Play the PE fund march with MJ Hudson

But how do ordinary retail investors get in on the action? One way is to invest in one of the private equity investment trusts that trade in public markets. Another strategy might be to simply buy the FTSE 350 Index and wait for the next wave of takeover offers.

A third option is to back the type of company that has sales that are linked to private equity fund activity. In investing, this is also known as a picks-and-shovel play, named after the businesses that made their money selling tools to miners in the 19th century during California’s gold rush. MJ Hudson (MJH), which listed on Aim in 2019, sells picks and shovels to the alternative fund industry. Specifically, it provides end-to-end services for the private funds world, where it expects to see strong demand growth over the coming decade.

It's not the only listed company of its type. Sanne (SNN), a provider of services to the alternative funds industry, was recently valued at more than 30 times forward earnings when it received a bid from Cinven, a (you guessed it) private equity firm. While comparisons between the firms are not precise – given the businesses’ differing maturity and cash generation – MJ Hudson's mixture of strong earnings growth, operational leverage and market focus means it offers many of the same attractions.

Small company, broad offer

Founded in 2010 in the credit crisis, MJ Hudson was originally conceived as a law firm specialising in private equity fund administration. This bent towards advisory work still accounts for around half of the top line, although this fell to £5.1m of the £11.3m in underlying revenue recorded in the six months to December as the pace of fund formations, closures and transactions slowed in the period. However, like Sanne, MJ Hudson management has since confirmed "strong signs of increased activity", as funds initially timetabled for launch in 2020 were delayed, along with the revenue this brings.

The rest of the company's services have been built up through the acquisition of smaller teams over the past decade, and are now grouped in a higher-margin business outsourcing division, a data and analytics arm and a separate revenue line for the still-nascent Luxembourg office.

This expansive strategy shows little sign of slowing down. Already in 2021, the company has announced a deal to provide ESG reporting services to clients of Japanese banking giant Mitsubishi UFJ Financial, refinanced its borrowings through a new £17.5m senior debt facility with Santander and acquired analytics group Clarus Risk for up to £3.5m.

As a result, MJ Hudson looks like a fairly broad church of services for a company valued at less than £100m and that has only just about hit the break-even point. Encouragingly, the breadth is reflected in a client base that stands at more than 1,000 and includes 18 companies in the FTSE 100.

This isn't an accident. Seeking to exploit the increasing complexity of fund management, the company has structured itself to cross-sell its services and push up group-wide margins.

“The drivers of our business are pegged to three trends,” the company's eponymous founder and chief executive Matthew Hudson told us earlier this year. “First is the growth in volume of AuM (assets under management) in private markets. Second is the growth in transparency and regulation; the harder the job of fund management gets the better it is for us. Third is the need for these funds, with fees under pressure, to outsource work.”

Given this backdrop – which one industry forecaster believes will equate to a 16 per cent annual growth rate until 2025 for private equity AuM alone (see chart and table) – investors expect MJ Hudson's top line to climb strongly in the coming years.

The result is that MJ Hudson shares are priced for growth, and trade on 35 times earnings for the most recent financial year to June. But the nature of the company's growth and the sensitivity of profits to rising sales (so-called operational gearing) means that the price/earnings multiple (PE) quickly slides to 18 for the year to June 2023.

Measured on an enterprise value to sales ratio – which provides a closer comparison with businesses with greater economies of scale – the shares look undemanding on a multiple of just over three. That's cheaper than asset management consultancy Alpha FMC (AFM) and less than half Sanne's multiple.

Just how much growth?

Quite how much this expected top-line expansion translates to future cash flows depends on many factors, including MJ Hudson's capital spending, acquisition pipeline and ability to boost and maintain margins. Fortunately, brokerage Investec – itself a corporate customer of MJ Hudson – has provided one estimate by way of a discounted cash flow model.

To do so, Investec assumes a 6 per cent annual growth rate from 2023 with a 2 per cent terminal growth rate, alongside a stable tax take and a combined operating profit margin of 30 per cent. If depreciation nets off against capital expenditure, then Investec reckons unlevered post-tax free cash flow of £9m is possible in 2025. Stretching this forward, the broker arrives at a value for the shares of 75p.

Of course, such long-term forecasting will inevitably fail to capture new sources of competition, market events and changes in the cost of capital. But Investec's numbers also look conservative. Not only do private equity industry growth forecasts point to double-digit top-line organic growth, but the data and analytics division – which grew 22 per cent on its own in the half-year to December – is targeting an operating margin of 40 per cent over time. Given MJ Hudson’s track record to date, one would expect plenty more acquisitions over the next decade.

The drawback with any high-growth strategy is the management of liabilities. And on the face of it, MJ Hudson’s balance sheet bears the hallmarks of a business that has been growing quickly. While at the end of December cash and equivalents stood at £2.4m after deducting for short-term borrowing, trade and other receivables, which stand for payments the company is owed, came to a hefty £12.4m.

At the same time, the business had £10.7m of liabilities to settle within 12 months, including £0.8m in leases and £3.3m in deferred consideration payments for previously acquired businesses. The balance was a somewhat toppy-looking £6.7m in trade and other payables, split between standard payments owed, accruals, tax and social security payments and contract liabilities. The latter includes a mixture of short-term advances to clients and partly deferred revenue, which climbed to £2.2m at the end of June 2020 following an acquisition.

Though investors will want to keep an eye on this, the business now feels any stress has been resolved with the Santander loan. Another sign of confidence in the company’s cash management is evident in the expectation of an inaugural dividend this year.

The sooner MJ Hudson can start to generate free cash flow the sooner we'd expect its business proposition to start to attract the attentions of more investors – and who knows else.