, Mercia invested £19.4m in 17 of its 21 directly held portfolio companies, including two new investments. The portfolio was valued at £87.7m at the financial year-end after factoring in a net valuation uplift of £3.9m. Since then, a further £4.6m has been invested, which leaves free cash of around £25m on the balance sheet, or a fifth of net asset value (NAV) of £126m (41.6p a share). The aim is to seek realisations after a holding period of three to seven years. Bearing this in mind, chief executive Mark Payton notes that Mercia has received “a number of approaches” for its portfolio companies, highlighting scope to realise potentially significant valuation uplifts on disposal while at the same time “maintaining a [new] investment runway of £20m a year”. Mr Payton also adds that his company aims to increase its market share from 6 per cent to 20 per cent of the £1.3bn regional investment market that it’s targeting, and double assets under management (AUM) to £1bn within three years.

That’s well worth considering because with the shares trading 18 per cent below NAV, we are effectively getting a free ride on Mercia’s third-party asset management business, which currently has AUM of £381m (including free cash of £168m) and which generated management fees of £10.7m in the last financial year. Admittedly, bulking up Mercia’s investment team from 68 to 85 employees to service the substantial mandates won in 2017 and 2018 led to an increase in annual administration costs from £10.6m to £12.1m, but the directors now expect a levelling off of the cost base. Analyst Justin Bates at Canaccord Genuity, who has just published a hefty research note on the company, believes that Mercia’s third-party asset management business could break even on average AUM of £512m.

In other words, if Mercia continues to win mandates – AUM has grown 16-fold from £22m at the time of the IPO – the operational gearing of the business model is such that once it turns profitable, an increasing amount of the 2 per cent management fee charged on incremental AUM will drop to the bottom line. The point being that Mercia is likely to continue to benefit from mandate wins from both new and existing investors on the back of its track record. Indeed, chief investment officer Julian Viggars points out that Mercia’s closed and legacy funds have returned £176m, representing an IRR of between 15 and 17 per cent. The most successful investment to date has been the £900,000 invested in software robot company Blue Prism (PRSM) in 2004, which subsequently realised a £94m profit on full exit. Shares in Blue Prism rose 23-fold after I first highlighted the company’s potential just after the IPO in 2016 (‘Robotic growth’, 26 June 2016).

The bottom line is that I maintain my view that Mercia’s asset management business is worth around £30m (10p a share) and introduce a sum-of-the-parts valuation of £146m (48p a share), or 62 per cent above the 29.57p entry point in my market-beating 2019 Bargain Shares portfolio. Reassuringly, the directors and the management team are heavily invested, owning 23 per cent of the share capital. Strong buy.

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