Bells rung on recent high-profile initial public offerings (IPOs) have turned out to be a death knoll for investors’ hopes, with companies such as Aston Martin Lagoda (AML) and Funding Circle (FCH) seriously disappointing. Not all listings go badly, but too often it seems companies go public to create a windfall for existing stakeholders, rather than genuinely to raise money for expansion.
Overall, including successful IPOs, research by Merian Global Investors shows expected growth rates for the first two years after listing are typically around 50 per cent of those achieved in the two years pre-IPO. Such disparity raises concern investors in public markets are missing out, especially as companies in emerging industries such as fintech show a propensity to stay private for longer.
On average, the time between new companies’ date of incorporation and when they IPO has risen from five to 11 years, a trend underpinned by the multitude of financing options available to businesses. With cost of capital suppressed by low interest rates and competition to invest in their equity, innovators can eschew the short-term focus on earnings that comes with a public listing and work with patient investors who back their vision.
Closed ended funds open venture capital and private equity opportunities
Investment companies are one of the few ways retail investors can access growth opportunities off exchange. Unlisted investments have no guaranteed price discovery mechanism of their own, so being able to publicly trade the shares of holding investment companies adds a layer of liquidity. The caveat is investment companies’ share prices fall in periods when it is hard to realise value on underlying portfolios. Yet, given the problems open-ended funds have faced liquidating unquoted assets to meet redemptions (another issue highlighted in the Woodford saga), closed-end structures are a more attractive option.
For investors who can afford to sit tight during economic uncertainty, a wealth of opportunity in venture capital and private equity is unlocked. Historically, start-ups would have been considered the domain of venture capital, with private equity more likely to target management buy-outs and spin-offs of corporate divisions. Nowadays, the trend in companies staying private and the prominence of tech and tech-enabled disruptors creates cross-over and competition for equity in these businesses. That said, asset managers exist in a variety of structures and investment companies specialise in different industry sectors and stages of funding, so there is great diversity in exposure and management style.
Path to profitability crucial for technology
Haunting memories of the dotcom bubble encourage scrutiny of technology businesses, especially those yet to turn a profit. Some investors will baulk at entrusting money off exchange, where there is less official requirement for visibility, but specialist fund managers are well placed to assess companies’ progress towards sustainable earnings growth and cash generation.
Augmentum Fintech (AUGM) holdings include digital investment platform Interactive Investor; pan-European challenger banking service Monese; providers of banking services to small-to-medium enterprises (SMEs) like Tide and Iwoca; and Zopa, the world’s first peer-to-peer lending platform. Some of these brands are gathering prominence but the key to Augmentum’s approach, described by chief executive Tim Levene, is “not being seduced by the sizzle, but by the substance” of opportunities. He also stresses the importance of board representation (and therefore full information rights) and a manageable sized portfolio of investments: “You can’t spray and pray your cash hoping for rocket ships”.
If a business isn’t yet profitable, Mr Levene lists acquisition costs, break-even points, retention rates and the expected lifetime value of customers as key performance indicators, and evidence of a scalable addressable market is crucial. What would make him nervous by contrast is “a business blindly building a customer base, where there is no certainty of long-term viability because [customer] unit economics aren’t compelling”.
Finding a niche, adding value and economic moats
Augmentum invests as a straightforward investment company, although its approach to stewardship has plenty in common with private equity firms that take great interest in helping businesses appoint experienced non-exec directors, recruit talented senior staff and manage capital structure. Adding value during the holding period means a profit on exiting the investment is more assured than just relying on continued froth in capital markets to drive up the price.
One drawback of investing off exchange is the competition for quality assets bids up prices to an extent that creates significant valuation risk. Global private equity monitor Preqin estimated at second quarter’s end 2019, private equity funds globally had $1.54 trillion cash not invested (referred to as “dry powder” by the industry). Combined with demand from sovereign funds, corporate M&A activity, pension and endowment funds, upward pressure on prices is inevitable.
There is, however, enormous variation between fund strategies. Just as Augmentum specialises in providing venture capital to fintech firms, private equity groups with a niche are better placed to meet the challenge posed by valuations. Oakley Capital, which is a limited liability partnership (LLP), has a series of funds that invest in unquoted equity, with a specialty in European businesses founded by entrepreneurs.
In private equity partnerships, the general partners (GPs) manage the investments in the funds, that are made with capital raised from limited partners (LPs), which can include large institutional funds or family offices and, in the case of Oakley Capital, its listed closed-end investment company Oakley Capital Investments (OCI). As well as stakes in the Oakley Capital managed funds, OCI has some direct co-investments in private equity, that are managed by Oakley Capital.
Recent deals by the managed funds have demonstrated a flair for merger and acquisition activity and a focus on buying into businesses with proven cash flows, scalability and barriers to entry. In May 2019, the acquisitions of maritime e-learning businesses Videotel and Seagull, were combined in a deal described by Partner Rebecca Gibson as representing “the sweet spot” of Oakley’s investing strategy. Synergies were identified to cut overheads and improve technologies that provide mariners with safety training that is required both by government regulators and insurers – so future revenue streams are very stable. On valuation, Ms Gibson emphasises discipline in bidding for assets to ensure Oakley maximises upside from the benefits it brings to businesses: “[we] don’t pay for the synergies up front”.
The partnership’s overall portfolio is split across three main areas – TMT (technology, media and telecoms), education and consumer. The acquisition of a controlling stake in German e-gift card business Seven Miles in August 2019 added a business to the portfolio that is well placed to take advantage of a market expected to grow at 15 per cent a year. Seven Miles offers digital gift vouchers that can be redeemed at multiple retailers. Its technology is difficult to replicate, and 80 per cent adoption by German retail partners provides another barrier to competition.
Much is owed to a network of entrepreneurs, which Ms Gibson cites as a key differentiator, “[these types of] opportunities don’t often cross the desks of other groups”. Operating in this segment of the private equity space has helped Oakley add value and, as a common exit strategy has been to sell assets on to other private equity or strategic corporate buyers, arguably it has turned demand for quality to its advantage.
Diversification across the private equity universe
Broader investing strategies manage the challenges of private equity valuations differently. Pantheon International (PIN), is the oldest PE fund-of-funds listed on the London Stock Exchange (LSE). Since inception in 1987, it has achieved a compound annual growth rate (CAGR) of almost 12 per cent in terms of net asset value (NAV), and share price gains have been at a rate of 11.5 per cent a year.
The investment company is referred to as PIP (although the ticker is PIN) and it invests across the private equity universe, diversifying exposure across geographies, industries and managers – including fund maturity and the stage of investment they specialise in. Although the portfolio is exposed to dozens of different funds and companies, there is a rigorous methodology behind risk allocations. Primary funds, where the managers have initiated a private equity investment, make up 27 per cent of the portfolio; 40 per cent of the portfolio is allocated to secondary funds (that acquire interests in private equity); and 33 per cent is co-investment in businesses alongside PE managers.
Although the investment universe is broad, Partner Helen Steers says PIP is very actively managed, with flexibility to tilt the portfolio between sectors. Close attention is paid to the liquidity profile of the portfolio as well as generating cash to reinvest in the vehicle. Recognising large buy-outs as a funding stage where multiples are inflated, 60 per cent of the portfolio is focused on small- and mid-sized buyouts and growth strategies. There is enormous dispersion of returns in the PE sector and Ms Steers emphasises there is 2,000 basis points difference between the top and third quartile of PE funds’ performance.
Getting manager selection right is a balance of qualitative and quantitative factors. “On the quant side, we look at track record in terms of creating value and identifying sustainable cash flows, patterns where money has been made and the size of deals.” In making qualitative judgements, Ms Steers is also an advocate of managers being represented on boards of companies they invest in and being sure they “have a deep bench of [industry] experts around them”.
Being on the right side of IPO
The thriving private capital eco-system incentivises companies to tap public markets at a later stage in their development, although thanks to appetite for growing businesses, companies can raise significant capital cheaply when they do choose to list. The UK government has proposed changing listing rules to help tech start-ups but, as the Merian Global Investors data shows, for investors there is huge value to be had getting exposure before listing takes place and profiting from IPO as an exit strategy.
MGI’S Merian Chrysalis (MERI) investment company was launched in November 2018 to invest in a pipeline of companies in stages of pre-IPO funding. Chrysalis benefits from the group’s wider experience buying into successful IPOs such as Boohoo (BOO) and Fevertree Drinks (FEVR) via its open-ended funds. Fund Manager Richard Watts also says, having invested in companies such as Rightmove (RMV) and AutoTrader (AUTO) at the point of IPO, they understand how the market will value tech-enabled businesses at IPO.
‘Unicorn’ has several uses in digital vernacular, one was coined in the US to describe tech businesses valued at $1 billion or more just prior to, or after, IPO. Profits realised on Nasdaq listings have heightened interest in Europe and, interestingly, research from Dealroom.co shows it is mainly American and Asian money leading the way.
The UK has been a particularly fertile breeding ground with 57 realised unicorns (ie, that have gone public) and 18 unrealised (that might decide to IPO, be taken over or simply continue to grow as private businesses). Unrealised off-exchange unicorns include food delivery business Deliveroo, fintech vanguards such as neo-banks Monzo and Revolut and companies such as BenevolentAI (which is developing artificial intelligence). Some of these brands are increasingly well known, exactly the sort of businesses that attract a high price on floatation.
Chrysalis has stakes in Graphcore, a semi-conductor business and Klarna, Europe’s most valuable fintech unicorn. Co-investors include a variety of leading institutions, which helps develop liquidity. The unicorn definition is now used broadly to include tech-enabled as well as core technology businesses, and Chrysalis holdings with potential to attain unicorn status include discount luxury travel business Secret Escapes and Starling bank – a pure fintech play.
With low cost bases and scalable marketing plans to access cheap retail deposit funding, Mr Watts is bullish on the potential of digital neo-banks to disrupt incumbents. He argues that although retail banks are investing heavily in technology, they are too slow and bureaucratic to out-run the nimble inroads neo-banks can make into their customer base. Starling is tantalisingly on the threshold of 1m customers and the landmark of £1bn in retail deposits is predicted to be passed soon afterwards.
Starling won’t be the only successful disruptor. Unlike search engine businesses at the end of the 1990s, Mr Watts doesn’t think one winner will take all in digital banking, although “early mover advantage will be with the likes of Starling, Monzo, N26 and Revolut [that have already raised significant capital], rather than later entrants”.
Rising interest in off-exchange, but does PE have an image problem?
Investors seem to have bought into the Chrysalis philosophy, and the fund has made successful capital raises. Morningstar data has the MERI share price trading at a 5 per cent premium to its last published NAV – at the end of June – reflecting confidence that it will continue to find attractive deals to put funds to use. Interest in fintech has also seen Augmentum’s share price closely track NAV, but it is still a cheaper way to back innovation than shares in Big Tech.
By contrast, the private equity vehicles are trading at a deep discount, with OCI shares at around 30 per cent and PIN shares about 20 per cent of NAV, respectively. Admittedly, OCI did score an own goal in January 2017 issuing shares at below NAV – a move poorly received by existing investors. Oakley’s head of investor relations, Steven Tredget, says the company has no plans to repeat such a move but argues the wider issue for the PE industry is negative perceptions after the financial crisis of 2007-09, when companies that used massive leverage to fund buyouts became unstuck. He says PE companies are now far more conservative, and across the industry net debt is at a far lower multiple of ebitda (earnings before interest, tax, depreciation and amortisation), compared with before the crisis.
Helen Steer at Pantheon agrees, she says PIP makes stress tests against crash scenarios. Managers they use “remember what happened 10 years ago, and have scars on their backs. They aren’t just out of business school with a bright idea.”
Fundamentally, the risk of less liquidity in underlying assets and the longer-term premium for investments to come good needs to be rewarded. This means the projected profits of businesses held, and the price paid for them, needs to imply a degree of upside above that of more liquid investments. Companies such as Augmentum and Merian Chrysalis that invest at the vanguard of new industries are not on a discount but they remain considerably cheaper than big tech disruptors.
In the case of PE vehicles such as PIP and OCI, investors may be waiting to see how resilient investments are in the next crisis before they reappraise the asset class. That said, with underlying investments that have many hallmarks of quality businesses, the discounts on offer now imply an incentive to take that chance earlier, at least with a portion of capital that can be committed for longer.
For all the features in our Investment Trust special, click below:
Trusting in fast-growing unlisteds
IC investment trust income portfolios: 12 months on
Investment trusts: professional picks 2019
Around the world in 8 investment trusts
