Asset managers are back – and this stock is a unique proposition

The main reasons appear to be increased investor confidence in the economic backdrop, as well as the realisation of the limited appeal of staying in cash with inflation still in the high single digits. That said, asset managers cannot rely on macro factors to tempt investors to buy their shares. These days, size is seen as a disadvantage, which only really leaves specialisation and geographic focus as sources of differentiation.

We have previously highlighted how smaller managers with interesting niches can dominate specific corners of the market. Mercia Asset Management (MERC) relies on its venture capital-style investments in regional businesses within the UK to stand out from its sector peers. On the evidence of its fund flows, it is a formula that has succeeded in attracting interest from investors with an appetite for early-stage investments – albeit within the context of a listed company, and without the use of leverage that has turned private equity funds from financial wizards to debt-burdened figures to avoid in the space of two years. In that context, Mercia’s leverage-free model and regional focus has echoes of the old 3i (III) regional investment business model.

Preliminary results for the year to March showed promise, even if the variations around fair value investments caused wide fluctuations in reported income. From an investor perspective, the key number was the organic fund inflows of £134mn, with no redemptions, showing that Mercia seems to have the relationships in place to keep investment funds flowing in the right direction.

The return of the NEB?

The £134mn figure was broken down into three main funding streams: the retail investor channel contributed a total of £74mn through its tax-efficient enterprise investment scheme (EIS) funds and Mercia’s Northern venture capital trusts (VCTs). Another £30mn came from institutional investors and £30mn came direct from the British Business Bank (BBB).

Interestingly, this wholly owned government bank – which started in 2014 and invests in businesses outside London – proved to be a broadly effective way of distributing pandemic recovery loans and has been building a profile as an investor in small- to medium-sized enterprises (SMEs) via a series of area-specific investment vehicles. The bank’s last annual report listed Mercia as its official delivery partner in the Midlands.

Both main political parties seem enamoured with the concept, which is a positive for Mercia in that a possible change of government next year is unlikely to impact its relationship with the BBB. On the contrary, the Labour Party’s stated objective is to give the bank greater autonomy and independence in its investment decision-making, so a sudden cut-off of funds for regional investment in local businesses does not seem to be on the cards. Readers of a certain age will remember the old National Enterprise Board functioning along similar lines.

The company’s investment model prioritises companies outside of London and at the year-end it had £165mn invested in 176 firms, with 85 investments added during the last financial year. Levels of unrestricted cash of £378mn suggest that the future funding of its investment programme will not prove difficult, £250mn of which has been earmarked for deployment in the 12 months to March 2024.

Such direct equity investments have an attraction for companies at a time when the cost of debt, particularly for SMEs, has risen hugely. According to the BBB’s own figures, around 41 per cent of small businesses expect  access to new finance to dry up over the next 18 months, creating an opportunity for equity investments in a tight financing environment. The company offers lending services if needed with the top level of loans capped at £10mn.

Tech: downside or enduring appeal?

While technology company valuations have been recovering at the top end of the market, as this year’s run-up in the S&P 500 shows, the topic remains a delicate subject for many investors. Particularly in private markets, a narrowing of the obvious exit strategies for growth companies has cast considerable uncertainty over sometimes toppy paper assumptions.

This creates a clear valuation problem for Mercia’s technology funds as fair value changes must reflect falls in sales at key companies and relatively low, if still profitable, exit prices for buyouts in its portfolios. In the year to March, Mercia’s software investments were either flat, or in relative decline, while the faster paced video game segment enjoyed good growth, which offset some of the falls. The single successful sale of Intechnica Holdings, a software and technology consultancy business, generated £3.7mn in cash proceeds for Mercia’s 25.5 per cent stake, equal to a 1.7 times return on its original holding value.

However, management has noted that potential acquirers have stepped back from businesses with high cash burn rates or insufficient signs of growth. One disappointing example was the exit for Sense Biodetection, which sold for a fraction of its indicated value after US-based investors pulled out, causing a realised loss of £2.6mn. This was just a small reminder that early-stage investors run high risks, as well as potentially reaping high rewards.

There are also the usual caveats over investing in illiquid assets as there have been plenty of famous examples of funds getting caught out by a rush of redemptions and having to close the doors to meet them. For Mercia, if its portfolio is not over-concentrated, it should be able to manage the redemption risk. Plus, the majority of investors in its funds will recognise the importance of backing start-ups over years, and the need to keep capital committed until market conditions improve.

Finding a straightforward valuation metric isn’t easy, as the fair value changes in Mercia’s portfolio can complicated its earnings figures, which also makes direct comparisons with its nearest peers difficult. With around £1.4bn of funds under management – with around 45 per cent in venture funds, 3 per cent in private equity, 40 per cent in debt funds, and the balance in proprietary capital – it does not have the scale of tech specialists such as Polar Capital (POLR), nor the unique business model attributable to Tatton Asset Management (TAM). But with a share price at a discount of 50 per cent of reported NAV, investors appear to have overlooked Mercia’s good track record in cash realisations and start-up incubation, and the fact that its own direct investment portfolio saw a small net fair value gain in the most recent financial year. What’s more, the size and scale of its investments should mean it can do this more nimbly, and that just a handful of investments need to be sold each year to help cover overheads.

Broker Canaccord sees fair value at 61p, a metric which blends 20 times fund management profits and a projected net asset value (NAV) of 46p for 2024. Even though Mercia’s portfolio is exempt from the volatility that tends to affect asset managers with market-based portfolios, recent sentiment toward the stock suggests that looks a tad optimistic. All the same, there are good grounds to believe the stock should be able to close the NAV gap as Mercia continues to attract funds from multiple sources.

With strong connections to the BBB, Mercia’s scale and access to regional development funds are clearly strengths. In many ways, it is less an asset manager and more a transmitter of government funds, which makes it a unique proposition within the asset management industry. It is true that what the government gives, it can also take away, but with the political mood music still in favour of encouraging regional development – avoiding overconcentration on London and the southeast – the immediate future looks secure.

If investors want a company with a strong and unusual niche – albeit with some risky asset exposure – then Mercia fits the bill.